Picky style keeps focus on returns

Standard Life Global Absolute Return Strategies survived the bizarre ructions in the market despite a 30%bias to derivatives – and the manager, Euan Munro, is optimistic about its prospects.

These have been testing times for all funds. But if you are in charge of a derivative-based absolute return fund, then the challenge has been extraordinary.

In May, Standard Life opened its Global Absolute Return Strategies (Gars) fund to retail investors. The fund, was first launched in June 2006, has been a success with institutional investors, and by the end of August had reached £722m in size. It aims to beat the UK six-month London Interbank Offered Rate (Libor) by 5% a year, gross of fees, over a rolling three-year period. It invests in traditional instruments, such as equities and bonds, with 70% or so placed in a range of other Standard Life funds.

But up to 30% is set aside for derivative positions, with a ‘Strategic Investment Group’ led 7 by Euan Munro identifying 17-18 strategies for the fund to pursue.

Munro says the past two weeks have seen a string of events that most managers will see just once in a lifetime. But it is testament to the fund and the team at Standard Life that it has come through remarkably well. It is down – by 4-5% over the past fortnight – but that is at a time when everything else involving risk has fallen by at least 10-15%. So it has passed a critical test, for the time being at least.

He balks at suggestions that the Gars fund is a “black box” full of weird and wonderful instruments that can blow up on unsuspecting investors.

“Black boxes are run by hedge fund managers who don’t really tell you what they are doing. We are very different – we are physically invested for a large part of the fund, and we have clear market views. Things such as mortgage backed securities are not the sorts of things this fund holds.”

But hang on, the fund is heavily exposed to derivative trades, and with Lehmans out of business, has that not exposed it to counterparty risk?”The derivatives we use are big and liquid ones – such as FTSE 100, S&P 500 and Eurostoxx. A collapse of a major derivatives counterparty like Lehman has been a big problem. But we have always had strict criteria when it comes to who we do swaps deals with. They have to have a credit rating of at least double-A. That means we have not had contracts with Lehman or Merrill Lynch for that matter. The key to surviving in this market is to have appropriate counterparty risk criteria.”

The other key thing about Standard Life’s approach is that the fund is lightly traded. “If you have a strategy that is based on high-frequency trading and abundant liquidity, you are in difficulty. But if you have a long-term investment approach, and you are not trading every five minutes – sometimes we trade the Gars fund just once in a week – your model is completely different.

Interestingly, he says that trading in cash markets has, if anything, become worse than in derivative markets. Until last year it was relatively easy for Standard Life to carry out a £500m gilts deal to protect against inflation liabilities for a pension fund. “It never used to be a problem. Now, I wouldn’t dream of doing such a transaction. For a broker to pony up £500m right now is quite a thought. Traders in physical assets [such as gilts] have to settle and find real cash. In derivatives, everything is on the margin.”

Has he found himself on the wrong side of strategies during the market turmoil that have cost the fund dearly? Not too many, although he has seen one of his riskiest strategies – long Brazilian real, short yen – go up by 20% only to fall almost 20%. “It has been quite messy, but it’s still up over the period we have held the strategy. And you have to compare that with equities, which have fallen over the same time-frame.”

The fund has managed to peg back losses with gains from strategies involving 30-year Japanese swap rates. “That’s made us a lot of money, but not enough to stop the fund going down,” says Munro.

A position in German bunds has also helped, as well as exposure to short-term interest rates. Over the past few months, performance was buoyed by several interest rate and currency strategies, such as the dollar-sterling rate. “When we could buy the dollar at two to one pound, we bought it. We thought dollar weakness was running out of steam, and historically, $2 has been an interesting level to get in”Munro sets expectations for each of his themes – with a targeted return within a targetted risk. “On the dollar, we have hit the target. We still like the dollar, but it is funded from a euro position now. The ECB [European Central Bank] is talking tough on inflation but we suspect that in 18 months, that 15% outperformance of the euro will come out.”

Over the past week he has, bravely, begun adding to a position in investment grade financial credit, where spreads have widened out dramatically. Back in 2007 the fund performed particularly well when it hedged out credit risk, but now he thinks you are being paid for risk again.

In addition, he is closely watching the gap between government rates and swap spreads. “Government rates reflect an anticipated fall in interest rates, but the swaps market is not reflecting that,” he says.

“We have a central view of the world,” says Munro. “Inflation will fade, and central banks will cut rates, which will be good for credit markets first, then equities, then real estate. Things will get better in the medium term, although for now we would rather be in carry-type trades.”

Although Munro is the lead manager for the fund, it develops its approach within Standard Life’s Strategic Investment Group – the four most strategic thinkers within the group, who are not necessarily the best fund managers.

At a time when all asset classes apart from cash are heading down, this remains a highly defensive, wealth-preserving fund despite the unusual nature of many of the strategies within it. Unlike a hedge fund, it cannot borrow or leverage up, it is daily priced and has no fancy performance fees. Given that it has survived the most bizarre fortnight in most managers’ memory, if it continues to offer decent returns with reduced volatility, it should have a terrific future.