When it’s time to play it safe

While most investors should retain equity allocations in their portfolios, they may need to give serious thought to capital protection as well. However, many fixed interest investments look expensive, commercial property fund managers have suspended trading and cash rates are at historically low levels.

There are 93 funds in the Investment Association’s Targeted Absolute Return sector. It can be difficult to directly compare these funds as they can take hugely different approaches to achieve their goals. However, the objectives of many of the funds are broadly similar, whether that is a target return or achieving positive returns in all environments.

Many absolute return funds are highly correlated to stock markets, so when markets fall they lose value;

From an investor’s perspective, they are not looking for these funds to ‘shoot the lights out’. Instead they want protection. They are looking for funds that will plod along and beat the returns on cash regardless of what is happening elsewhere. This is not always what they have got.

Many absolute return funds are highly correlated to stock markets, so when markets fall they lose value; not to the same degree, but then they do not capture all of the upside either. It is difficult to generalise too much because of the wide range of funds in the sector. However, those looking at absolute return funds to provide capital protection should look closely at their correlation with equity markets.@Image-99d9542e-d638-456f-8ccd-bd6d71c075bc@

Another concern is the level of charges. It is understandable that ongoing charges on these funds are slightly higher than on conventional long-only funds. However, for products that are often trying to generate just a few percentage points of return, it is difficult to justify some of the performance fees charged.

Often these performance fees are hidden in the small print of fund managers’ documents. Based on online research, it is fair to say that many investment companies are not particularly forthcoming in telling people that they impose performance fees and then how they actually work.

The good news on performance fees is that funds usually adopt a high water mark. This at least means managers cannot impose extra fees after a short turnaround following significant negative performance.

However, that is about where the good news ends. Performance fees are often charged at 20 per cent of outperformance for beating a notional benchmark. That benchmark might, for example, be Libor rates, which are currently about 0.5 per cent per annum. On this basis the performance of the Santander 123 bank account would be considered good enough to rack up some juicy performance fees.

If a fund manager is confident in their ability to out-perform and wants to apply performance fees, the fairest way is first to reduce the ongoing annual charge and, second, to introduce a meaningful performance hurdle. Funnily enough, managers do not seem particularly keen to do this,

The Schroder Absolute UK Dynamic fund, for example, has a 20 per cent performance fee. In its last financial year this meant an extra 1.48 per cent charge to investors on top of the ongoing annual charge of 1.67 per cent. In the past three years the total cumulative return to investors has been just 4.6 per cent.

The FP Argonaut Absolute Return fund has a 20 per cent performance fee. It returned 40 per cent, 14 per cent and 12 per cent in 2013 to 2015 respectively, no doubt generating significant performance fees. Perhaps investors will not be so keen to see the fund is down by 20 per cent in the current year.

Undoubtedly the major success story in this sector is the Standard Life Investments Global Absolute Return Strategies (Gars) fund. This fund has assets of more than £26bn, with the total being run with this mandate being about double that. While many investors have been attracted by a consistent performance record, even this fund has met with difficult times, having fallen by 7 per cent in the past year or so.

A commercial benefit Standard Life has is that by adopting a multi-strategy approach it faces fewer liquidity concerns than single-strategy funds, which might hit a winning formula, but then have to soft close as popularity builds.

A commercial benefit Standard Life has is that by adopting a multi-strategy approach it faces fewer liquidity concerns than single-strategy funds

Other companies are trying to piggyback from Standard Life’s success, with both Aviva Investors and Invesco Perpetual recruiting members of the old Gars team as they try to build their own franchises.

It is likely that we will see further innovation. If investors are going to hold more of their assets in absolute return funds then it makes sense to offer income-generating versions as well. This can be difficult because most of the underlying holdings will not naturally produce an income, but there are probably ways around this.

The Aviva Investors Multi Strategy Target Income fund pays a yield of 4.6 per cent and there are rumours that other managers may be looking to develop their own income-producing absolute return funds.

So the stage is set. Absolute return funds are already popular, but could have a much bigger role to play. For advisers the first challenge is knowing the products to select. Some are too volatile, some too correlated with equity markets, some have high charges and some have poor performance records or performance that is not likely to be repeatable.

The second challenge is explaining this to clients so they understand what they are buying. I am sure most clients do not understand the intricacies of the Standard Life Gars product, although hopefully most did understand their investment could fall by 7 per cent.

Patrick Connolly is a certified financial planner at Chase de Vere