The evolution of absolute return (Archived)

Absolute return investing has attracted praise and censure in equal measure in recent times. Indeed, ever since this style of investing gained popularity in the wake of the financial crisis of 2008 it has been the subject of intense scrutiny. It is not surprising. Any investment manager that promises clients steady, growing returns that are less affected by wider market volatility is deserving of such scrutiny.

As with any nascent retail investment technique there has been a wide disparity between those funds that have delivered on their goal and those that have failed. But the wider question for 2014 is: do we really need absolute return funds at all?

It is not hard to justify investing in an absolute return fund at a time of profound economic uncertainty. The prospect of steady, lower risk returns at a time when economic growth is stagnant and markets are capricious is a tempting one. In particular if that fund aims to protect your capital on the downside.

But at a time when markets appear to be gaining consistent upward momentum, will there be a place for these kinds of funds in three, six or 12 months’ time? Will investors simply move into funds that offer more exposure to rising markets?

Matt Oomen, head of distribution for EMEA at BNY Mellon Investment Management, does not believe interest in absolute return funds will wane in 2014. On the contrary, he thinks 2014 will be the year when absolute return funds truly come of age.

“Investors have a more developed understanding of how to use absolute return funds today,” he says. “Whereas before the financial crisis people had looked upon these kinds of products as purely a proxy for hedge funds, today long/short style funds are used more holistically, for example, as a dampener of volatility, or as part of an investor’s broader equity or fixed income exposure.”

Volatility fears

Oomen says there is a high chance markets will remain volatile this year. “Enough potential problems remain (in the global economic system) that need to be worked through to keep investors in fear of volatility rearing its ugly head again,” he says. “There will be a lot of focus on flexible absolute return strategies and we will see that trend continue.”

Most commentators agree that the biggest threats to market stability this year will be the US Federal Reserve’s on-going tapering of its quantitative easing (QE) programme and the end of near zero interest rates across the developed world. It is these twin risks, says Ivo Batista, an investment strategist from the BNY Mellon Investment Strategy and Solutions Group, which could lead to further turbulence in financial markets.

“Demand will be driven primarily by investors’ risk appetites, but also by the characteristics and perceived risks of different asset classes,” he says. “For example, if US interest rates were to rise in 2014, investors may seek shelter from the duration risk inherent in fixed income assets. An absolute return approach employing an interest rate hedging strategy could help to mitigate this risk.”

According to Peter Bentley, head of UK and global credit at Insight Investment (Insight), taking on more risk is not the only way for absolute return investors to seek to generate the same level of gains achievable under previous, higher-return conditions. “Having a duration neutral, or an essentially interest rate risk-free stance as a portfolio’s starting point can serve investors well if their primary concern is capital preservation.

“This can entail buying offsetting pairs of markets and instruments: a benefit of such a long/short approach is that there is the potential to generate positive returns in both rising and falling markets,” he adds.

David Chellew, global head of marketing at Insight Investment, agrees volatility will continue to lurk in the shadows of growth. “Given the risk inherent in equities and where yields are, demand for absolute return investing is likely to remain strong in 2014,” he says. With demand for absolute return funds set to continue, just what kinds of funds will make the grade? For Chellew absolute return funds will be judged on whether they offer their aims. It seems an obvious point to make, but these strategies are very prescriptive in what they offer investors and success can only be judged on the delivery of those objectives.

“The best absolute return funds are outcome orientated in their approach,” Chellew says. “It is not a horse race, you can’t choose the winner by looking at the peer group ranking over five years. Some funds aim for positive returns over both the short and long term, while others target higher positive returns in the longer term, with the potential for greater volatility on the way. The funds that will grow will be the ones that deliver on their promises year in year out – critically without any nasty surprises”.

As to whether there will be more ‘me too’ launches of absolute return funds in 2014, Chellew thinks it is more a case of existing competitors proving they can stand the test of time. “Investors in the successful funds will be tempted to increase their exposure while new clients will be attracted by those with long-term records,” he says.

Help the aged

One big opportunity for absolute return funds in the years ahead, according to Chellew, is the developed world’s ageing population. What he refers to as “clients on the glide path into retirement.”

“As people approach retirement they need steady, low volatile returns because their investment horizon is getting shorter and their tolerance for big drawdowns is reducing,” he says.

“Investments that aim to deliver on a short-term horizon with a high degree of capital preservation give the client more control over the timing of their investment and redemption dates. This is a growing need and it is currently under served by the investment industry.” For Oomen absolute return funds will remain popular due to a change in attitudes among investors since the financial crisis. “Today there is more emphasis on the journey rather than the end game. There is a swathe of the investment community that doesn’t want too rocky a ride.”

This is not investment advice. Regulatory Disclosure