This quarter, we asked our panel: are targeted absolute return funds desirable in portfolios at this time, how do they use them and why?
Abbas Owainati, head of asset allocation and portfolio management, Charles Stanley
Absolute return funds can play a valuable role in multi-asset portfolios, particularly as a complement to traditional equity and bond exposures.
This is especially relevant in the current environment, where markets appear to be pricing in a relatively optimistic outlook.
Many risk assets have largely retraced to pre-conflict levels, despite the potential drag on economic growth and the risk of renewed inflationary pressure.
Against this backdrop, elevated geopolitical tensions leave little margin for disappointment. We therefore see a clear role for absolute return strategies as a diversifying allocation. Their appeal lies in their potential to generate returns from sources that are less dependent on the direction of equity or bond markets.
Abbas Owainati, head of asset allocation and portfolio management, Charles Stanley
‘Many risk assets have largely retraced to pre-conflict levels, despite the potential drag on economic growth and the risk of renewed inflationary pressure’
With flexible mandates across asset classes, regions and instruments, managers can seek to exploit relative value opportunities, dislocations and market inefficiencies. This can help smooth portfolio outcomes, reduce drawdowns and improve resilience when traditional assets come under pressure.
Although these funds typically come with higher fees, we believe they can justify a place in portfolios. They allow us to add risk incrementally without materially increasing exposure to directional market moves, which is particularly useful when the near-term risk-reward balance for equities looks less compelling.
In practice, we do not view them as a substitute for equities or bonds, but as a portfolio construction tool: a way to retain return-seeking exposure while preserving some protection if markets pull back.
Matthew Stanesby, managing director and head of collectives, TrinityBridge
There are a few reasons why absolute return funds are attractive today. First, uncertainty in the world, both in terms of the macro backdrop and geopolitics, and this typically leads to higher volatility. An absolute return strategy is designed to work in all market environments, and with more volatility, higher returns should be achievable.
Second, higher interest rates tend to create company winners and losers, and good absolute return managers can profit from this without being dependent on market direction.
Matthew Stanesby, managing director and head of collectives, TrinityBridge
‘We do have a relatively small allocation to absolute return funds. One of the reasons it’s not higher is finding good funds that are not capacity constrained and available at a reasonable fee is difficult’
There is also the potential for rising inflation. This is not good for fixed income, which is typically the hedge for equity within a multi-asset portfolio; so, alternative strategies become more attractive in comparison.
We do have a relatively small allocation to absolute return funds. One of the reasons it’s not higher is finding good funds that are not capacity constrained and available at a reasonable fee is difficult. When we have owned absolute return funds in the past, our selection process has been focused on finding opportunities that do not correlate with equity and bond performance.
However, ultimately, our experience hasn’t always been good relative to what is available from cash and short-duration credit strategies in times of market stress.
Lindsay James, investment strategist, Quilter Investors
We hold absolute return funds across our multi-asset range. These holdings sit within the alternatives allocation, where we currently have an overweight position in both our Cirilium and WealthSelect ranges relative to their long-run strategic asset allocation.
While this encompasses a wider variety of strategies than purely absolute return, liquid alternatives can be a better source of diversification to an overall portfolio than holding more traditional fixed income, with sporadic bouts of inflation in developed economies a recurring problem for both equities and bonds. Alternatives are also a much better source of return than holding cash in the long run.
Drilling down further, our absolute return fund exposure typically translates into several long-short equity hedge fund holdings as well as fixed income funds that seek absolute returns regardless of broader market direction, while other strategies, such as a systematic approach, also feature.
Lindsay James, investment strategist, Quilter Investors
‘Liquid alternatives can be a better source of diversification to an overall portfolio than holding more traditional fixed income’
Aside from their portfolio construction, there are other factors to consider. On the one hand, market dispersion has increased in recent years, which is the lifeblood of a long/short strategy. AI disruptors versus the AI disrupted are the most obvious example.
However, at times markets can be heavily driven by macro events, such as an inflation shock, tightening up cross-asset correlations, while US retail investors can turn a popular ‘short’ into a meme stock overnight, leading to violent reversals.
This means diversification is just as important here as elsewhere, with the right mix of managers and strategies more important than ever.
Robin Ellis, director of multi-asset portfolio management, St. James’s Place
Targeted absolute return funds can play a role in portfolios, but their attractiveness is ultimately context dependent and, in our view, less compelling in the current environment. Today, we favour defensive assets with structurally diversifying beta – particularly government bonds and inflation linked bonds – over strategies that rely primarily on manager skill.
With yields in the region of 4-5%, high-quality sovereign bonds once again provide a meaningful source of income alongside their traditional role as a portfolio stabiliser. Crucially, they also retain the potential to deliver capital appreciation in the event of growth shocks, as central banks have scope to cut rates, reinforcing their defensive characteristics.
Robin Ellis, director of multi-asset portfolio management, St. James’s Place
‘Targeted absolute return funds can play a role in portfolios, but their attractiveness is ultimately context dependent and, in our view, less compelling in the current environment’
By contrast, targeted absolute return funds tend to deliver more variable outcomes. Returns are often driven by manager skill and implementation, which can be inconsistent over time and harder to underwrite with conviction.
In addition, many of these strategies exhibit some degree of equity market correlation, particularly in periods of stress, limiting their effectiveness as a true diversifier when it is most needed. With government bond yields now materially higher than in the past decade, the opportunity cost of allocating to absolute return strategies has also increased, and the hurdle for inclusion is meaningfully higher.
As a result, we do not currently make significant use of targeted absolute return funds, instead prioritising assets that offer more transparent and reliable diversification benefits within multi-asset portfolios.
Ryan Hughes, managing director, AJ Bell Investments
The term ‘targeted absolute return’ is a catch-all title that encompasses a very wide variety of different investment strategies, so it is important to look hard at what is actually happening in each strategy. Not all absolute return funds are equal.
With the challenges to some parts of the fixed interest market, there is certainly appeal in looking at some diversifying strategies, to ensure that factor risk is reduced in portfolios which may have traditionally been focused on equities and bonds.
Ryan Hughes, managing director, AJ Bell Investments
‘Careful selection is needed, particularly when returns for cash or ultra-short-dated bond funds are sitting at close to 4%’
We have been using a combination of managed futures and long/short equity strategies for some clients as a way of adding in more diversification amid what looks to be an increasingly challenged backdrop. This has worked very well this year, with both the Montlake DUNN Managed Futures fund and iMGP DBi Managed Futures fund performing strongly, offsetting the weaker performance from Premier Miton Tellworth UK Select.
However, it is worth remembering that many absolute returns fail to deliver on their promises or simply do not bring the diversifying qualities expected.
Therefore, careful selection is needed, particularly when returns for cash or ultra-short-dated bond funds are sitting at close to 4%. This sets a high bar for absolute return to make it into a portfolio with a need to ensure they are genuinely additive rather than just bringing theoretical diversification.
Mark Preskett, senior portfolio manager, Morningstar Wealth
We are using absolute return funds more in our portfolios today than at any time in the past, and have been increasing exposure levels in recent months. There are several factors to call out.
First, we are typically using them as an alternative to fixed income, not equities. Bond diversification is being challenged – particularly with gilts – and we have seen correlations of sovereign bonds to equities swing meaningfully up and down.
In addition, credit spreads remain tight relative to history, leading us to allocate away from this area.
Mark Preskett, senior portfolio manager, Morningstar Wealth
‘We are typically using them [absolute return funds] as an alternative to fixed income, not equities’
This has guided us towards lower volatility funds with proven drawdown characteristics, rather than the more gung-ho offerings seeking to maximise returns. Our typical blend is to combine a managed futures fund with global macro and equity market neutral portfolios.
Another aspect is the improving quality of alternative fund managers in the Ucits space. It was only a few years ago that the menu of liquid alternative funds was limited and managed by fund houses with a pedigree in long-only investing.
Today, we are seeing a wider variety and higher quality of funds becoming available to us, driven by managers from the traditional hedge fund space launching Ucits vehicles.
