How to choose an absolute return fund
30 September 2016
As their name suggests, absolute return funds aim for positive returns in all markets. Normally they will target a stated level of return, such as ‘CPI +4% net of fees’ or ‘cash plus 3%’ and usually this will be over a specified period.
At Defaqto, when calculating our Diamond Ratings for absolute return funds one of the criteria we rate them on is the rolling time objective (period to achieve the absolute return), with shorter time horizons receiving a greater score as the hurdle is higher.
Absolute return funds will generally use derivatives and similar strategies much more extensively than other types of fund, therefore we consider important and also include fund manager tenure, total manager(s) years’ experience and number of supporting personnel as part of the rating, due to the extra experience, resource and risk control required.
Multi-asset absolute return funds are scored higher than single-asset ones as the former will have greater sources of alpha and diversification, all else being equal, thereby aiding the absolute return objective.
In terms of outcomes, we look at the following:
- Conditional Sharpe ratio, which is a variant of the more commonplace Sharpe ratio, with the risk of the fund being measured by the average of the worst 5% of all daily returns over the measurement period
- Calmar ratio, again similar to the Sharpe ratio but with the worst peak to trough drawdown of the fund over the period as the risk measure
- Batting Average, a measure of how often the fund has met its targeted absolute return objective over the period
As can be seen from the first two bullet points, risk adjusted performance is being measured but with the focus here on downside risk, as opposed to the Sharpe ratio which considers and penalises large deviations both above and below the risk free rate.
Other factors we use as part of our rating for absolute return funds include ongoing charges, group AUM and number of distribution partners.
All of the above scores are then added up to give an overall Diamond Rating for each fund, with Conditional Sharpe, Calmar and Batting Average receiving extra weighting such that performance accounts for 50% of the rating. Our Diamond Ratings therefore show where each fund sits against its absolute return peers in terms of the criteria that we believe to be important.
Many of the generic fund selection factors will also apply when selecting an absolute return fund: strength of underlying business, quality of the fund managers and the investment process.
Absolute return funds have grown in popularity and use over the last few years, due mainly to (1) the recent Pension Freedom reforms, with absolute return funds being seen by some as an alternative to annuities and (2) investors trying to avoid similar large market falls to those seen in recent times, in particular 2008. However, there has been a large dispersion in the performance of such funds, with many failing to deliver positive returns, therefore great care is required when selecting an absolute return fund and also monitoring it on an ongoing basis.