Andrew Short asks if absolute return funds are failing to fulfil their remit and whether they still have a role to play in today's fund portfolios
Absolute return funds have been hit from every angle of late. The assault began in the retail space with ratings agency Fitch sending out a scathing press release stating the funds were prone to mis-selling because of a lack of understanding.
Next up, FE Analytics found that in a 12-month period only 43% of absolute return funds beat inflation in the Investment Management Association (IMA) absolute return fund sector (adding that after fees the figure could be higher).
Finally, S&P remarked in a recent report that the performance and investment strategies of funds defined as absolute return varied considerably and that the promise of absolute return was a target rather than a promise.
So are absolute return funds failing and are these concerns being carried over to the institutional market? The main difference here is that institutions tend to be more sophisticated, have bigger budgets and more experienced staff.
Many investment professionals believe absolute return funds have many benefits, and that an understanding of them is crucial for trustees to get the most for their scheme’s portfolio.
Trustees also need to understand that a long-term view needs to be taken with these products as they may not always pay out in the short term.
For those looking to get to grips with the concept of absolute returns, a good place to start is the Pension Management Institute glossary.
The definition of absolute return given here is: “an investment strategy that tries to achieve a given level of long-term return, often related to cash, rather than related to a benchmark.”
However, in the real world the definition breaks down. Many pension funds will be attracted to the lure of wealth protection and returns related to a cash benchmark.
However, some absolute return funds use an eclectic mix of investment strategies that may invite equity-like volatility rather than cash.
“A lot of fund managers offer and I’ll put this into inverted commas ‘absolute returns’ in many guises,” says Natixis head of UK/Ireland business development unit and global consultant relationships Terry Mellish. “For example, dressing up a long-only, concentrated UK equity portfolio as an absolute return fund.”
This will certainly mislead trustees, who may not have the time to investigate what underlying investments the funds have.
They may get a shock when things do not go according to what the absolute return label implies.
International Asset Management chief executive officer Morten Spenner concurs with this view:
“No disrespect but if a person who is not familiar with investments comes across the term absolute return; I can see what type of signals managers are trying to send to that individual and I suspect they take that in good faith,” he says.
However, how much focus should really be given to the exact asset allocation of an absolute return fund? Mercer principal Simon Fox believes absolute return should be viewed as more of a “manager’s philosophy and approach” as opposed to representing a type of investment.
It is a form of active management that shifts assets depending on performance and is not hinged to market index returns.
A new definition?
In a recent report, Fitch states that opaque definitions of these types of funds can lead to what it calls “style drift”.
In the retail market there have been calls for the IMA to re-define what they call absolute return and split it into a number of sub-sectors between funds that use structured products and derivatives.
Many believe this will help investors understand absolute return more clearly. The IMA is currently reviewing its absolute return sector and there have been calls from consultants to undertake a similar exercise in the institutional market.
“The industry needs to come up with a definition to emphasise there are differences,” says Barnett Waddingham associate Alex Pocock.
“When managers launch new funds they look to ensure key words appear in the fund name you see funds being named ‘diversified target absolute return’; they are dying to get into every database.”
There are those who believe taxonomy will do nothing to negate the misunderstandings with absolute return and that the term itself should be done away with.
International Asset Management’s Spenner feels that a clearer definition would merely be an act of pacifying investors rather than increasing their understanding of the absolute return concept.
He continues “Frankly, I would prefer that people moved away from the term, simply because there is so much confusion.”
Hedge funds in a tuxedo
This confusion also lies in the perceived similarity of absolute return funds to say, hedge funds. Aon Hewitt UK head of liquid alternatives Guy Saintfiet views "hedge funds as absolute return products".
Both strategies seek to dampen the effect of market falls with a variety of tactics.
International Asset Management's Spenner feels marketing departments have shifted towards using the term absolute return as it is seen as more palatable to people who remain wary of hedge funds.
"We have seen through the network that boards and committees like the concept of absolute return but don't want to discuss hedge funds. That puzzles us what are the differences?"
Trustees, as mentioned, may be lulled into a false sense of security by the term, but they do have a fiduciary duty to understand what they are investing in.
They must peel back the layers and find out how the fund is made up. "With absolute return you need to look beyond the label.
It's important how trustees spend their governance budget to do this," says Cardano head of solutions Ralph Frank "Looking at the fund's investment approach and resulting structure is key.
Trustees should not simply follow fashion because everybody is looking at absolute return."
So after all the due-diligence has been done and a pension fund has decided to invest in an absolute return strategy, what part of the portfolio do they re-allocate assets from? Frank believes it is not a substitute for any part of the portfolio, but can enhance the overall portfolio construction.
"UK pension funds have three very large risk exposures: underexposure to interest rates and inflation, with these exposures you can't take money away to reduce risk; you need to get it in. The third is being overweight in equities. The equity holdings are typically where any re-allocation is fed from. Reducing equity exposure is expected to enhance diversification with portfolios," Frank says.
Mercer's Simon Fox agrees that many UK funds are overweight equities and that absolute return funds can play an important diversifying role in a portfolio.
"Typically, we see absolute return as one of the growth assets in a portfolio. And for the majority of clients that means assets being sourced away from equities," he adds.
This move away from long-only equities in the portfolio may help to limit asset drawdown.
Say, for instance, equities in your fund fall by 20% you need to climb all the way back just to get level again. Spreading investments may help to limit this.
So it is clear absolute return funds do have a role to play in a fund portfolio.
While taking a short-term view on these funds may produce disappointing results, over the longer term many providers believe the funds will beat the markets.
What is most important is that the concerns around absolute returns highlighted in the retail market seem to be unfounded in the institutional market.
Those willing to take on board the absolute return investment philosophy look set to benefit from the increased diversity and lower volatility these funds can offer.
GAM Investments has begun the liquidation process of a number of its absolute return bond funds following the suspension of one of its lead fund managers.
Pension schemes are being urged to brace themselves for more volatility in the fixed income markets next year and to expect smaller returns from government bonds.
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