Recession could trigger absolute return ‘bloodbath’

Woodford scandal could trigger scrutiny over whether fund outcomes match their hype

A recession could prompt a “bloodbath” for the Investment Association Targeted Absolute Return sector, where confidence is already at an all-time low as funds fail to do what they say on the tin.

Investors have pulled £5.9bn from absolute return funds over the last year, according to the IA, which pegs it as the worst selling retail sector for seven out of the last 12 months.

Assets in the sector have tumbled 30% from £108.6bn last July to their current level of £78.0bn.

“I’m actually surprised that so much money is still in the sector as so many funds have disappointed over many years,” says Shore Financial Planning director Ben Yearsley. “These funds haven’t worked in rising markets and haven’t worked in more volatile markets so frankly what is their use?”

Outflows have been driven by the sector’s biggest behemoths with Standard Life Investment Gars leading the charge, losing shy of £10bn in the last 12 months. It is less than three times the size it was three years ago with assets under management contracting from £26.4bn to £8.1bn.

Fund size as at 30 June 2019Net flows 12 months12-month return
Invesco Global Targeted Returns£11.2bn-£1.2bn-1.88%
ASI Global Absolute Return Strategies£8.1bn-£9.7bn3.60%
Merian Global Equity Absolute Return£6.9bn-£4.0bn-9.35%
BNY Mellon Real Return£6.8bn-£2.9bn9%
Aviva Investors Multi-Strat Target£4.9bn-£719m0.96%
Schroder ISF EM Debt Absolute Return£3.7bn-£286m2.09%
Nordea 1 – GBP Diversified Return£2.6bn£8.8m5.07%
BlackRock Absolute Return Bond£2.4bn£688k0.81%
BNY Mellon Global Dynamic Bond£2.1bn-£288k5%
Janus Henderson UK Absolute Return£2.0bn-£503k-0.90%
 Source: Net flows and AUM calculated by Morningstar; total returns in sterling from FE Analytics

‘There’s going to be an absolute bloodbath’

Beaufort Investment CIO Shane Balkham says liquidity crises at Gam, Woodford Investment Management and Natixis-owned H2O should be prompting investors to take stock of the absolute return sector where in many cases there has been a mismatch between what the fund does and what it says on the tin.

“I’m surprised in hindsight, that when Gars was under pressure for the amount of outflows it was having and its poor performance, that didn’t instigate a wider, ‘Oh let’s look at all of these multi-strategy, absolute return vehicles’. The biggest concern we have is there’s a lot of vehicles out there that on the tin purport to be doing ‘x’ but haven’t been tried or tested in a real consistent market downturn.”

When recession does hit Balkham reckons “there’s going to be an absolute bloodbath”.

Positive equity correlations

“There is undoubtedly a positive equity correlation from the majority of these funds so we would not expect to see a material outperformance in times of market shocks but the drawdowns have been lower than wider markets historically so I would expect a more defensive performance versus equities,” says GDIM investment manager Tom Sparke.

“I think that the value at risk (VAR) figure is key in determining how far each of these funds can fall in extreme circumstances.”

Seven Investment Management senior portfolio manager Peter Sleep thinks if absolute return funds fall less than the equity market during the next recession or even manage to get positive returns this could revive interest in the sector.

He thinks the “bloodbath” is already upon us fuelled by losses and regret at missing out on 10 years of the equity bull market.

Giving up on Gars

In that time many investors have grown impatient and simply given up on the absolute return giants or quit out of the sector altogether.

Sparke relinquished his position in Gars five years ago and since then has not held meaningful exposure to any of the larger funds in the sector. “I have not found that these funds provide a diversifier from equities in portfolios and therefore are only useful as lower beta equity,” he says.

A possible exception to the rule is the £11.2bn Invesco Global Targeted Returns fund, which he notes had a better degree of non-correlation to equities than the others in the market dip of Q4 18.

Yearsley, who once held the multi-strategy Standard Life Investments fund in his personal Isa, says Shore Financial does not invest in any absolute return strategies.

He says as long as absolute return funds are net short in the next downturn, they should deliver outperformance “but not enough to make up for the many years of poor performance”.

A spokesperson for Aberdeen Standard Investments said that while net flows for Gars have remained negative over the last 12 months the pace of outflows has been “much reduced” due to improved performance over the past 10 to 12 months in absolute terms and relative to peers. Year-to-date the fund has generated 6.0% net of fees, double the IA Targeted Absolute Return average.

“Looking ahead, GARS’ adaptability, with its broad investment freedom and durable diversity, implemented in a risk-controlled manner, makes it well suited to navigate the uncertainties changing market environment and take advantage of opportunities as they arise,” they added.

Merian Gear sees assets halve

But over the last year Merian’s Gear fund has done considerably worse than Gars. It has handed investors a 9% loss, compared with Gars’ 3.6% return, and was the fifth worst performer in the IA Targeted Absolute Return sector.

Redemptions during the period have been severe (£4bn) and the fund has halved in size from £13.4bn to £6.9bn.

Merian Global Investors head of global equities and co-manager on Gear Ian Heslop described performance over the last 12 months as “uncharacteristic” and driven by fast-paced style rotation in markets, as well as “unusually high correlation between investment themes” which dragged on the performance of factor-driven strategies.

Gear has “more or less non-existent correlation to equities,” agrees Morningstar associate director of multi-asset and alternatives Matias Möttölä, but “it’s opportunity set is still limited to equities, and the equity market has arguably been quite a difficult place for long-short and market neutral funds recently.

“The market has been driven by macro-level news about trade wars and such, while equity funds such as Merian are typically more driven by bottom-up security selection. Also, in terms of equity factors, 2018 was disappointing for practically all styles.”

Kissed a lot of frogs

Balkham has not written off the sector completely but says the investment team has “kissed lots of frogs” to find a couple of really good funds, like the Investec Diversified Income and Sanlam Multi Strategy. Balkham says he knows exactly how they run which is why he would sleep soundly during a correction.

Sparke rates the JP Morgan Global Macro Opportunities fund and H2O Multi-Returns fund as two standouts in the sector, the latter of which he says has posted some of the best numbers over the last 12 months.

Both funds openly take a higher degree of risk than the sector average, he says, which have helped them deliver better performance during some difficult periods. They also have a lower correlation to global equities compared with other funds in the sector.

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