Getting to the bottom of absolute return funds

If we are to believe the hype, absolute return funds are expensive, risky and performing poorly. Are they simply misunderstood or is their long-term survival in jeopardy? Was it all just a fad?

A good starting point is to understand what makes an ‘absolute return’ fund. As little as five years ago, the bulk of assets in actively managed funds went to those with tiny overweight and underweight positions in constituents of an index in an effort to generate excess returns after having taken out an active management fee.

The world has moved on with exchange-traded funds taking the place of index plus funds. The ‘active’ arena is considerably more interesting now, populated by fund managers who focus on the long-term outcome of their strategy and taking real investment positions to meet these objectives.

Genuine active managers confine themselves to operating in areas in which they have experience, skill, confidence and the opportunity to achieve their long-term objectives. They can generally be separated in two different ways.

First, the various approaches these managers adopt to achieve their objective. Most managers are likely to have similar long-term aims but will use very different approaches. The second basis for differentiation is the time in which they aim to achieve these objectives and the acceptable levels of volatility to achieve the returns.

Many of these new active managers focus on long-term absolute returns yet, perversely, the traditional description of an absolute return fund is restricted to funds that employ non-traditional techniques to achieve that end. It has become industry shorthand for a fund that is not just long-only.

The consequence of this is that the range of funds and outcomes investors should expect from absolute return funds is akin to putting an Asian micro-cap fund in the same sector as a UK gilt fund. This provides neither a basis for comparison nor a useful guide for prospective investors.

If the sector label becomes discredited, investors run the risk of ignoring all the funds described under the ‘absolute return’ banner. However evidence strongly suggests their inclusion is beneficial to the risk/reward trade-off in any diversified portfolio. What is critical is that the objectives and path to achieving them are clearly understood.

The authorised funds industry is not alone with the problems of fund classification. The hedge fund industry has been looking at this for a number of years with success. Many of the most sophisticated portfolio constructors have been using funds that employ non-traditional investment techniques for years.

Traditional allocators to non-traditional funds have developed their own set of parameters for comparing funds, very similar to those that the likes of Lipper or the IMA apply to long-only and balanced funds.