Recent market trauma makes the notion of an ‘absolute return’ fund an attractive prospect. They often promise you lower risk than equity funds with better returns than the likes of cash and a low correlation to broader markets – especially when they fall. Global equity markets have been gripped by volatility so far this year, making the search for effective diversifiers more urgent.
Unfortunately, many so-called absolute return strategies fail to consistently deliver their target performance while charging high fees for their efforts. Of the 101 funds in the Investment Association’s Targeted Absolute Return sector with a three-year track record, more than a quarter have suffered losses over three years, says Dzmitry Lipski, head of funds research at Interactive Investor.
That said, some funds have managed to perform broadly in line with their promises and can work well within a portfolio. Darius McDermott, managing director at Chelsea Financial Services, says you should lose “much less” with a suitable absolute return fund in times of volatility and allocates 15 per cent to such strategies in a cautious portfolio run by his firm. But the variety of outcomes, and the disparate make-up of the sector itself, means finding the right fund is no easy task.
How do they work?
Many absolute return funds use complicated investment techniques such as short selling and derivatives to target positive returns in all market conditions. A good number aim to return cash plus 3 to 6 per cent over a period of one to three years. In many cases they fail to consistently meet these targets, and there is no guarantee of positive returns over any given investment period.
There is a huge range in approaches taken. Managers of long/short equity funds, for example, can invest in equities they expect to perform well, but short sell those they expect to struggle. This involves borrowing stocks in order to sell them, and buy them back – ideally at a lower price – to return to the original owner. Investors can also use derivatives, which give them the right or obligation to buy or sell assets at a set date in the future. In theory this reduces market risk.
Some absolute return funds stick with equities and some with bonds, while others take a multi-asset approach. Some funds invest thematically and pair assets against each other, for example by betting on the chance that one currency strengthens against another. Funds in the sector can ultimately differ not just in their view of markets, but the regions they invest in, the asset classes they use and how much risk they take.
Why are people so wary of them?
Many absolute return funds fail to consistently meet their target returns. They can be extremely complicated and perform in unexpected ways, including in times of severe market volatility. Jonathan Moyes, head of investment research at the Wealth Club, points out that in 2018, when the FTSE 100 dropped by 12.5 per cent, many funds struggled to deliver a positive return. FE data shows that just 16 managed to do so, with 89 registering a loss.
“I think they promise something that cannot be achieved,” he says, adding that investors "would be better off in good old fashioned traditional defensive fixed income investments where they can get what they expect in terms of returns”.
Patrick Connolly, chartered financial planner at Chase de Vere, is also sceptical about their ability to provide capital protection during bouts of volatility. “The fact that over the past month 27 absolute return funds have delivered a positive return while 86 have lost money is, perhaps, not a very positive sign,” he says.
The sector is relatively new, having launched in 2005, with the majority of funds untested in a bear market. Mr Lipski says this makes it difficult to appropriately assess the likelihood of funds succeeding and warns investors to only invest in a proposition they understand. According to FE, just 18 of the funds currently in the sector launched before 2010.
By their nature they take bets on how companies will perform based on analysis of fundamentals, but these can be very hard to predict, says George Lagarias, senior economist at Mazars, citing the unexpected Federal Reserve rate cut of 0.5 per cent earlier this month. “Absolute return funds fail to deliver because they have insurmountable obstacles,” Mr Lagarias says, adding that there “may be a few good ones” but investors must look at their investment process very closely.
“Many absolute return funds have come under criticism for being opaque and expensive with disappointing performance,” adds Emma Saunders, senior collectives analyst at Rathbones. “This increases the importance of strong fund selection, which can identify not only the best-of-breed funds, but also looks to avoid those names with questionable approaches and outputs.”
An example of an absolute return fund whose strategy hasn’t worked in recent years is Jupiter Absolute Return (GB00B6Q84T67), a fund predominantly focused on long/short equity investing. The fund held up well during the market sell-off in the final quarter of 2018, but was down by more than 20 per cent over three years to 6 March 2020. Manager James Clunie has a large short exposure on the US, including a short position on Tesla, and has suffered as a consequence.
A Jupiter spokesman said: “We are conscious that this has been a really challenging period for investors in this strategy. James has been working closely with our sales teams to make sure that all clients fully understand his process, the reasons behind the strategy’s current underperformance and the positioning of the strategy to navigate the present market environment. The team has Jupiter’s full support throughout this process.”
The BMO Global Equity Market Neutral Fund (GB00BY7S9K74) is another example of a strategy that spectacularly misfired. The fund lost 30 per cent during the bull market of 2019 and it is set to close following a slew of outflows which had left the fund with just £10.6m in assets at the end of February. BMO declined to comment.
The whole sector has haemorrhaged assets recently and was the worst-performing sector by sales last year, with net outflows of £14.5bn, according to Morningstar data. In 2015 and 2016 it was the best-selling sector. The worst-selling fund was Standard Life Aberdeen’s Global Absolute Return Strategies Fund (GB00B28S0093), which had net outflows of more than £8bn in 2019. The fund was once the UK’s largest fund with over £50bn in assets – it now holds around £5bn.
Invesco’s flagship Global Targeted Return fund (GB00B8CHCY21) also had a difficult year, losing around 20 per cent of its assets as investors withdrew money. The fund delivered cumulative returns of 2.03 per cent over the five years to 6 March, despite targeting 5 per cent gross return per year above UK three-month Libor over a rolling, three-year period.
An Invesco spokesman defended the fund's performance, saying it had recovered over the past 15 months, putting it "much more in line" with long-term return and volatility targets.
"Given an environment of heightened uncertainty, we believe our highly diversified approach to investing is well suited to current markets. We anticipated that there would be some withdrawals following a difficult year for performance in 2018 for us and the broader sector. Although we consistently review our process, our philosophy of investing in ideas has remained constant, supporting our benchmark of delivering positive returns with a target of cash plus 5 per cent per annum over rolling three years with less than half the volatility of equities," a spokesman added.
You should view absolute return funds as a defensive, portfolio diversifier rather than a growth option, despite the fact a handful have produced equity-like returns. Be wary of funds with large price movements as you can be taking on high levels of risk. Polar Capital UK Absolute Equity (IE00BQLDRN11), for example, is the best-performing fund over three and five years, but it also has a higher volatility than any other fund in the sector, according to FE.
Another name, Argonaut Absolute Return (GB00B7MC0R90), has had notable ups and downs. The long/short fund had made a 2020 year-to-date gain of some 12 per cent as of 9 March, but lost 11.7 per cent in 2018.
When might they be good for your portfolio?
While you should think carefully before buying an absolute return fund, there are a few “gems” in the sector that have managed to deliver on their objectives, says Fatima Khizou, research analyst at Morningstar. You need to do thorough research on any fund before you buy to ensure it performs in line with its investment profile and suits your risk tolerance. We have detailed some absolute return recommendations and their recent performance, both on standard timeframes and over five calendar years.
Ms Khizou likes Janus Henderson UK Absolute Return (GB00B5KKCX12). She says the managers Ben Wallace and Luke Newman have a “solid approach” to risk management with a flexible investment process and an ongoing charge of 1.05 per cent. The strategy delivered a positive return in all but one calendar year since its launch in 2009. Its fall of 2.71 per cent in 2018 was considerably less than the FTSE All-Share index’s fall of -9.47 per cent.
Adrian Lowcock, head of personal investing at Willis Owen, recommends BNY Mellon Real Return (GB00BSPPWT88), which has achieved positive cumulative returns over one, three and five years. The fund aims for a total return of one-month Libor plus 4 per cent a year over rolling five-year periods, and a positive return on a three-year rolling basis.
Mr Lowcock says: “The core of the portfolio invests in assets that can grow. This is then surrounded by a cushion of defensive assets such as gilts, cash, gold and derivatives, which reduce volatility and limit losses in the fund.” The fund went more defensive in January as equity valuations reached all-time highs in the US.
You should not ignore investment trusts if you are looking for an absolute return product, says Mr Lipski. He recommends the Capital Gearing Trust (CGT) as it is not overloaded with unintelligible derivatives but primarily uses global bonds, cash, commodities and other investment trusts to protect wealth over the long term. The board also tries to keep the trust’s discount close to its net asset value by buying shares at a discount and selling when the discount closes.
Mr Moyes likes TwentyFour Absolute Return Credit (LU1273680238), which has returned 7.9 per cent in three years to 6 March. The fund, domiciled in Luxembourg but available to UK investors, is a long-only strategy investing in fixed income.
