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Fund Focus: Absolute return funds

Absolute return funds continue to divide opinion. Fund inflows have remained solid but critics highlight poor performance across many vehicles amid the turbulent conditions of recent years.

Since the sector launched in 2008, several absolute return funds have been among the industry’s biggest sellers, with a fifth of the funds within the sector now over £500m in size.

Among the 52 vehicles in the sector are equity, bond, currency, macro and multi-asset funds and 12-month returns to the end of March are equally diverse, ranging from Odey UK absolute return’s 28 per cent to a near 10 per cent loss from Octopus absolute UK equity.

Such mixed performance – and the fact that 12 portfolios are in negative territory over a year – is at the heart of the criticism of the sector. However, several high-profile fund buyers remain advocates of the concept, citing two occasions in the last decade when the FTSE 100 has almost halved.

Bond products remain in the ascendancy over three years, although they have dropped back slightly in the last 12 months as opportunities became less apparent.

Schroders ISF emerging markets debt absolute return is among the best performers with 37.1 per cent year to date from its long-only strategy.

Geoff Blanning has run the fund since December 1998 and the team focuses purely on emerging market debt and currencies across more than 60 countries.

Schroders product manager Christopher Wyke says: “The only comparable factors in the sector are return and risk and we see emerging debt as an attractive but inefficient area.”

Overall, the team’s aim is to avoid negative years and 2008 was the first ever, albeit relatively flat at -0.31 per cent.

They broadly anticipated the credit crunch, slightly too early the previous year, and used the full 40 per cent cash capacity for protection.

Wyke says: “We then invested aggressively at the end of 2008 and start of 2009 when there was major value in the market but it was only possible to take advantage if you had cash.

“2010 was difficult, with bonds expensive and spreads tight, so we have been more defensive and looked for selected opportunities.”

Henderson credit alpha has been another strong performer, up by 36.2 per cent over three years. The team use credit analytics to drive performance while hedging out duration and FX risk.

Managers Stephen Thariyan and Tom Ross produced particularly strong returns in 2009, boosted by a long position in financial debt.

The pair highlight three main strategies for the portfolio, with pair trades at stock and sector level plus more tactical short-term positions.

Thariyan says: “With no duration, FX or market risk, our portfolio basically needs volatility, liquidity and good ideas to perform. 2008 was a struggle for liquidity but 2009 provided opportunities as sectors like financials saw a repricing. We now see many big themes as played out but the volatile background creates a good environment for our analysts to identify which bonds will perform against one another.”

Apart from the long financials position in 2008, credit alpha was also short in various consumer sectors, focusing on the UK and areas such as autos.

Several multi-asset funds in the sector have also performed strongly, with Newton real return’s 30 per cent return heading this sub-group. Manager Iain Stewart invests across asset classes with various hedging positions, aiming to pick up upward momentum in risk assets while protecting capital in down markets.

Since moving to the current strategy in 2004, most of the early performance came from equities but Stewart took a call in 2007/08 to slash sterling exposure from 100 per cent to about 35 per cent, benefiting from the currency’s devaluation through the credit crunch.

He says: “We also avoided indebted areas of the stockmarket such as banks, real estate and consumer discretionary and had various equity hedges in place plus a large position in government debt.”

During 2008, equities dragged on performance despite the hedges in place and returns came from government debt and options on these bonds, as well as gold and an all-time high 40 per cent cash position.

After Lehmans, Stewart shifted away from government bonds into corporates and benefited from the sector’s rally but remained defensive on equities.

Looking forward, he is increasingly concerned about the macro picture and says asset valuations look less appealing.

Stewart says: “On a cycle-adjusted basis, the price-to-earnings multiple of the world equity market is significantly above average, implying below-average returns ahead. Returns from government bonds, implicit in low yields, look similarly unattractive. Current policy settings are inflationary and portfolios should continue to hedge monetary inflationary risks.

“Against this backdrop, as well as our preference for equity investment, we continue to advocate exposure to other real assets, such as commodities, energy and natural resources.”

Insight Investment’s absolute insight fund is another solid multi-asset performer, with the fund of funds made up of five separate absolute return products run by the group.

Initially, Absolute Insight included three strategies – market-neutral UK equities, currency and emerging market debt. In 2009, the company added a credit offering and a more directional equity vehicle earlier this year.

Manager Reza Vishkai highlights three central aims for the overall fund – stability, diversification and upside capture.

The UK equity market-neutral fund is included for stability. Currency sits in the diversification bucket – with very little correlation to the other funds – while credit, emerging market debt and absolute return equity are charged with upside capture.

Vishkai says: “Allocation is based on a risk-focused approach but we do not attempt to time shifts into or exits from the different products based on market conditions.

“All the underlying vehicles are dynamically managed and Alex Veloude on credit has a better grasp of when to be risk on or off in bond markets than I do, for example.”
Neutral weightings are 25 per cent in the stability equity portion with 8 per cent moved to absolute return equity. The remainder of the assets are 25 per cent in the currency fund and 21 per cent each in credit and emerging market debt.

According to Vishkai, the portfolio’s basic diversification has worked well, with one or two sub-funds outperforming at particular points in time – emerging market debt is the best over three years, with 30 per cent.

“Our UK equity market-neutral fund, for example, had a very strong 2008, with its gross performance of more than 7 per cent making a major contribution to the overall portfolio’s solid showing.”

Looking at the equity funds in the sector, Odey UK absolute return is by far the strongest performer over 12 months, running an average net long position of 55 per cent through 2010.

Manager James Hanbury highlights several major stock contributors to this performance, with long bets in Sports Direct, Cookson and Sky Deutschland all adding value.

Current market exposure is around 80 per cent net long and Hanbury is favouring developed economy exposure on his long book, more comfortable with lower multiples and growth expectations.

He says: “The UK economy is likely to provide pleasant surprises – the mix of ultra-easy monetary conditions index (MCI) and strong global growth normally equates to 5 per cent real GDP growth.”

Elsewhere, the manager has been adding tobacco and reducing general insurance positions. The fund is also shorting government bonds and avoiding commodity positions. In the short term, Hanbury said the general trend for the market has been a rotation from emerging markets to domestic-facing equities this year, benefiting his portfolio.

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