Re-examining relative versus absolute returns

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15 June 2023

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‘You can’t eat relative returns’ is an investment aphorism that is appealing in its simplicity, yet is probably at odds with most clients’ expectations.

‘Compare and despair’ – a phenomenon psychologists describe as an ‘unhelpful thinking style’ – may be nearer the mark in some cases. But while the need to compare against something is understandable, it is important to choose the right comparator.

In the case of absolute return funds or investment strategies, that may be a return that exceeds the risk-free rate (usually the return on short-dated government debt), or the rate of inflation (tricky in the current environment), or it may be as simple as ‘don’t lose any of my money’.

Most absolute return funds or portfolios will contain a mix of assets – probably with some equities for growth potential, some bonds for incremental returns and downside protection, some cash and perhaps other assets such as gold or property. While some will be long-only, others take a long/short or derivatives-based approach.

The range of assets and exposures presents an obvious difficulty with benchmarking – while it is easy to see if your broad UK equity fund has beaten the FTSE All-Share, it is less simple to compare portfolios where underlying exposures may vastly differ, even if they share similar objectives.

Asset Risk Consultants (ARC) developed its private client indices on the basis that ‘all returns are relative’. The indices – Cautious (up to 40% equities), Balanced Asset (40-60%), Steady Growth (60-80%) and Equity Risk (80-110%) – are based on 350,000 real private client portfolios, and Paul Kearney, ARC’s managing director, describes them as “a unique reference point of what good looks like”.

He says investors with similar objectives and risk tolerance should in theory get similar portfolios from different wealth managers, but each manager has their own ‘secret sauce’ – “they may be overweight this and underweight that, investing in different geographies, using direct equities or funds of funds, low-cost ETFs or high-cost hedge funds; we should be indifferent to the sauce. But after five years you want to be able to see, net of all fees, if you could have done better somewhere else.”

By publishing 25^th and 75^th percentile returns for each index as well as the average return, investors can see what ‘median good’ and ‘median bad’ looks like.

“If your manager is consistently fourth quartile (i.e. below the 75^th percentile return), you need to understand why: is it because of high fees, are they just not very good at investing, or do they have a contrarian approach – such as being very defensive – that you believe is right even if it is out of favour?” says Kearney.

‘Being very defensive’ is often the modus operandi of absolute return funds where loss avoidance is key. Chris Clothier, co-manager of the CG Absolute Return Fund and Capital Gearing Trust, says: “Our view is that investors need to think in terms of acceptable risk.

Effectively, that translates to a maximum drawdown tolerance, and if that means your expected returns are quite low, that is something you just have to live with. There is a huge temptation to have a return target in mind – whether that is a fixed number or a range, such as high single digits, but having such mental targets is dangerous as it can lead you to fill your portfolio with assets that will hit that target regardless of where interest rates are.”

He adds that the post-financial crisis era of extraordinary monetary policy had the effect – indeed, the intention – of pushing investors out along the risk curve, thus increasing “the risk of a nasty surprise”.

The CG portfolios (the open- and closed-ended strategies are very similar, although as an investment trust, Capital Gearing can run with slightly more illiquidity risk) have c.30% equity exposure (mainly through ETFs and closed-end funds, investing in a range of asset classes with only around 11% being direct equity funds), with a core (c.45%) of index-linked government bonds and additional holdings in government and corporate debt, property (c.6%), gold (c.2%) and cash (c.1%).

This puts them firmly in the ‘cautious’ camp (per the ARC indices). “We have an aim – although we have not met it over the past year – to avoid losing money over a 12-month period,” says Clothier.

“We are trying to limit peak-to-trough drawdown in the range of 5%, and if we get those things right, the upside will largely take care of itself.” The recent performance wobble was largely caused by exposure to property (currently c.7% through funds), which had provided very good returns in the wake of the pandemic, but which Clothier says the team were too slow to reduce as the market rolled over in 2022.

The manager is currently finding the best opportunities in bond markets – “We are loving that you can get low-risk sterling denominated assets delivering attractive returns – short-dated government debt is yielding over 5%, we are getting positive real returns on index-linked bonds, and our sterling corporate credit (c.2 years duration) is returning 6-7%, which feels great as well,” says Clothier.

He is far less optimistic on equity markets: “With the Nasdaq fantastically strong so far this year, it feels like there is a bit of irrational exuberance returning, and it is surprising to us that equity markets are so resilient in the face of monetary policy that we have not seen the like for 15 years,” he concludes.

Performance, 10 years to 14 June:

Morningstar multi-asset sectors

Name	Category Average %
GBP Allocation 20-40% Equity	28.52
GBP Allocation 40-60% Equity	44.36
GBP Allocation 60-80% Equity	66.58
GBP Allocation 80%+ Equity	82.31
Source: Morningstar Direct