How to navigate absolute return funds

19 November 2018

Jason Baran explains what an absolute return fund is, and why the sector has been criticised by the regulator.

This article was originally published on FTAdviser.com, and updated in November 2018.

Jason Baran, Investment Consultant (Funds & DFM)

The Investment Association Targeted Absolute Return sector has been one of the top sectors for investment inflows over the past few years, primarily driven by retiring baby boomers and pension freedom reforms implemented in 2015.

The reasons for this are two-fold: firstly, low returns among annuities and other ‘traditional’ retirement investments, and more retirees using pension freedoms to run drawdown portfolios.

However, it has also been one of the top fund sectors to receive criticism.

These funds have been called opaque, difficult to understand, and criticised for not meeting their objectives. In particular, some of the larger funds in the sector have been attacked for lacklustre performance over the past year.

The sector has also drawn attention from the Financial Conduct Authority (FCA). In the FCA’s Asset Management Market Study, released in June 2017, it echoed the criticisms above while also highlighting absolute return funds not measuring themselves against stated benchmarks in fund marketing, and charging varying performance fees on top of the ongoing charges figure (OCF), thereby making comparison between funds difficult.

In light of these drawbacks, it’s no surprise that advisers and their clients find the sector confusing.

Sequencing risk

Why are absolute return funds proving so popular with investors post-retirement?

The main reason is sequencing risk.

Below (see figure 1) are two examples of an investor in retirement using their investment fund to provide an income. One investment has a smooth return profile, while the other is more volatile and with some negative returns early on.

Importantly, both have the same average compound return over time.

Figure 1: Return profile comparison

Source: Defaqto

If this were an accumulation investor, then the final portfolio would be the same in both cases.

However, let’s say an investor is drawing 4 per cent from the portfolio each year to provide for a post-retirement income.

The impact on the portfolio value at the end of each year can be seen in Figure 2.

Figure 2: Drawdown portfolio comparison

Source: Defaqto

In this 4 per cent drawdown case, the final value of the portfolio with volatile returns is roughly 27 per cent lower than the portfolio generated by those with smoothed returns.

Hence, the order of investment returns clearly matters for decumulation investors. Here we are experiencing sequencing risk, or as it’s also known ‘pound cost ravaging’.

Should an investor experience a long period of low returns in their fund, then the long-term income generation of the fund may be permanently impaired.

What are absolute return funds?

The key criteria for being an absolute return fund is that it must state, within its objective, a time horizon for when it will deliver a positive return.

In-keeping with sequencing risk, by aiming for a positive return over a defined time period, sequencing risk can be reduced, akin to smoothing the investment returns as illustrated above.

However, what is confusing for investors is that beyond this definition, the fund strategy can be anything. It could be a long only multi-asset fund, or a long short equity or bond fund or, like some of the larger and well-known funds, multi-strategy and using a significant amount of derivatives to target very specific exposures.

These different absolute return fund investment strategies can be confusing.

1.    Long-short equity or equity market neutral strategies

Most investors are comfortable with the notion of owning company shares via a fund that attempts to beat its benchmark. However, a long-short equity fund ‘goes long’ and buys company shares that it believes are undervalued, and borrows (and sells) to ‘go short’ shares in companies that the fund managers view as overvalued.

The benefits to this are firstly to take advantage of more mispricing opportunities on the short side within equity markets, and also to reduce net exposure to the equity market. In the latter case, if equity short exposures roughly cancel the fund’s long holdings, then the fund’s directional exposure to the underlying equity index is similarly reduced and the fund is then positioned as ‘equity market neutral’.

2.    Long-short bonds

Quite simply the same strategy as long/short equity, but involving bonds and fixed income securities only.

3.    Multi-asset

Generally, these funds invest in a diverse range of assets, but are long only. This will include fixed income, equity, property, commodities, infrastructure and others. Generally multi-asset funds will not use a large number of derivatives, except for efficient portfolio management.

4.    Macro funds

Very similar to multi-asset funds, but with more focus on global macroeconomic themes and events. Macro funds tend to be very top-down and are likely to employ more futures and derivatives than a multi-asset fund, for example, to make long and short foreign exchange positions or short a commodity.

5.    Multi-strategy funds

Potentially the most complicated of all the absolute return fund types, these funds aim to involve any strategy that is capable of generating a return. Multi-strategy funds can include any of the investment strategies mentioned above.

In theory, multi-strategy funds are more diverse than single strategy funds, and frequently employ specialist quantitative risk analysts to understand all the positions within the fund, how they are diversified and their potential performance during stress test periods – both historically occurring and hypothetical.

In all the absolute return fund types described, an adviser should do their due diligence to understand the structure of the investment team and the range of expertise informing positions into the fund. The number of personnel and level of experience within the risk team can be very illustrative of how well ‘targeted’ the fund’s absolute returns will be.

Absolute return funds may appear complicated, however, an adviser should consider against other decumulation investments.

For example, direct property holdings are often mentioned as providing steady income generation and are also purportedly suitable for retirement. It is questionable whether investors properly appreciate the illiquidity risks when investing in property, as seen with the various redemption holds that were put in place following the Brexit vote in 2016.

Arguably, at least with an absolute return fund you are much more likely to have more diversification. Many retail investors often do not grasp this point.

How to assess risk

For most advisers looking to avoid sequencing risk for their clients, the first measure to focus on is the absolute return time period. Typically, funds in this sector target being positive between over any one-year to three-year period.

The shorter the time period, the less risk the fund is likely to take and the lower the drawdowns the fund could achieve.

Some absolute return funds also target any five-year period, but it is questionable how useful this is for an investor who is post-retirement and attempting to avoid the effects of sequencing risk. A fund with this time horizon has more chance of experiencing a longer period of losses, thereby increasing the potential effects of sequencing risk.

Another way to measure the risk of absolute return funds is to consider how they have performed in volatile market periods.

While not many absolute return funds were around during the 2008 global credit crunch, there have been smaller market events since then such as 2011’s ‘taper tantrum’ (when the US Federal Reserve indicated it may start raising interest rates), or the UK’s Brexit referendum vote in the middle of 2016.

During these short-term volatile market episodes, a decent absolute return fund should limit losses and remain stable.

Remember, well managed absolute return funds seek to generate stable returns during all market environments in order to reduce sequencing risk. Funds making simplistic directional bets are likely taking too much risk and the volatility of the returns can be just as important as their size.

Performance pitfalls

The main difficulty investors face when assessing absolute return fund performance is that many funds have only launched recently, so there are a limited number with a decent length of performance history.

From the Defaqto Engage data, only 60 funds in this rating universe have a five-year or greater history available.

In spite of the short history of most funds and markets exhibiting low volatility in recent years, many funds still find it difficult to meet their absolute return objective.

If we consider the time horizon stated by a fund we can look at all the underlying rolling periods in the fund’s history. For example, if we were to consider a fund with a three-year absolute return target that has five years of performance history available, we would have 24 periods of monthly return for the fund to meet its absolute return target.

Surprisingly, according to the Defaqto Engage data, only a quarter of absolute return funds have met their time horizon objective over all time periods since fund inception.

This is a disappointingly low number, and it’s no surprise that the FCA is still looking at the sector.

However, what is interesting is that within this 25 per cent of successful funds, are some of the well-known names that have come under criticism in the wider financial press for underperformance. It would appear that at least looking at the absolute return time horizons, this criticism is unwarranted.

Fee transparency

Another confusing area for investors is the transparency of absolute return fund fees.

Looking at absolute return funds within the Defaqto Diamond Rating universe, the OCF averages 1.09 per cent across 129 funds.

However, approximately two thirds of these funds also charge a performance-related fee which can range from 10 per cent to 20 per cent of performance above a benchmark (typically three-month Libor), a hurdle rate of 5 per cent, or just any annual positive return, subject to a watermark.

To make this even more unintuitive, there appears to be little connection between the performance fee and the objective of the fund.

For example, of those charging an annual performance fee, approximately half of those are aiming for an absolute return over three years.

It would make more sense to have a performance fee relating to three years’ rolling performance. Instead, all performance fees are paid on an annual basis.

Additionally, for absolute return funds being offered from the same fund house, the OCF and performance fee can vary widely.

Performance fees can be used to align fund manager and client interests, but generally we find their implementation within absolute return funds to be excessive and not matched to fund objectives. It is probably no coincidence that funds with a performance fees also have higher than average OCFs as well.

It’s understandable that the FCA highlighted performance fees as one of its concerns with the sector.

Advisers would do well to double check the fees listed in each fund’s Kiid document and compare with other funds before recommending to a client.

The importance of research

With pension freedoms still applying, it’s very likely that absolute return funds will remain popular with post-retirement investors.

Advisers can overcome many of the criticisms of the sector by carrying out further due diligence and research.

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