Can absolute return handle volatility?

During the past month, 80 out of the 101 funds in the Targeted Absolute Return sector lost money, leading investors to question, as volatility makes a comeback, whether they are too correlated with stock markets.

Absolute return has been a highly popular strategy in recent years due to its bold claim to offer investors a positive return in all market conditions.

Looking at the past three years, the Investment Association’s Targeted Absolute Return sector has delivered a return of 5.89% versus the FTSE 100’s 20.94% and the S&P 500’s 56.36%. Over the past year, the sector has returned 3.22%.

At the end of December, the Targeted Absolute Return sector had £81.3bn under management and in that month alone, took in £245.8m, making it the seventh best-selling sector, according to the IA. It was also the best-selling sector in both 2015 and 2016.

This is to be expected given these funds are not supposed to shoot the lights out in rising markets and that fact that markets have been surfing the wave of the 10-year bull run. But is this set to change as volatility returns to the market and are equity markets and absolute return funds too correlated?

Poor return

According to FE data, the vast majority of the sector’s funds lost money in the past volatile month, with only 18 out of the sector’s 101 delivering a positive return. The sector has returned -0.87% over the same period.

One only needs look at some of the biggest players in the market to see the reversal in fortunes of absolute return funds.

Standard Life Investments’ flagship Global Absolute Return Strategies (Gars) fund has been losing money. In 2016 the fund lost £4.3bn and in 2017 its losses accelerated to £10.7bn, according to the firm’s latest results.

But John Goodall, research analyst at WH Ireland, says absolute return funds form part of the firm’s managed portfolios’ alternatives allocation.

It uses the Newton Real Return fund which he says has struggled of late because of the volatility, but it has its place in the portfolio over a longer time horizon. WH Ireland also recently added the Investec Diversified Income fund which Goodall likes for its different approach to bonds.

“I am happy with keeping money in the sector,” he says. “We may look to do more in the future.”

There is also an appetite among European investors for absolute return. According to data from PA sister title Expert Investor’s research team, in Q4 2017, 39% of fund selectors across Europe said they want to buy absolute return strategy funds over the 12 months to 31 December 2019. Another 30% want to hold their allocation, 25% do not use the strategy, and only 6% want to cut their holdings over the same period.

Too correlated

But other advisers and fund selectors in the UK are less keen.

Patrick Connolly, head of communications at IFA firm Chase de Vere, says he is wary that many of these funds overcharge and in terms of performance do not deliver much more than cash, even when markets are rising.

So, does he believe they are too correlated to stock markets?

“As a sector, yes, they are. They tend to go up when markets go up and tend to go down when they go down; obviously not as much in either direction but investors thinking their capital will be secure in all environments with these funds are likely to be disappointed.”

That said, Chase de Vere does use some absolute return funds for clients but Connolly stresses it does not overuse them, with most of its portfolios allocated to equity, fixed income, property and cash.

A struggling sector

Ben Yearsley, director at Shore Financial Planning, is not convinced about the ability of absolute return funds to deliver their targeted performance.

“Many are opaque in structure and simply don’t provide investors with much if any of a return,” he adds. “Managers wheel out excuses as to why they haven’t performed in this sector, but those excuses are getting bit lame now.

“I’m struggling to see the purpose of the sector anymore.”

Alan Beaney, investment director at RC Brown Investment Management, believes absolute return funds are simply a fad and the returns they have achieved have been “shockingly low and miles behind their target” in an environment when every asset class has gone up.

“In my opinion it takes a lot of skill to do that,” he adds. “It is actually quite difficult to get the returns they have achieved.”

Too complex

Beaney also believes most absolute return strategies have become too complex by “going long this and long that” which, given the returns, has been counterproductive.

He concedes they can be useful in a down market because they can go short but in the last five years while we have experienced phases of down markets, in an up market they have failed to deliver.

“Some of their raison d’être has disappeared,” he says.

Beaney prefers to be able to make his own asset allocation calls rather than rely on a multi-asset manager.

“We prefer to make our own mistakes,” he adds. “We always know what we have done.”

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