In the past year absolute return funds have had their fair share of negative headlines, and big-name funds in the Investment Association’s Targeted Absolute Return sector have suffered outflows – notably Standard Life Investments Global Absolute Return Strategies (GARS). When the fund group reported its profits for 2016 at the start of this year the results showed a lower demand for its flagship fund. According to the figures, gross inflows fell by 40 per cent over 2016, from £17bn in 2015 to £10.2bn at the start of the year.
Although the fund remains by far the largest in the IA Targeted Absolute Return sector, does this trend highlight a lower appetite from investors for these absolute return products? Looking purely at performance it is easy to see why they may have become less desirable.
When a plain vanilla UK equity index tracker would have generated double-digit returns of 16.76 per cent in 2016, why would investors bother investing in complex strategies that have averaged a mere 1.06 per cent (as represented by the IA Targeted Absolute Return sector) last year?
But performance is not the be all and end all in portfolio construction, and absolute return strategies can add value to a portfolio by controlling risk and adding diversification benefits.
With valuations on global bond and equity markets at historic highs, return expectations over the medium term for traditional asset classes are now skewed to negative numbers. Therefore, investors might feel the need to diversify away from relative/directional/long-only strategies.
For example, long-short equity strategies can adjust their net and gross exposures to increase or decrease their sensitivity to equity markets. The same applies to long-short fixed income strategies by playing on duration and credit spreads. Global macro strategies make several bets on both directions of different asset classes or markets as the combination of those differing macro views should generate a performance independent of the direction of the main asset classes over time.
Absolute return strategies also offer the benefit of understanding risk before investment (ex-ante risk). Most absolute return strategies integrate risk management in the investment process so the portfolio manager can assess how much absolute risk (as measured by volatility) is in the portfolio. Thanks to the portfolio construction process an absolute return manager can adjust the volatility of the portfolio before implementing an investment decision. Long only managers do not have this capacity as they can only control the beta (or sensitivity) to the benchmark.
Before the EU referendum vote UK equity managers could only limit the volatility of their portfolios relative to the FTSE All Share by decreasing the beta.
UK long-short equity managers could simply decide to move net exposure to zero so performance only depended on their stock-picking skills, rather than the direction of the UK equity market.
Therefore, the graphs below should not come as a surprise. Over time, the volatility of the IA Absolute Return sector has been significantly lower than main IA sectors, even compared with mixed asset sectors.
Absolute return strategies bring diversification benefits to a portfolio in addition to their capacity to control risk.
As explained above, these funds have a lower sensitivity to traditional asset classes. They can also rely on different sources of returns to generate performance.
This feature is highlighted in the graph below, which shows the R squared of the IA Targeted Absolute Return sector against major indices. Although being slightly skewed to UK and global equities, on average 50 per cent of returns from the absolute returns sector are explained by this equity factor. This skew might also be explained by the high number of long-short equity strategies in the sector.
Superior returns over cash
So far, we have highlighted the fact that absolute return strategies should be considered by investors due to their capacity to control risk and add diversification benefits to a portfolio. Therefore, this asset class shares many features with cash.
However, we believe that instead of sitting on cash the robustness of their investment process should allow absolute return strategies to generate additional return while maintaining strong risk control.
Looking at the funds with a minimum of a three-year record in the IA Targeted Absolute Return sector we could observe that 73.49 per cent of these funds have managed to generate a positive Sharpe ratio over the past three years (13 per cent with a Sharpe ratio above 1).
In other words, these funds have justified their extra risk relative to cash by generating excess return.
Let us now consider the funds in the IA UK All Companies sector and their information ratio relative to the FTSE All Share over the same time.
Only 59.27 per cent of these funds have managed to generate a positive information ratio (and 0.81 per cent with information ratio above 1). So less than half the active UK equity funds can justify their excess active risk (as measured by the tracking error) to generate excess return relative to the FTSE All Share index.
The odds are therefore on our side – and we believe absolute return strategies are still relevant.
Charles Younes is research manager at FE
40% Inflows fall to £10.2bn in SLI GARS in 2016
16.8% Returns from plain vanilla UK Equity index in 2016
1.1% Returns in IA Targeted Absolute Return sector in 2016
73.5% Proportion of IA Targeted Absolute Return sector with positive Sharpe ratio