30 June 2015
Jason Baran – Insight Analyst (Investments)
Pension freedoms and low interest rates are focusing investor attention on retirement incomes and how they can be achieved from investment portfolios. A key consideration is the use of absolute return funds.
Indeed, since the UK pension freedoms were implemented in April 2015, the Targeted Absolute Return sector recorded its highest ever net retail fund inflows, £529 million in April (source: Investment Association).
Accumulation versus decumulation
The vast majority of funds available in the UK market are aimed at saving in the run-up to retirement, that is the accumulation phase. While diversification is a consideration, the primary aims are maximising returns over the long term and increasing the size of the eventual pension pot.
Now, with pension freedoms, investors can also use funds as part of a decumulating portfolio. Within the funds currently available that blend in with these solutions, absolute return funds provide a well-fitting solution. Targeted absolute return funds aim to lower the risk of capital impairment by specifically targeting positive returns over a set time period.
How to assess absolute return funds
Now that we have seen how absolute return funds can be used as part of a decumulating portfolio, we are still left with the issue of how to assess them. Absolute return funds use a wide variety of investment strategies, but we can look at other aspects to gauge their risk and performance.
Targeted return objective
The first and most obvious factor to consider is how does the fund objective compare against what is required. A fund targeting positive returns over a 12-month period will have lower volatility and hence lower risk than a fund aiming for positive returns over a three-year period or longer.
Secondly, we can measure the historic performance against the stated investment objective. For example, a fund that has targeted a positive return over any 12-month performance period but has only actually delivered that half of the time, would raise some concerns.
We can also gauge historic performance on risk adjusted measures, for example comparing funds against each other for return, volatility, Sharpe ratios and drawdown measures. In particular, as we are very concerned about permanent impairment to capital, we should focus on tail risk measures.
This includes drawdown measures over different time horizons, and conditional value at risk to provide an average of the worst returns from a fund historically. In addition, these risk measures can be combined with the fund returns to calculate modified Sharpe ratios, such as the Calmar ratio and Conditional Sharpe ratio.
Another area to look at is how the funds have performed during turbulent market periods. While this can prove a little tricky given the relatively low volatility of most investment markets since 2008, there have been a few notable periods during which volatility rose and there was some sense of ‘panic', for example the taper tantrum during 2013 or various wobbles caused by Grexit concerns. During these periods we can compare funds for volatility, drawdown and risk adjusted performance.
Number of fund managers and their experience
Absolute return funds need to consider and incorporate different investment views in order to provide stable future returns. A key part of this is being able to accommodate sometimes opposing investment ideas so that the fund still performs under different scenarios. For this reason it’s an advantage for absolute return funds to have multiple fund managers with a long career history.
Funds that have exposures and strategies covering several asset classes tend to be better able to source returns and diversify. All else equal, multi-asset funds should provide smoother risk adjusted performance.
Funds that are better resourced will have large supporting teams beyond the lead fund managers in order to provide economic and security research, risk control and dealing functions. The most sophisticated funds have these areas set up as dedicated resources for the absolute return fund as opposed to shared with other business units in the firm.
Also, in common with other more traditional investment funds, funds with high fees will act as a drag on net returns to the investor. In particular, and in common with their hedge fund background, some absolute return funds charge performance-related fees as well.
Complexity versus suitability
Absolute return funds are capable of providing a good solution to decumulating investors' portfolio needs. The funds may appear more complicated at first glance, and this is due to their encapsulation of running many strategies at once. However, their appeal should not be ignored and it's possible to understand and break down an absolute return fund’s performance, for example using the criteria mentioned above.