The recent Ucits III regulations have encouraged the launch of a raft of new absolute return products, but what exactly are they? And can they really be as low-risk as they seem? Opinion in the investment industry appears to be divided, so James Teasdale tries to get to the bottom of absolute return funds.
The basic premise of absolute return funds is that they focus on consistently delivering positive (absolute) returns in both rising and falling markets. A new breed of such funds is emerging in the retail market with the introduction of updated European Union Ucits regulations.This new class of products should not be confused with hedge funds. Although both have an absolute return mandate, the traditional market for hedge funds is institutions and private clients. The typical high level of minimum investment precludes the vast majority of retail investors. Hedge funds are unregulated investments using a wide range of different trading strategies. One of the main differences between hedge funds and traditional long-only portfolios is that hedge funds can use derivatives and hold short positions in stocks or indices. But the regulatory environment is changing and the introduction of Ucits III regulations has had a substantial impact on the ability of retail investors to access more sophisticated investments (see cover story, February 28). Add to this the disappointing performance in the past of many traditional equity funds, and it is unsurprising that the concept of an absolute return fund has attracted much attention. Ucits III rules have given retail fund managers more flexibility. In the past, other than for short-term liquidity reasons where small cash positions may have been held, rules on portfolio asset allocation were restrictive. Put simply, an equity fund invested solely in equities, a bond fund invested solely in bonds, and multi-asset funds were not permitted. The new regulations allow investment managers to allocate actively across asset classes based on their views of the markets. Traditional equity funds are measured relative to a benchmark, generally a mainstream equity index or hybrid of indices. When equities perform strongly compared with other asset classes, most people see performance measured against such an index as an appropriate benchmark. But when equity markets underperform or encounter relatively long periods of negative return, the concept of an absolute return strategy could make sense. The allegedly good news that a fund manager has returned top-decile annual performance by beating the Tindex by 10% is of little consolation to an investor if the benchmark fell 20%. With the benefit of hindsight the investor would clearly have fared better investing in cash over such periods. Clearly the investor, possibly assisted by their financial adviser, has to make an asset allocation decision at some point in time. This might lead to the decision to invest, say, 60% of assets in an equity fund, 30% in a bond portfolio and 10% in cash. But such decisions are made at discrete intervals (perhaps reviewed quarterly or annually) rather than on a continuous basis. And this is where absolute return type funds could be used, since managers can actively asset-allocate on a continuous basis. The risk/reward profiles of current absolute return products vary dramatically. They also differ markedly from conventional long-only funds. In its broadest sense, one could define a fund that takes active asset allocation decisions as an absolute return fund. Switching a portfolio of equities into cash in a falling stockmarket might be interpreted as an absolute return strategy. Based on this definition, Threadneedle UK Accelerando, launched in May 2003, was the first of the new breed of Ucits III funds to be given an absolute return label. It was the first UK equity fund that could theoretically be 100% invested in cash. It should be noted, however, that this fund adopts an equity index benchmark, so is not an absolute return fund in its purest sense. Since then, several retail funds have been launched with contrasting absolute return mandates. Most of these have a “cash plus” benchmark, with the aim of beating the returns available on cash by a target amount. But the methods and types of investments used by fund managers to achieve their objectives, and the risks taken in doing so, differ significantly. Launched in March 2004, the Baring Directional Global Bond fund targets a total annual return of three-month Libor (London interbank offered rate) plus 4%. The 131m fund invests in fixed interest securities and aims to achieve its objective by anticipating interest rate and exchange rate movements. It can hold both long and short positions in traded interest rate and exchange rate instruments. Credit Suisse quickly followed in April 2004 with its Target Return fund, also a bond and money market fund. The portfolio invests in fixed and variable interest securities, convertibles, cash, money market instruments and warrants, and aims to achieve a return of six-month Libor plus 2.5%, gross of charges. However, unlike the Barings fund, the Target Return fund is a long-only portfolio. More recently, UBS Asset Management launched the Absolute Return Bond fund in April 2005. This 45m fund invests in fixed interest assets ranging from gilts to emerging market bonds. It can invest in bond futures, allowing it to take a positive or negative position on interest rates. The portfolio aims to achieve a return 2.15% above bank base rates and targets a low volatility of 3%. According to UBS, this equates to a 1% probability of the fund losing 1% in value over a 12-month period. It can also take currency positions. Tristan Mawdsley, head of UK retail sales at UBS, says: “With a long-only bond fund, 80% of the capital risk is due to interest rate sensitivity. Global bond funds have a typical duration of six to seven years. This portfolio has a duration of between two years and minus two years. It reduces the interest rate sensitivity by two-thirds but gives the option of going the other way with negative exposure. If we think yields will go up, the fund can short. We can still get the decision wrong but we are containing the risks.” Also launched in April, the DWS RateBuster fund uses a different approach. It invests in deposit-based instruments with a high credit rating. Income generated from deposits is then invested into a managed account that is run on a multi-manager basis by five Deutsche Asset Management teams. Both long and short positions in currency and bond markets are held by the managed account. RateBuster’s initial annual target return is 7.75%. Investors’ capital is secured at the end of each six-month period, and the fund can be held in a cash Isa. The above funds are essentially bond and currency-based products, not making use of the more risky asset classes. Close Finsbury rolled out its Dublin-domiciled MultiAsset portfolio in September 2004. Managed on a sub-advisory basis by Berry Asset Management, the fund of funds can invest in up to eight different asset classes: equities, bonds, commercial property, structured investments, alternative investments, hedge funds, commodities and cash. Pascale Moray, senior marketing manager at Close Finsbury, says: “The MultiAsset portfolio invests in a much wider range of assets than traditional funds of funds. The aim is to reduce risk by increasing diversification – if equities are heading south, the portfolio can be exposed to other asset classes, hence reducing volatility.” The recently launched Insight Target Return fund is also a fund of funds investing across a broad range of assets, including hedge funds. Structured as a non-Ucits retail scheme, it targets equity-like performance over the economic cycle, to provide positive returns in all market conditions. Each asset class has an upper investment limit. For instance, equity exposure is limited to 60% of the fund and up to 70% of the portfolio can be in fixed interest securities. With a focus on UK equities, the Merrill Lynch UK Absolute Alpha fund makes use of hedge fund techniques and can hold cash. Managed by Mark Lyttleton and open to retail investors from May 13, the portfolio uses pairs trading to cancel out market risk. Pairs trading involves buying shares in one company and holding a short position in another stock in the same sector. The portfolio targets positive returns in all market conditions. JP Morgan is launching its Cautious Total Return fund this month. The fund will make use of equities, convertible bonds, bonds and cash, and includes the use of derivatives for hedging purposes. It will target a return of 3% above one-month Libor after annual management charges (see Q&A, page 19). The funds described above do not make up an exhaustive list of the absolute return products available to retail investors, but do illustrate their widely contrasting mandates. With a wider array of portfolios becoming available to investors, an understanding of their risk/reward profiles and investment aims is clearly vital. Moray says: “There is a process of educating people and it takes time for intermediaries and their clients to understand these products. The MultiAsset fund is a next-generation product but it is very transparent and people will begin to realise the benefits it can bring to their portfolios.” Ian Pascal, marketing director at Baring Asset Management, explains: “Just because a fund has an absolute return mandate doesn’t automatically make it a low-risk product. Hedge funds are an example of absolute return funds and can be risky.” He adds: “The challenge as product providers is to make sure investors know where the risks are. We have done a huge amount of work with IFAs; much more training and education was required than for other fund launches. You need to understand clients’ objectives and it reinforces the need for customers to get good advice.” UBS’s Mawdsley says: “There is no doubt that the arrival of Ucits III brings a wider range of investment opportunities. This will encourage investment managers to launch funds in this space. The difficulty in marketing these products to clients is matching their risk and reward expectations. He argues: “They want equity-type returns with cash-like risks. The concept definitely appeals to people, but the proof has to be in the pudding. Our fund has a cash target, but is marketed as a low-risk bond fund rather than a high-risk cash fund.” One of the advantages of active asset allocation is that portfolios can be more diversified and theoretically can achieve lower volatility. But to achieve this more efficient risk/return profile, there is one big proviso – fund managers need to know exactly what they are doing. This may seem an obvious prerequisite for picking someone to run a portfolio, but it should be noted that the added flexibility these products bring means fund managers need broader skill sets. Conventional long-only equity fund managers may find running a multi-asset long/short portfolio rather daunting, because the number of variables affecting a fund’s performance increases dramatically. Rigid risk controls and scenario testing should presumably be taken as a given. In short, the added flexibility brings about greater complexity which, if not completely allowed for and understood, could actually contribute to a higher rather than lower-risk portfolio. Richard Philbin, F&C director of funds of funds, says: “A number of long-only fund managers have moved to run hedge funds and have found they don’t have the skills to do it. Some have come back to long-only management. The flexibility brought in by Ucits III is good, but we have not seen volatility low enough yet.” A recent Financial Services Authority discussion paper (Wider-range Retail Investment Products) explains: “It is possible that some fund management companies operating Ucits III funds may not implement appropriate risk management systems and controls that need to be in place to manage effectively and safely their new portfolios.” The FSA also argues in the paper that retail consumers may find it difficult to understand the new Ucits III vehicles sufficiently to make sensible investment decisions. The fact these seemingly contrasting portfolios are grouped together is also a potential problem, as investors may associate certain characteristics with absolute return funds that do not universally apply. The different hedge fund strategies also need to be understood by those with exposure to them. Patrick Armstrong, co-manager of the Insight Target Return fund, says the portfolio is being drip-fed into the market: “It is important that investors and intermediaries understand the structure and risk profile of the product. We don’t want to create unrealistic expectations for the fund.” Pascal identifies a division within these products: “There are two main groups of absolute return investors. There are those who want to be in fixed income assets but are concerned about the direction of the markets. Our fund provides low correlation with traditional bond funds and can be used as a diversifier within the bond markets. “The second group is those wanting hedge fund type exposure using shorting techniques. These are the classic absolute return products that offer low volatility and low correlation with other asset classes – basically a hedge fund without the borrowing.” Toby Hogbin, head of product development at Credit Suisse Asset Management, agrees: “This category of fund is growing but is still relatively immature. Clearly as the sector continues to grow, it will split to better reflect the array of styles available. There are the more aggressive quasi-hedge funds in the market, and the much lower-risk capital protection models. Hogbin explains: “They are currently viewed in the same space as seeking to provide positive returns in all environments. But the risks to the investor differ through the mandates. Only when the absolute return sector achieves critical mass will it be able to subdivide. The volatility of these funds varies materially. It is for the investor to decide whether they want a rollercoaster or a smoother ride.” Charging structures also vary widely across funds. The DWS RateBuster has no initial fee, a 1% annual management charge and minimum investment of 1,000. Compare this with the Close Finsbury MultiAsset fund, with a 4.5% initial charge, 1.5% AMC, performance fee of 15% of a notional benchmark and a 25,000 minimum stake. Clearly the contrasting mandates of the respective funds necessitate different charging structures. Performance fees are common among hedge funds and the MLIM UK Absolute Alpha portfolio may introduce a share class including them. Insight’s fund has no performance fee. There also appears to be demand for total return products as an alternative to with-profits funds. According to a survey by Incisive Research on behalf of JP Morgan Asset Management, 75% of IFAs would be most likely to recommend total return products to cautious investors who would traditionally opt for a with-profits product. The research also revealed that two-thirds of advisers consider total return funds to be best suited to Isas, and 59% say they are best for personal pensions. Momentum in demand for these types of fund appears to be growing and a number of groups are looking to launch new funds. Threadneedle, for instance, is looking to introduce an absolute return bond fund. Barings’ Pascal says: “Over time, if people see these products delivering, they could become an increasingly important part of their portfolios.” Armstrong is more optimistic for his fund: “It could be the perfect solution for the core part of an investor’s portfolio. With daily liquidity, low risk and reasonable potential for strong capital growth, it is a good starting point for an investment portfolio.” Views of fund strategists
Tony Lanning – research and investment director at Origen
“Historically we have not been big promoters of absolute return hedge funds, but the flexibility of Ucits III has changed things. We have recommended the Credit Suisse Target Return fund for investors. Another fixed interest fund we like is the Baring Directional Global Bond fund. They can fit well into a diversified portfolio. A bond portfolio might be made up of four different funds including the Barings fund. However, absolute return funds may not enter on to the radar screens of high-street IFAs because they are generally looking for greater returns. They won’t become a mainstream part of investors’ portfolios.” Ben Yearsley – senior investment manager at Hargreaves Lansdown
“They will be increasingly used, but the funds have to prove they actually work. The DWS and JP Morgan products are key for the industry. If these can work it provides for an encouraging future. If they have a patchy start they may have a problem. The biggest risk is in disappointing clients – if clients expect 8% and they only get 4%, they won’t be happy. Education is key and investors need to receive a full explanation of the risk profiles involved. The DWS and JP Morgan products look interesting but we are unlikely to recommend them for the moment. The first six months are crucial for these funds.” Views of fund strategists
Darius McDermott – managing director of Chelsea Financial Services
“We are not generally using them, although a number of clients have invested in the DWS RateBuster fund within a cash Isa. There has been a raft of bond-type products launched by Barings, Credit Suisse and UBS. We are taking a watching brief and I am sure products will eventually be successful and popular. We are looking at the various strategies and at who can deliver what they say they can. Some of the bond products have not achieved their targets.” Richard Philbin – fund of funds director at F&C Asset Management
“For a fund of funds manager it is difficult to use these types of fund from an asset allocation perspective. It is difficult to know what you have bought as you can’t control asset allocation. For an asset class that is supposedly meant to give lower volatility, the volatility of [absolute return] equity funds seems to be very high. Looking at the absolute return bond products, we are unlikely to use these for a long time. A lot are using shorting techniques and I am not convinced in their ability. Also, most of these funds only have accumulation units and do not provide income – this doesn’t meet the needs of our clients.”