With uncertain times ahead for the global economy, understanding how funds work is vital
The Investment Association Targeted Absolute Return sector is a diverse group of funds with varying strategies and levels of risk.
The common goal that unites them, as defined by the IA, is that they aim to achieve a return “greater than zero after fees”, and the timeframe for this “must not be longer than three years”.
The range of strategies that managers employ to try to achieve these results is vast. Most employ diversification as one of the key tools to hedge against market movements, with the typical number of portfolio positions being several hundred.
Funds that solely employ this strategy generally just take long-only positions in securities and hence are best defined as multi-asset.
However, this on its own is not enough to truly diversify risk and there are many multi-asset funds in this sector that provide a good risk/return when markets are stable, but are still exposed to the breakdown of correlations in extreme market conditions. This is particularly important to note given recent stable market conditions inflating one, three and five-year performance figures beloved by analysts. Thus, to truly be absolute return, managers must also employ hedging strategies, so they benefit when markets fall.
A lot of good news is often bad for the markets, as we have seen with several sharp sell-offs in the months of February, March and October.
Therefore, this year provides a good subset of data of which to show exactly how absolute return funds can add value. Chart 1 shows year-to-date performance of the MSCI AC World index and the IA Targeted Absolute Return sector.
It may seem ridiculous that funds characterised by their higher-than-average fees, including performance fees, have performed worse than the world index, which can be bought through a passive tracker fund for very little cost. However, the true value of these funds can be seen during the three big drawdowns in February, March and October.
During these three periods, the MSCI World index fell 8 per cent, 6.9 per cent and 8.1 per cent respectively, while the IA Targeted Absolute Return sector fell only 1.1 per cent, 0.6 per cent and 1 per cent.
We can see the sector continuing this trend throughout the year, as the average downside capture was only 16 per cent of the index. Thus, during times when being invested in the market is most fraught with danger, absolute return funds can provide downside protection.
Having established the benefit of selecting absolute return funds, and their key purpose being to dampen volatility and protect from downside risk, the question remains of which funds to pick. It is better to focus on those funds that are truly “hedged” and have exposure to security prices moving up and down, rather than just multi-asset funds which are exposed to different long-only return drivers.
This is demonstrated clearly in chart 2, which shows the 2018 performance of Portfolio B, an equally-weighted portfolio of six hedged absolute return funds, versus Portfolio C, an equally-weighted portfolio of six multi-asset funds.
The hedged portfolio has clearly produced a better return over the year, but also protected better during the sell-offs previously mentioned.
During the drawdown periods of February, March and October, Portfolio B only fell by 1.1 per cent, 0.6 per cent and rose by 0.1 per cent during the October sell-off.
Portfolio C fell by 1.4 per cent, 0.6 per cent and 1.2 per cent, in February, March and October respectively.
This performance record is not just visible in 2018 but can be seen over the past five years as well. There has been significant and consistent outperformance of the hedged portfolio, as shown in the chart.
The hedged portfolio has clearly outperformed the IA Targeted Absolute Return sector and multi-asset portfolio, while producing a lower maximum drawdown.
Given the uncertainty in global markets, with structural challenges emerging in Europe and trade tensions, it is imperative you pick the right funds and understand their investment process to provide an absolute return and protect capital.
Louis Tambe is a fund analyst at FE