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Targeting absolute return: the strategies to consider

UK investors are flocking to absolute return funds for protection but there are several different strategies on offer.
June 9, 2016

UK investors seeking protection from a possible UK exit from the European Union (Brexit) and global growth concerns are piling money into targeted absolute return funds, which aim to deliver positive returns in all market conditions and use strategies traditionally associated with hedge funds. But some investment analysts are concerned that many private investors do not know what a mixed collection of funds sit within this sector.

Adrian Lowcock, head of investing at Axa Wealth, says: "Targeted absolute return is a broad, jargon term, but within that you've got funds that are not similar at all.

"You might have a long short equity fund sitting alongside a more short-orientated bond fund - the two have very little bearing and similarity in terms of the level of risk they take, what they invest in and how they go about making money - yet they're clumped together in the same sector."

Some of the main strategies used by absolute return funds include the following:

Long short

Long short strategies allow managers to be able to go long on the market - hold shares in the market, or short the market - effectively sell shares. The upside of this strategy is that managers can profit from a rising market, as well as a falling market.

But Mr Lowcock says: "[Long-only] fund managers can effectively only buy the wrong shares whereas a manager who can go long short can buy the wrong shares, as well as sell the wrong shares."

Within long short strategies there are lots of different levels of shorting and types of funds, including bond funds, equity funds and global equity funds.

Global macro

Managers who employ a global macro strategy use long and short positions in equities, fixed income, currency and futures markets to match their big picture, economic convictions on various countries.

"These funds attempt to look at many aspects of the world's economy and markets and try to isolate those they have a strong view of," explains Rob Burdett, co-head of multi-manager at F&C Investments.

"Quite often they will pair them with other areas which [they think] will reduce the risk of being wrong and damaging investor returns. They will focus on seven or eight factors - be it the currency or particular sector in the market. This is very rarely an individual stock, instead it will be something like 'short healthcare, long US equities."

Market neutral

Net-exposure is the percentage difference between a fund's long and short exposure, and is a measure of how much a fund is exposed to market fluctuations. Market neutral absolute return funds aim for zero net-market exposure - i.e. the fund's short and long positions have equal market value. This strategy is designed to be lower risk than a long-biased strategy.

James de Bunsen, manager of Henderson Multi-Manager Absolute Return (GB00B8113P38), a fund of funds which can invest in other absolute return funds, is particularly interested in market neutral funds at the moment.

He says: "What these funds do is something called pair trading where you will quite often pick a couple of stocks - maybe even in the same sector - and you have equal weight in them. For example, you might be long BMW (BMWX:GER) and short Volkswagen (VOW3:GER) (both car manufacturers), so you're basically making a call on one doing better than the other for whatever reason.

"Even if they both fall, provided BMW falls less than VW, you make money. If they both go up, as long as BMW goes up more than VW, you make money and, even better, if BMW goes up and VW goes down, you make money from both sides."

 

The case for absolute return

Mr Lowcock thinks absolute return funds can provide useful protection for investors, especially in falling markets.

"If you look at a traditional, long only UK equity fund you are effectively making a bet that the market and share prices are going to rise," he says. "But if markets are falling, a traditional equity fund is unlikely to give you attractive returns, however, an absolute return fund - which can invest long or short in the market - could."

Absolute return funds can also be helpful for creating a diversified portfolio as their use of derivatives, currency hedging and other financial tools helps de-correlate their performance from other asset classes, he argues.

Mr de Bunsen has been increasing Henderson Multi-Manager Absolute Return's allocation to absolute return funds because of concerns that equity and bond markets are too expensive. The share of assets in absolute return has risen from about a third three years ago to more than 50 per cent today.

"What an absolute return fund should do is not lose too much money when equity markets are falling sharply," he explains. "But if valuations are quite high, as they currently are in equities and fixed income, you have much less confidence that your equity exposure is not going to hurt you if markets fall a lot.

"I don't think you can rely on the assumption that when equity markets have a correction bonds are going to bail you out, because yields are already at zero and they can only go so far into negative territory before people will not want to own them at all."

Mr Burdett also thinks that absolute return funds can provide useful diversification in a portfolio, particularly at a time when bond yields are low.

"With the interest rate cycle turning in the US - although how far or how quickly no one knows - you will start to lose money in fixed income when rates go up. Absolute returns funds can be an alternative to that," he says.

But he warns investors to be cautious about how they choose a fund in a sector that has only been operating since around 2007.

"Absolute return is not a homogenous category. You have to look at each fund in isolation, especially as it's a relatively young sector," he says. "It's probably one of the hardest areas to pick a fund because of the complexity, the lack of track records and the wide variation in methods and approaches to running absolute return funds."

 

The pitfalls

Sam Lees, head of research at FundExpert, is concerned that some long short funds can be very volatile. If they make the wrong move they can encounter big losses.

"These funds aim to make a positive return over a certain period, but it's obviously not a guarantee. Market uncertainty can't be completely hedged away," he says.

"Targeted Absolute Return" implies something suitable for widows and orphans, but in reality the sector is more, [perhaps] too diverse with the majority of funds really only suitable for experts who can look under the bonnet and understand the inner workings.

"There are some equity strategies that are very volatile and some more stable funds. There are single asset and multi-asset strategies, as well as long-only and long short strategies."

Mr Burdett thinks it's important for investors to have realistic expectations as to what absolute return funds can provide, and pay close attention to their strategies and manager's experience. Investors should do their homework by scrutinising the fund's past performance, prospectus, fact sheet and Key Investor Information Document (KIID).

"You're still exposed to manager skill, human error and trends changing," says Mr Burdett. "So I think you need to be very aware of what a fund's manager is trying to do.

"We tend to only invest in absolute returns funds where the manager has a reasonable track record of shorting. I think experience is even more important in this sector than others."

Investors also need to watch out for the high fees some absolute return funds charge as a number of these have performance fees.

Because of the risks, Mr Lees says: "A higher-risk investor could allocate 10 per cent to one of the spicier funds, while a low-risk investor may hold upwards of 15 per cent in a less volatile fund, depending on their requirements and goals."

 

Funds to consider

Mr Lees says an equity-focused fund like City Financial Absolute Equity Fund (GB00B2PX1C62) could form part of a more aggressive investor's portfolio, whereas a fund such as Insight Absolute Insight (GB00B89QJK70) would be more suitable for investors with lower tolerance for risk.

He also likes Henderson UK Absolute Return Fund (GB00B5KKCX12)* and Threadneedle UK Absolute Alpha Fund (GB00B8BX5538). He says: "These are long-short funds that have been solid performers, but with less volatility than many other funds in the sector - things that we look for when profiling."

Mr Lowcock is a fan of Standard Life Investments Global Absolute Return Strategies (GB00B7K3T226)*, which has assets of more than £26bn. He says: "It's quite a good diversifier and [can use] a broad range of strategies. It is run by a very experienced team and can invest in a vast range of assets such as shares, bonds, commodities and currencies, and uses derivatives. It's diversified portfolio means ultimately there's a lot less risk."

He also favours Newton Real Return Fund (GB00BSPPWT88)*, which focuses on capital preservation. He says: "It has the absolute return philosophy - basically getting a decent return above cash - without necessarily taking any huge form of risk."

Mr Burdett rates Legg Mason WA Macro Opportunities Fund (IE00BHBFD929), which is focused on the bond market. He says: "Its dollar share class is up 5.6 per cent and that's a great result for any fund this year, but particularly an absolute returns fund."

Mr Burdett also thinks highly of Henderson UK Absolute Return (GB00B5KKCX12)*.

"It's probably one of the best and smoothest, UK equity long-short funds out there. That's a purist's absolute return fund and run by a great team," he says.

*IC Top 100 Fund

Annual returns

Fund2015 2014  2013  2012 2011 
Henderson Multi-Manager Absolute Return 0.91.64.33.8-0.7
City Financial Absolute Equity 22.720.932.43.88.2
Insight Absolute Insight 0.61.73.86.40.2
Henderson UK Absolute Return 7.75.117.64.80.1
Threadneedle UK Absolute Alpha 7.35.210.32.63.8
SLI Global Absolute Return Strategies2.85.56.87.42.1
*Newton Real Return 0.93.15.33.4-0.4
*Legg Mason WA Macro Opportunities7.013.4n/an/an/a
FTSE All Share TR GBP1.01.220.812.3-3.5
MSCI World ex UK NR GBP5.512.525.010.8-5.2
MSCI World NR GBP4.911.524.310.7-4.8

Source: Morningstar as at 7/6/2016

*Returns show the performance of an older share class rather than the one indicated in the text

Cumulative performance

Fund1 year total return (%)3 year cumulative total return (%)5 year cumulative total return (%)Ongoing charge (%)
Henderson Multi-Manager Absolute Return-1.64.29.31.23
City Financial Absolute Equity4.661.6102.70.96
Insight Absolute Insight -1.63.28.80.98
Henderson UK Absolute Return4.524.237.61.06
Threadneedle UK Absolute Alpha3.017.429.50.88
SLI Global Absolute Return Strategies-3.28.324.50.89
*Newton Real Return3.810.016.40.69
*Legg Mason WA Macro Opportunities9.2n/an/a1.25
FTSE All Share Index-3.614.534.2
MSCI World ex UK3.734.164.9
MSCI World 3.031.961.5

Source: Morningstar as at 07/06/16

*Returns show the performance of an older share class rather than the one indicated in the text