It doesn’t take an expert investor to tell you that 2018 was an extremely challenging market for most managers, particularly those focused on investing in ‘risk-on’ assets such as equities and high yield credit.
This has certainly been the case with the IA Targeted Absolute Return sector (TAR), which was down 2.8% for the year in sterling terms as global markets were hit hard by sell-offs in February and March, followed by strong growth in Q2 and Q3, before selling off at even greater levels in October and December.
In relative terms, this compares quite favourably with the performance of most equity markets in 2018: UK, European and Emerging Market equities all fell by more than 9% and the MSCI AC World index was down almost 4%. In fixed income markets, UK bonds dropped 0.1% with UK high yield falling 1.62% at the bottom end and UK gilts rising 0.57% at the top end. Meanwhile two relative ‘safe havens’ could be found in US equities, up 1%, and Global bonds, up 4.9%, as both were helped by a weakening pound, particularly against the US dollar.
Within the sector there are some strategies that managed to perform better than others, namely credit and equity market neutral funds, showing that any funds taking directional risk in equities would have been penalised. It is important, nonetheless, to remember that many of the funds in this sector are aiming to generate a positive return over a 3-year time horizon and are also targeting a low correlation to equity markets. Therefore, it is particularly important to look at the performance of absolute return funds when equity markets were falling rapidly.
During the four equity market sell-offs in 2018 (February, March, October, December), the MSCI World index fell 8.0%, 7.1%, 8.4% and 12.9% respectively, while the IA Targeted Absolute Return sector fell only 1.1%, 0.6% and 1.4% and 0.9% in these periods. The sector’s average downside capture of the MSCI World index across the four sell-offs was 11%, making it clear that, in 2018, absolute return funds protected investors’ capital better than major equity markets at times when they were most needed.
Seeking positive returns from absolute return
Some investors might still have expected a positive return for the sector over the whole year. However, given the sharp market rotations throughout the year – for example in October when markets moved from positive on the fed rate cycle, to negative, and then back again to rebound in November and then sell-off anew in December – it has been a more uncertain market than previous years and therefore harder for managers to make successful directional bets, so the lack of positive returns is not totally surprising. This is evidenced by the fact that only 16 out of 117 funds in the TAR sector produced a positive return, according to FE data.
Going one step further, if you consider the potential benefit of positive fund selection within the sector, the downside protection on offer could have been even greater. A crude way of selecting absolute return funds is to select only those that are truly ‘hedged’, i.e. will invest in short positions to also produce alpha when markets are falling, as opposed to the ‘multi-asset’ style funds that are simply investing in a diversified portfolio of long-only bets.
If we take, as an example, an equally-weighted portfolio of six ‘hedged’ funds and compare its performance over 2018 against a portfolio of six ‘multi-asset’ funds (all funds are either 4 or 5 FE crown-rated) we can see there is some benefit to selecting ‘hedged’ managers. The ‘hedged’ portfolio was only down 1.1% for the year, while the multi-asset portfolio dropped 3.3% and during the key sell-off periods the ‘hedged’ portfolio returned -1.1%, -0.1%, +0.1%, and +0.7% whilst the multi-asset portfolio returned -1.8%, -1.3%, -2.1%, and -2.3%.
Whilst absolute return funds as a sector were not the best asset class to be invested in last year, they did provide good downside protection at significant moments in the market, giving investors liquidity at those crucial moments.
The case for absolute return remains, and from an investor’s point of view, the low-correlated returns provided by these strategies could offer a strong diversification benefit for those portfolios with a significant weighting to risk assets.
Louis Tambe is a fund analyst at FE
