Behind the Numbers: Beware the surge in absolute return

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There is no doubting the current popularity of funds within the IA Targeted Absolute Return sector. Today there sits around £53bn overall in the sector in the UK, with some £450m of estimated net inflows for September alone.

Year-to-date flows into the entire sector have totalled more than £8bn and, as at end of September 2015, there are now 10 funds with assets in excess of £1bn. The growth in the sector has been commensurately reflected in product launches. In 2000 the lone standard bearer was Newton Real Return which was joined in 2004 by a small trickle of funds. Since 2014, there have been 16 new funds launched into the sector, which now comprises 75 funds overall.

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What exactly is an absolute return fund? Absolute return funds generally seek to generate a specified return over a given period. This can be an amount over a rate of interest, such as Libor, or an inflation metric. Often the given period is stated as three years but can be a vaguer “market cycle” or another loosely defined rolling period.

Industry sector classification schemes allow investors to compare like with like for many investments, but absolute return can be harder to aggregate. The UK Investment Association for example, has seven qualifications to the definition of its Targeted Absolute Return Fund sector and includes a rolling 12-month monitoring analysis “on the expectation there is a wide expectation among consumers and advisers that funds in the Targeted Absolute Return sector will aim to produce positive returns after 12 months.”

The IA is correct to include so many qualifications and indeed the 12-month ‘expectation’ is probably a reasonable assumption in reflecting investors’ perceptions and a prudent backstop. The name “absolute return” although perhaps not intentionally misleading, could lead unwary investors into a false sense of security.

The reality is that many of the funds in this classification are in fact market-linked and although may contain structures to reduce volatility may not entirely eliminate it in the event of a substantial market move. The IA, since introducing the ‘targeted’ component in 2013, is clearly tried to move away from the perception that these funds may be guaranteed.

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Investors who have suffered through the volatility of 2015 and the recent Black Monday correction may be attracted to the concept of an absolute return. However, the lack of homogeneity in this sector is evident. Overall, it is populated with corporate bond funds, equity long/short funds, equity long funds with index short strategies, diversified multi-asset funds and multi-asset long-only funds to name a few. Indeed, the IA Targeted Absolute Return classification contains funds from more than 20 of the more specifically defined Lipper Global Classifications. This makes true like-for-like comparisons much more difficult than many other sectors.

The varying nature of the composition of the sector is further revealed in the returns. The best performing fund year-to-date, City Financial Absolute Equity has returned 26.9 per cent to September 30, while the worst performing fund over the same period, Henderson Credit Alpha has returned -5.7 per cent. Over this period, more than 30 per cent of all the funds in the Targeted Absolute Return sector have returned a negative amount.

For the longer-term, absolute figures appear better. Over three years to September 30, only two funds in the sector have returned a negative amount and over five years to the same date, only a single fund has returned a negative amount. However, this doesn’t mean investors have benefited from stellar comparative performance. Over the three years to September 30, 2015, only 15 per cent of absolute return funds have beaten a UK RPI +3 per cent benchmark. Over five years, this increases to 21 per cent (although there are fewer funds with a five-year track record).

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Looking at the sector for those funds that have a three-year track record, Table 3 highlights some of the more consistent performers. Only 14 funds overall for the three year period were able to average a Sharpe Ratio Metric and the top 10 are shown.

It is encouraging to see a good mix of differing types of funds in this list, which indicates that consistent returns can be generated by good managers across a range of asset classes and styles. But clearly investors need to understand thoroughly what strategy their absolute return fund is using. Many funds are esoteric with somewhat vague objectives.

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Investors who are sold on the concept of positive returns in all markets may not actually get this and although many funds in this classification do exhibit lower volatility than other market-linked funds, the opportunity cost as evident in the relative performance might be higher than one would expect.

Key Takeaway: A look at the performance tables for absolute return funds shows they are a mixed bag, with varying investment styles, returns targets and time horizons. Some have outperformed consistently and delivered solid returns, while others have been more lacklustre. Assets continue to flood into the market, but are they going to the right funds?

Jake Moeller is head of UK and Ireland research at Thomson Reuters Lipper.