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Alpha particles

The wide range of investment strategies used by absolute return funds mean that most have little in common beyond their basic positive performance target.

Across the 45 onshore products, there are equity, bond, currency and multi-asset portfolios and this spread of investment approaches is reflected by the returns over 12 months to April 6, ranging from 34.3 per cent to -4.4 per cent.

Overall – and as much as the sector average conveys – absolute return vehicles produced an average 12.3 per cent over this period against 45 per cent from the UK all companies sector, for example.

This lower average is largely down to the fact that most of these vehicles are expected to lag in strongly outperforming markets – targeting consistent alpha rather than beta.

Among the more established funds in the sector, BlackRock UK absolute alpha managers Mark Lyttleton and Nick Osborne have continued increasing their gross market exposure in recent months, approaching a two-year high of 90 per cent.

This figure – which combines the long and short positions – includes various additions on the long side, with the pair boosting exposure to stocks set to benefit from the expected rebound in corporate discretionary expenditure.

Osborne says the recent reporting season has been notable because companies began to beat expectations at the top as well as bottom line.
He says: “This is a crucial step in giving executives the confidence to invest and ultimately rehire, which creates employment and a sustainable recovery.”

On the short side, they recently introduced a position in the UK life insurance sector, partly to hedge financial exposure elsewhere and also on the call that capital pressures will intensify.

’This will translate into countries trying to engineer controlled devaluations and could be the forerunner of protectionism as it is hard to find currencies that will be allowed to appreciate’

BlackRock UK absolute alpha produced 8 per cent last year, which Osborne described as disappointing after a strong first half.

“We were up by 6 per cent over the first six months against a flat market, ident-ifying many cheap equities in March and moving from neutral to 20 per cent net long. While we kept this position throughout the year, we were slow to appreciate how quickly the world would recover and did not introduce enough cyclicality or risk.”

Osborne and Lyttleton largely bought better-quality cheap stocks but more economically sensitive and leveraged companies led the rally.

Another high-profile equity investor in the sector is Cazenove’s Tim Russell, who is seeking a better year for his UK absolute target investors fund than in 2009. His portfolio benefited from market dislocation in 2008, taking positions against financials and commodities, but was flat last year after being relatively late into the cyclical-led recovery.

Russell remains cautious, saying he is sceptical the recovery in earnings will be as smooth as the market has quickly assumed and believes a double-dip is possible.

This view has seen him remain long in defensives and short areas, including industrials, metals and oils. He says: “We still see cyclicals as the biggest potential area of disappointment and are surprised to see many commodity stocks trading on double-digit price/earnings ratios.

his ignores their considerable earnings’ variability and investors seem blind to the low-added-value nature of many commodity companies.”

Russell is also concerned about the imminent withdrawal of government stimulus packages and whether economies can stand on their own without these. “Last year saw a huge transfer of personal and corporate debt to the public sector but this will have to reverse in order to reduce budget deficits and that process is unlikely to be painless. The East versus West and, to a lesser degree, cyclical versus defensive trend remains strong but the market is complacent about the risks of growth disappointment globally and excessive enthusiasm for Eastern stocks leaves them particularly vulnerable.”

Elsewhere in the absolute return universe, global macro products from Legal & General and Standard Life Investments are among the best performers over 12 months.

These adopt strategic positions across assets and world markets, offering greater diversification than equity or bond-only peers.

L&G’s diversified absolute return trust, for example, invests across equities, bonds, currencies, interest rates and commodities, using Ucits III powers to express bullish or bearish sentiments.

Manager David North says the fund has enjoyed a strong start to 2010, with the flexibility and liquidity of instruments allowing the team to take advantage of opportunities within volatile markets.

He says: “We believe developed equity markets will remain in a range for the first half of this year. Performance in 2009 was driven by a dramatic turn-round in economic data but that momentum is now behind us and there is increased risk of economic data disappointing versus consensus expectations.”

Looking forward, North believes interest rates will remain unchanged and stay lower for longer and sovereign risk will increase as market participants re-examine issues associated with debt levels.

North says: “This will translate into countries trying to engineer controlled devaluations and could be the forerunner of protectionism as it is hard to find currencies that will be allowed to appreciate.”

A current key position on the portfolio is the sterling short, as the team expects the UK’s currency will be the next to be challenged.

He says: “With a currency that can be used as part of the monetary policy toolkit, it is not unreasonable to expect sterling to fall, which is unlikely to be fought against by the political and financial leaders of the country.”

On the equity front, the team is bullish on dividend-producing stocks and has been boosting positions into weakness, believing the fall in sterling will help the outlook for UK companies.

More recently, North has also made money through the month by being short on equity volatility and initiated a position within European equities with an industrials versus utilities trade. “As markets lack a directional bias over the next six months, we will endeavour to initiate more of these pair trades to take advantage of sector differentials across the market,” he added.

Overall, the best-performing absolute return fund over 12 months – highlighting another strategy in the sector – is Henderson credit alpha. This portfolio uses credit analytics to drive performance, hedging out duration and FX risk and taking a marketneutral approach.

Managers Stephen Thariyan and Tom Ross produced stellar returns in 2009, boosted by a long position in financial debt, but they warn that future performance is likely to be steadier in a difficult market. The pair highlight three main strategies on the portfolio, with pair trades at stock and sector level plus more tactical short-term positions.

Thariyan says: “With no duration, FX and market risk, our portfolio basically needs volatility, liquidity and good ideas to perform. 2008 was obviously a struggle for liquidity but last year provided major opportunities as sectors such as financials saw a major repricing. We see many of these big themes as largely played out but the volatile background creates a good environment for our analysts to identify which bonds will perform against one another.”

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