credit fixed income absolute return struggle

Given the low interest rate/low bond yield environment, Rob Harley argues that the fixed income strategies we have seen so much of recently coule be in for a torrid ride.

credit fixed income absolute return struggle


These funds have increasingly found themselves in the spotlight and are periodically demonised as having a disruptive influence on markets, for example being accused of driving down the prices of companies through short-selling. To many they are simply perceived as exclusive investment vehicles for the super-rich which pursue complex (and sometimes high risk) money-making strategies.

Growing investor scepticism

While there are undeniably high-risk funds that fall under the ever-evolving hedge fund banner, and there have been a number of spectacular high profile blow-ups (Long-Term Capital Management, Amaranth, Peloton), the original concept behind these vehicles was to reduce risk through hedging bets, so that investors are less exposed to market volatility.

As we are now more than well aware, since the introduction of new Ucits III regulations in 2004, some of the strategies traditionally associated with hedge funds have become accessible to retail investors through regulated funds pursuing absolute returns in structures that offer daily dealing and pricing.

Yet to-date, many of these funds have disappointed. As a result, scepticism from investors and advisers has grown towards these funds, which has been manifested in a backlash against the performance fees.

The IMA criteria for inclusion in its absolute return sector is a fund objective to deliver an absolute return over a 12-month period – a sensible starting point in terms of defining what constitutes an absolute return fund.

The sector is still fairly limited in terms of the number of funds (just over 50) that constitute the broader peer group but Kepler Partners, a UK-based research and distribution house, monitors more than 300 Ucits absolute return funds available to retail investors.

According to the Kepler Partners Absolute Hedge Database approximately a third of the Ucits absolute return funds it monitors delivered a negative total return over the past three years and around half of all funds have delivered a total return of less than 5%. Less than 16% of funds delivered an annualised performance in excess of 5%.

Where should investors look?

So why have these funds done so badly? In part this is because since 2008 the general market backdrop has not been conducive to many absolute return and hedge fund strategies. The low risk-free rate (cash yield) environment has affected the return profiles for some strategies and is often overlooked when making performance comparisons with the pre-2008 era.

In addition the increasing influence of policymaker decisions (e.g. quantitative easing) on markets, historically high correlation within markets and between asset classes and at times poor trading liquidity combined with short and diminishing aggressive market rotations have all resulted in fund managers struggling to manage risk and capture returns.

In our view, interest rates are likely to remain low for some time yet. Yields on other debt instruments are also close to record lows which could challenge fixed income/credit-related strategies.

Interventions from policymakers such as central banks are a risk that is difficult to predict although recent intervention has actually supported market sentiment. As a result, markets have started to become less correlated and trends could become more established potentially providing a more positive backdrop for select absolute return strategies in the coming years.

In summary, while investors and advisers are right to be sceptical towards absolute return funds, it would be churlish to avoid them altogether, particularly as the market environment could become more conducive to them.

With traditional long-only defensive asset classes such as gilts and quality bonds having performed very strongly in recent years but now carrying an increasingly asymmetric risk profile as a consequence of their yields falling to record lows, cautious investors need to consider alternatives.

Rob Harley is a senior research analyst at Bestinvest


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