Absolute return funds aim to perform in all market conditions but only four of 11 open-ended products launched in the past three years delivered returns above 5% in the 12 months to January 2008. Simon Hildrey investigates.
The Boomtown Rats are not alone in disliking Mondays. It was said that Monday January 21 was the most depressing day of the year – it only brought gloom for investors. The FTSE 100 index fell by 5.48%. The Hang Seng index in Hong Kong dropped 5.49% on January 21 and 8.65% on January 22.
It is hard for investors to cope with such dramatic one-day falls across their portfolios. Furthermore, over the long term, steady returns every year might be more fruitful than volatile returns. For example, if a portfolio loses 20% of its value, it has to generate a 25% return to get back to where it started. Two years of 5% a year returns would leave another portfolio 10% ahead. It is rather like the race between the hare and the tortoise.
The stockmarket volatility of the past six months, therefore, could see greater interest in funds that can produce positive returns regardless of market conditions. According to Morningstar, 11 open-ended funds have been launched over the past two to three years that claim to deliver positive or absolute returns over a market cycle, which is typically three years.
The concept sounds great. They aim to preserve capital while markets are falling and benefit from some of the upside. But now we are in a volatile market environment, are these funds delivering absolute returns?
Morningstar says the 11 funds aim to achieve positive returns. This is usually stated in terms of at least 100 basis points and below 1,000 basis points (before fees) above an applicable interbank lending rate.
Morningstar does not include funds of funds in this sector unless “the manager can show he or she fully hedges out the beta of the underlying funds”.
Fund managers do not like being judged on a year’s performance. But the volatility of the second half of 2007 should provide a strong indication of funds’ abilities to generate absolute returns. This should be a positive return above cash, with Libor returning 4.8% in 2007.
Of course, as Tony Maddock, head of retail sales at Scottish Widows Investment Partnership (Swip), says, “any investment where the aim is to achieve a higher return than could be achieved on cash on deposit will be taking on a degree of investment risk in exchange for the higher long-term return”.
Of the 11 funds, only four delivered a return above 5% between January 1 2007 and January 7 2008, according to Morningstar (see table, page 24). The two funds that stand out are Threadneedle Target Return with a gain of 17.86% and BlackRock UK Absolute Alpha with 11.07%. In contrast, over the same period, the UBS Absolute Return Bond fund fell by 7.71% and Swip Absolute Return UK Equity fell by 6.95%. UBS was unavailable for comment about the performance of the Absolute Return Bond fund.
Between August 1 and September 3 2007, only four of the 11 funds delivered a positive return. They were the BlackRock UK Absolute Alpha, SG Treasury Plus, Threadneedle Absolute Return Net and Threadneedle Target Return funds.
Absolute return funds fared slightly better between October 15 and December 3 2007 when six of the 11 funds delivered a positive return.
Only one fund has a three-year track record, which is the Credit Suisse Target Return fund. This fund returned 8.8% between January 10, 2005 and January 7, 2008, which is below cash.
The universe of absolute return funds widens if funds domiciled in Dublin and Luxembourg are included. Some delivered strong returns last year, such as Pictet F (Lux) AR Global Div growing 21.12% between January 1 2007 and January 7 2008.
Jason Day, director of Allenbridge, says the performances show the importance of analysing the investment approach and risk profile of each fund.
The fund that is most favoured by advisers is BlackRock UK Absolute Alpha, which is managed by Mark Lyttleton. It delivered a positive return every month during 2007. The fund can short stocks although it cannot use leverage.
Lyttleton says the fund does not take much net market risk. “It is hard to deliver an absolute return if you take a significant market exposure. Over the past six months, our net market exposure has ranged from 5% long to 15% long. Shorts have contributed to the fund’s returns, particularly in November 2007.”
As well as shorting stocks, Lyttleton says the fund invests in pairs. This is where he takes short and long positions in stocks in the same sector. For example, he might short Shell and go long BP. Lyttleton can allocate up to 100% of the fund in cash. But in recently the exposure has been between 10% and 20%.
BlackRock UK Absolute Alpha has been given a buy recommendation by Killik. Mick Gilligan says: “The fund continues to perform to its mandate of producing positive returns irrespective of equity market direction.
“Over July and August 2007, the FTSE All-Share was down 3.8% in total return terms. Over the same period, the BlackRock fund was up 1.2%.
“The fund’s strategy of deploying the bulk of its capital into pairs trades, combined with good stockpicking, meant the fund did not suffer from the market turmoil. According to Lyttleton, the worst day in August 2007 ended with the portfolio down 0.8%.”
Gianluca Oderda, manager of the Pictet F (Lux) AR Global Div fund, says he invests in equities, bonds and credit through derivatives.
The fund can take net long or short exposures to these asset classes. Weightings are driven by a Pictet proprietary model and are usually changed every month. At the moment, the fund has a net long exposure of 0.14%. The fund can go to a maximum exposure of 0.50%. The maximum short position is minus 0.10%. The fund has had an average exposure of 0.30%.
The fund also invests in other Pictet funds. To try to take out market risk, the fund takes short positions in benchmarks for each Pictet fund. By doing this, the Pictet fund makes money if the underlying funds outperform their relevant indices. Even if the underlying funds deliver negative returns, they will still make money if indices fall by more.
Oderda says the fund aims to deliver an average annual return of 4% above euro Libor.
Threadneedle’s two absolute return funds both beat cash during 2007. The Threadneedle Target Return fund returned 17.86% between January 1 2007 and January 7 2008, according to Morningstar. The Threadneedle Absolute Return 1 Net fund returned 7.18% over the same period.
The two funds essentially have the same investment approach. The difference is that the Target Return fund invests and is denominated in euros while the Absolute Return fund is in sterling. The Target Return fund benefited from the euro rising against sterling and higher interest rates in 2007.
Peter Allwright, co-manager of the Threadneedle funds, says there are two elements to their investment approaches. First, the funds construct money market portfolios to produce Libor returns. Second, the funds have an overlay to seek to generate a return above cash.
Allwright says some absolute and target return funds suffered last year from having too high an exposure to high yield and other low quality bonds. “We took a view early in 2007 that there would be problems in the subprime sector. Therefore, we increased our exposure to gilts and other higher quality bonds. We lost some performance in the short term but benefited in the second half of the year.”
The two Threadneedle funds can take short and long positions in the overlay through derivatives in several investments, such as foreign exchange, interest rates and volatility. “We are looking for this overlay to generate 3% a year above cash,” says Allwright.
Six out of the other eight funds in the sector delivered positive returns between January 1, 2007 and January 7, 2008 but all except one was below cash. The Old Mutual Prosper 80 fund, for example, returned 0.5% and had the sharpest fall of 2.49% between August 1 and September 3, 2007.
Simon Wilson, head of marketing of Old Mutual Asset Managers, admits the Prosper 80 fund had a challenging second half of 2007. But he argues the fund still delivered a positive return in 2007 and before August 2007 had been delivering strong positive returns.
Old Mutual Prosper 80 is a multi-strategy fund of hedge funds that holds internal and external funds. Wilson says performance was more difficult in the second half of 2007 because of increased market volatility. The underperformance of cash was mainly driven by the quantitative funds in the portfolio.
Wilson says Old Mutual Prosper 80 reduced risk during the second half of 2007 to preserve capital. “It is important to remember the fund is aiming to deliver an absolute return over the long term,” adds Wilson. The fund also guarantees that investors will receive at least 80% of the highest net asset value.
Swip’s three absolute return funds had contrasting fortunes in 2007. Between January 1, 2007 and January 7, 2008, Swip Absolute Return Bond returned 5.34% against 0.88% by Swip Absolute Return Macro and a fall of 6.95% by Swip Absolute Return UK Equity. The Bond fund aims to return 1.5% above cash, says Maddock. He adds that the fund uses derivatives in overlay strategies to seek to deliver steady positive returns. “The Absolute Return Bond fund returned 5.24% in 2007. “In comparison, the UK Gilt sector median returned 3.72% and the UK Corporate Bond sector median returned minus 0.46%.”
Maddock says the Bond fund has a low risk investment strategy while the Macro fund has a medium risk strategy. The Macro fund seeks to return 2% above cash after fees by gaining exposure to a range of asset classes through derivatives. “The Macro fund has been defensively positioned in equities since inception because of concerns over the macro economic outlook,” says Maddock. “Initially, this meant the fund did not fully participate in the equity rally in 2006 and the first half of 2007.
“This cautious stance has paid dividends as the fund has suffered only modestly during the recent market sell-off. The fund rose during the sell-off in the summer of 2007.”
The UK Equity fund has a higher risk strategy and aims to return 2.5% above cash. The fund invests mainly in a concentrated portfolio of UK equities. The net long position varies over time.
In the seven months after launch in 2006, the fund returned 9.4% after fees but Maddock admits the performance in 2007 was disappointing. “The most significant factor behind this has been the poor performance of some of our larger stock positions, such as the collapse of Northern Rock.”Using a combination of options and futures, the fund’s market exposure ranged between 0% and 100% during 2007. Adjusting the fund’s overall exposure to the market added value while lowering the overall risk of the fund.
“The benefit of using short positions proactively can be illustrated by the performance of the fund during periods in which the market suffered a short-term downturn. From February 26 to March 14, 2007, the fund fell 2.7% compared with a drop of 6.5% by the FTSE All-Share. From July 13 to August 17, the fund fell 6.5% while the FTSE All-Share dropped 12.6%.”
There are other ways in which investors can try to generate absolute returns. Fund of hedge funds have traditionally not been accessible for regulatory and tax reasons. But fund of hedge funds investment trusts do not face these issues and several delivered impressive returns during 2007. For example, according to Morningstar, from January 1, 2007 to January 7, 2008, the Invesco Perpetual Select Hedge trust returned 38.31% and Thames River Hedge returned 30.62%.
Of the seven funds in the sector highlighted by Morningstar, none delivered a negative return. The only fund to return below cash was RAB Special Situations at 0% but performance may have been impacted by the manager’s stake in Northern Rock. Between October 15 and December 3 2007, the fund lost 13.23% in value.
Ken Kinsey-Quick, manager of Thames River Hedge, argues the volatility during January 2008 will demonstrate the benefits to investors of fund of hedge funds. “Over the past five years, there has been a bull market. People have questioned why they need absolute return funds during this period.
“Some investors have also questioned the high correlation between fund of hedge funds and equities. But this correlation is because both have generated positive returns rather than necessarily that hedge funds have been heavily exposed to equities.
“For example, we have analysed the returns of our Warrior fund of hedge funds over the past five years, which is the open-ended version of the Thames River Hedge investment trust. Warrior has had a correlation of 0.64 with equities. But when equities were down an average of 1.7%, our fund rose 3%.
“The advantage of fund of hedge funds is the fact they can short, use leverage in positive environments and have flexibility in their investment approaches. At the moment, we have underlying managers who are net short and therefore making money. In 2007, a big chunk of the returns generated by Thames River Hedge came from managers shorting subprime.
“Thames River Hedge has a multi-strategy approach but we differ from other funds because we do not focus on mainstream strategies and managers. We believe in trying to find the strategies and managers of tomorrow where strong returns can be made.
“It can be harder to gain returns from strategies as they become more crowded. A classic example is the convertible arbitrage strategy. This seeks to profit from the mispricing on deals between equity trades on one side and bond trades on the other.
“But as returns were good so more hedge fund managers entered the strategy until about 90% was owned by hedge funds. This meant hedge funds were arbitraging against each other and returns lowered.”
Dexion has four listed fund of hedge funds. Dexion Absolute, which seeks to have little correlation to equity and bond markets, returned 13.78% between January 1 2007 and January 7 2008. The fund is a multi-strategy fund of hedge funds and allocates 10% of assets to short sellers who do nothing but short.
Ana Haurie, group managing director of Dexion Capital, says the market volatility in 2007 contributed to the positive returns of Dexion Absolute’s macro strategies. “Trading across various commodity markets was a primary source of profits, as was fixed income trading. The fund’s hedge strategy delivered alpha, with its short sellers profiting from the consumer discretionary, financials and technology sectors.”
As with other absolute return funds, Haurie says investors need to consider their objectives and risk profile when choosing listed fund of hedge funds. “A more conservative investor might seek a fund of funds that targets relative value or market neutral strategies. A more aggressive investor might want something like Dexion Trading, which allocates to trading managers.”
Gilligan at Killik recommends Close AllBlue fund of hedge funds. This is a Guernsey-registered fund listed on the Alternative Investment Market and the Channel Islands Stock Exchange. “The fund is planning to move to the London market. It is on a discount of 6% but has generated growth of 7% over the past three months. In 2007, the fund returned more than 11%.”
In contrast, Gilligan says Dexion Absolute is on a 4.5% premium while Thames River Hedge is on a 3.9% premium. Over the past three months, the NAV of the Thames River fund rose 5% and Dexion was up 1%.
Another option is to use multi-asset funds. For example, John Husselbee of North Investment Partners says the City Financial Diversified Absolute Return fund delivered a return of 11.17% in 2007.
The fund’s allocation includes 25% to global equities, 15% to UK equities, 30% to absolute return strategies, which include listed fund of hedge funds, and 20% to commodities. To gain exposure to commodities, including oil, gold and soft commodities, the fund buys exchange traded funds.
Capital preservation can be gained through diversification across asset classes and investing in hedge funds and structured products, says Husselbee. He highlights that in mid January, it was possible to buy structured products at 6,000 points on the FTSE 100. If the index is at the same level or higher in 12 months then investors will gain a return of 17.5%. If the index is below 6,000 points, it is rolled over to the next year. If in 24 months it is at or above 6,000 points, investors receive 35%.
Another option is for investors to construct their own portfolios of funds investing in different asset classes. In theory, diversification can produce absolute returns as a fall in value of one asset class should be offset by a rise in another asset class.
Whatever approach is adopted, the key is for investors to determine their objectives and risk profile. They can then construct a portfolio or select funds that fit their individual requirements. This will feature diversification across managers and asset classes.
View of multi-managers and IFAs
Robert Burdett, co-head of multi-management at Thames River Capital, says it has been embracing absolute return strategies because of its caution about market conditions. But Burdett (pictured right) says there are not many absolute return funds from which to choose. “The BlackRock UK Absolute Alpha fund stands out in a class of its own. BlackRock has experience of shorting and managing hedge funds. They thus have experience of making shorting decisions and administering shorts.”
But Mark Dampier, head of research at Hargreaves Lansdown, says absolute return funds have not attracted a lot of money from investors. The company highlighted a Russian equity fund and the BlackRock UK Absolute Alpha fund in its newsletter to clients. Even though the BlackRock fund has delivered a positive return in 2008 while the market has been falling, Dampier says inflows into the Russian fund far exceeded the BlackRock fund. “In reality, clients want excitement when they invest,” says Dampier. “But we believe the BlackRock fund can be a core holding in a portfolio. An attraction of the BlackRock fund is that it is the only regulated hedge fund in the UK.”
Mick Gilligan of Killik (pictured left) says it looked at the fixed interest absolute return funds about 18 months ago. “We felt they were unlikely to add a great deal of value over fees. Instead, investors would probably be better placed to invest in a diversified fund of hedge funds.”
Darius McDermott, managing director of Chelsea Financial Services, says bond funds can not be relied on to generate their target return. “The problem in 2007 was that rising interest rates and inflation meant global bonds went down. This meant many target return funds missed their aim of generating cash plus returns. The UBS fund fell more than 7% last year so it will be difficult to generate a return above cash by the end of the three-year market cycle. If people are going to invest in fixed interest, we prefer strategic bond funds or the M&G Optimal fund.
“We also like multi-asset funds. The ability to hold asset classes with low correlations enables funds to generate absolute returns. Among the funds we like are Newton Phoenix and HSBC Open Global Return.”
Jason Day, director of Allenbridge, says it uses hedge funds as a core part of portfolios that are seeking absolute returns. But Day (pictured right) adds that hedge funds are not a homogeneous group. Therefore, investors need to analyse funds to evaluate their risk profile and objectives.
“A single long/short fund can be volatile,” says Day. “Investors need to decide the absolute returns they want to generate and then construct a portfolio to meet their objectives and risk profile. This can involve combinations of asset classes, including structured products and hedge funds.”