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The real deal

Randal Goldsmith, lead analyst at S&P Fund Services, details the objectives of real return funds

Like absolute return funds, real return funds aim to provide a stated level of return to the investor. Unlike absolute return funds, however, real return funds take inflation into account on their return targets to ensure that purchasing power is preserved, or even grows.

If a fund has a target (nominal) absolute return of 3 per cent and achieves it but inflation during the holding period is 5 per cent, the investor has lost 2 per cent purchasing power.

To be fair to existing absolute return funds, most target a Libor-plus rate, and Libor rates normally rise or fall with inflation. However, sterling Libor rates have been well below inflation for over a year now.

Typically, absolute return funds have performance fees that apply if the target Liborplus rate is achieved, which means that a performance fee could be earned while the investor’s holding suffers an inflation-adjusted decline in value.

We are seeing more launches of funds with real return objectives. This is a welcome development since the ultimate purpose of saving and investment is to preserve and grow purchasing power (make real returns).

The launch of real return funds is particularly welcome at a time when the Bank of England’s latest inflation report contains the overview statement: “The prospects for inflation remain unusually uncertain and there are significant risks to the inflation outlook in either direction.

”Funds with real return objectives are a diverse group with different mandates and strategies for achieving the target. There are 15 funds in the index-linked gilts peer group, most of which are managed relative to the FTSE index-linked government bond indices (which currently have real gross redemption yields of just below 1 per cent).

Some sample funds and real return targets are shown in the box at the top of the page opposite

Equities versus bonds
It is important that investors understand exactly what they are investing in. In particular, what is the typical portfolio mix of the fund (straightforward in the case of index-linked gilt funds but more complicated with the others) and what asset allocation flexibility does the manager have?

If the mandate offers considerable flexibility on asset allocation, then the manager’s track record and risk control techniques are also important considerations. In sum, a thorough qualitative evaluation is critical.

The portfolio mix is important because some asset classes have shown more reliability than others in achieving real returns.

Dimson, Marsh and Staunton’s study of the historical returns on different asset classes, Triumph of the Optimists (New Jersey: Princeton University Press, 2002) estimates that real returns on UK and US equities were 5.8 per cent and 6.7 per cent respectively during the 20th century.

The US outcome could be misleading to the extent that the country transformed from an emerging economy into the world’s leading superpower during this period. However, the study includes 14 other countries, some badly damaged by the impact of two world wars.

The mean real return was 5 per cent, the median was 4.8 per cent (Ireland) and 5 per cent (Switzerland). The lowest compound average real return was 2.5 per cent (Belgium) and the highest was 7.6 per cent (Sweden).

This suggests that the average fund manager running a portfolio with a high allocation to equities should be able to deliver meaningful real returns over time. However, the volatility of real returns on equities suggests that the risk of a negative real return target is also very high in the short term.

In his 200-year study, Stocks for the Long Run (New York: McGraw Hill, 2002, 3rd ed), Jeremy Siegel found that the best and worst year real returns were +66.6 per cent and -38.6 per cent. The worst year in the UK was actually much worse than for the US. In 1974, the UK stockmarket lost half its value and, adjusted for the UK’s high inflation of the mid 1970s, the real loss was closer to 70 per cent.

The spread of worst and best annualised returns over five and 10-year periods in the Siegel study falls rapidly (26.7 per cent and -11 per cent and 16.9 per cent and -4.1 per cent) and for 20-year periods, both worst and best are positive annualised returns (1 per cent and 12.6 per cent).

The standard deviation of annualised returns across these time periods drops commensurately – one year 18.1 per cent, five years 7.5 per cent, 10 years 4.4 per cent and 20 years 2.5 per cent.

The risk of big declines over short holding periods is much lower with bonds and is removed for very short-dated Treasury bills (but not in real terms). However, historical real returns have been small over the long term – government bonds returned an annualised 1.3 per cent over inflation during the 20th century in the UK and 1.6 per cent in the US, according to Dimson, Marsh and Staunton’s study.

Over the same time period, T-bills delivered compound annualised real returns of 1 per cent in the UK and 0.9 per cent in the US.

Investment-grade corporate bonds have shown slightly higher returns – 2.1 per cent over the same time period according to Dimson, March and Staunton, relying on data from Ibbotson Associates (1926 to 2000) and Global Financial Date (1900-1926).

While equities are generally less reliable than bonds in the short term, they show more reliability than bonds when inflation rates rise sharply.

Siegel breaks his study down into three time periods – two with no meaningful inflation and one with inflation. Nominal equity returns varied significantly between these periods while there was no material difference in real returns. In contrast, bonds showed little variation in nominal returns but significant differences in real returns, with lower real returns achieved in periods of inflation.

The extreme example here would be German government bonds, which became worthless over the course of the inter-war period hyper-inflation, while equities suffered but still preserved some value.

Other portfolio assets
Some other asset classes to look out for in a fund with a real return objective are inflation-linked bonds, gold and property.

Inflation-linked bonds are particularly important. An index-linked gilt compensates you almost fully for inflation (as measured by movements in the retail price index) so long as you hold it to expiry (the index from some months back is used to adjust the coupon and principal, which means that you are not protected from a sudden jump in the RPI at the time of redemption).

Funds that invest entirely, or primarily in inflation-linked bonds, are the most established form of real return fund and there are established peer groups of inflation linked bond funds, sub-divided by currency class (the IMA has an index linked gilts peer group, and S&P has euro inflation linked, US dollar inflation linked and global inflation linked in euro and US dollar peer groups).

While index-linked gilts provide reliable protection against domestic inflation (as measured by governmentcalculated RPI), they do not protect against loss of purchasing power overseas after sterling has depreciated against other currencies.

The other drawback with index-linked gilt funds currently is the real gross redemption yields priced in are currently less than 1 per cent.

One of the appeals of gold in a real return fund is that it protects purchasing power over the very long term regardless of currency movements because it is relatively scarce and annual production and new mining discoveries are minute in relation to total supply.

Gold often appreciates more than proportionately during a sharp rise in inflation (in contrast with bonds and equities) because the opportunity cost of holding a non-income-yielding asset is low when real interest rates are negative or very low.

Gold may have the longest and most reliable record of protecting purchasing power but the drawback is that it preserves wealth but does not grow it. Siegel’s study found that gold bought you in 2000 what it bought you in 1800 but no more.

The other point is that, like equities, the gold price can show significant short-term volatility. For example, it declined from around $800 in 1980 to below $260 at its lowest point in 2001. That was a nominal decline of over two-thirds and represented a real loss of purchasing power in the US of over 80 per cent.

The investor should also be clear on the risk management process. This can improve the risk return profile relative to a static portfolio but is generally reliant on past volatility and correlations showing some stability

Property, in common with gold, has the virtue of limited supply in contrast with money and financial assets. It is therefore innately an inflation-protecting asset over the long term. Because such a large portion of the average individual’s income in the UK is spent on accommodation, house price increases correlate much more closely with wage inflation. However, wage inflation tends to be higher than retail price inflation most of the time, making property even more attractive as an inflation hedge.

In contrast with gold, and in common with equities, property can also produce an income when it is rented out. A well located house or office block, may also protect against loss of purchasing power regardless of currency movements.

Property is generally a lowrisk asset. However, property investment becomes risky if it has been financed by too much borrowing and including directly invested property in an open-ended fund with daily dealing does not make sense.

This is because of the time it takes to complete a property transaction. Reits are far more appropriate for an open-ended fund but the return profile of these investments are more correlated with general equities in the short term because of changes in the NAV discount.

Assessing a fund’s suitability
The investor or his/her adviser should be aware of these asset class characteristics when looking at a fund with a real return objective and take a view about how realistic the target is (a 5 per cent real target would be unrealistically optimistic for a fund mainly invested in index-linked gilts but not for one that has a bias towards equities. Above 5 per cent real would seem to require good asset allocation timing).

Evaluating the manager’s track record in managing the fund or similar mandates is also important, particularly where there is significant flexibility to adjust the asset allocation (as in the case of the Iveagh wealth fund).

The investor should also be clear on the risk management process. This can improve the risk return profile relative to a static portfolio but is generally reliant on past volatility and correlations showing some stability.

Close attention should be given to performance fees. Some assets have volatile real returns in the short term (equities in particular) so it is easy for funds invested in them to beat an inflation objective by a large margin in any single year, or even over three years, generating high performance fees if the measurement period for the objective is short. It is therefore very important that past losses are made up for and even better that past shortfalls relative to the inflation target are made up before charging the performance fee, that is, that the hurdle rate for the performance fee is cumulative from year to year.

It is worth noting here that the Sarasin IIID funds have performance fees but do not have high watermarks or any requirement to make up past shortfalls in the target before earning their performance fee (20 per cent of the excess over its three year target for EquiSar IIID and 10 per cent of the excess for GlobalSar IIID). We rate these funds because they are well managed but our qualitative reports have criticised their product design.

Some sample funds and real return targets

Fund – Goal
Sarasin EquiSar – IIID RPI + 3.5% annualised over three years
Sarasin GlobalSar – IIID (EUR) 3 Month euro Libor + 3% over three years
BNY Mellon Newton Real Return – Libor +4% over a market cycle
Schroder Diversified Growth – RPI +5% over five years
Iveagh Wealth Fund – 7% real return over a market cycle

Fund focus
Fund managers assess the prospects for absolute return

Sector is a steady ship
Tam McVie, investment director, Standard Life Investments

We think that any sort of noticeable recovery will be muted. As a result, we do have a long market exposure, so we are long on equities and we do have quite a bit of credit exposure.

We have also been increasing our pairs’ trades, where we buy one market and sell another. We are increasing these because if you are less sure about market direction then you have to try and find something that is undervalued and overvalued and then exploit the difference between the two – so we are long on US large caps and short small cap, for example. It does not matter if the index goes up or down, as long as the large caps outperform the small caps we make money.

It is this amount of uncertainty that is driving the interest in the absolute return sector right now and that is why IFAs are interested in these funds. They are a steady ship and it seems like people are happy to give up some of the upside as long as they do not get the full downside. Absolute returns will lose money like any other investment, it is just getting rid of the volatility that is attractive because there is so much increasing doubt in the world right now.

Interesting opportunity on the short side
Luke Newman, co-manager, Gartmore UK absolute return fund

We are positioning ourselves for markets to remain volatile but this volatility does not concern us necessarily because we are positioned where we have two-thirds of our assets in our tactical trading part of the fund. This allows us to take shorter time horizon trading positions and tactical positions that allow us to make money and generate performance even in volatile markets.

Actually, an interesting opportunity for this year will be on the short side. A lot of managers have given up on the short side because it cost a lot of money last year but we would regard the short side of the fund as interesting as the long side because we expect more dispersion to come into the market, linked to the volatility, so we will have some good opportunities to make some money on the short side of the fund in the cyclical side of the market.

In terms of sectors, if I look at what happened in 2004, companies managed to refinance their debts adequately but then struggled to finance growth opportunities when they came to the market. This will happen again as investors are not expecting to have to write a cheque to fund the next step of the recovery, and the reaction to companies who do that will be negative.

With that in mind, we have been looking within the industrial and engineering sector, the construction and housebuilding sectors and also the recruitment consultant sectors. All of these consume a lot of cash early in the cycle to fund growth and profits at a later date.

Equity valuations look incredibly compelling
Nick Osborne, co-manager, Blackrock UK absolute alpha

We look at the market and we see valuations that appear quite modest in the context of very strong earnings’ growth. Lots of companies are going to grow earnings by as much as 40 per cent this year and we think equity valuations relative to other asset classes, notably cash and fixed interest, look incredibly compelling.

There are two real positive themes in our fund right now. The first is that the financial sector is continuing to heal itself and we can measure that in terms of credit spreads or in terms of profitability margins for some of these financials either in the retail sector or in the wholesale markets.

The other is that corporate expenditure is going to come back very strongly. We have been very keen to play the beneficiaries of those because corporates have not really invested for two years so there is a sharp need to invest, and we have been keen to play those who are going to benefit from that. We are looking at companies from the media sector who are benefiting from a steep rise in advertising and leisure firms who are benefiting from travel expenditure, for example.

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