Portfolio role of absolute return

This article is part of
Half-Year Review - June 2015

It has not been an easy year for investors. Market trends have reversed again, defying expectations, while the performance of absolute return funds has varied.

Absolute return funds aim to generate positive returns regardless of wider market conditions. But investors also need to consider the time frame over which a fund is aiming for positive returns, and how the manager aims to achieve this.

An investor should ask how a manager expects their fund to perform in rising or falling markets. Does the fund’s performance match up to these expectations?

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In-depth analysis of performance is always preferable. For example, a fund’s returns this year may have been affected by several factors either directly or indirectly, including the low price of oil, bond yields, or the fortunes of the US dollar.

Whether or not such moves are significant will depend on whether the fund manager is intending to have exposure to such factors and if that is consistent with the investment approach they have described.

An investor should also question how the manager controls risk. It can help to ask what risk limits apply to their portfolio and how those limits are set and monitored.

As an example, a sudden move in the Swiss franc in January caught many currency investors by surprise.

Finally, does the manager have the resources and the mindset to support their investment approach?

Generating returns requires specific skills and expertise, and fund management teams can range from small offices to institutional asset managers with a broad team of analysts and risk managers.

By considering both the theoretical framework behind an absolute return fund’s approach and how it is implemented, an investor can assess whether a portfolio is successful and is likely to remain so. It will also shed light on why the performance of these vehicles can vary widely.

Asking these questions in the wake of volatile markets can sharpen investors’ focus and clarify exactly how a fund might fit within a wider portfolio.

Broadly speaking, funds with a longer-time horizon – which tolerate higher volatility in pursuit of more aggressive return targets – are more suitable for investors looking for capital growth, perhaps as an alternative to an equity allocation.

Funds with a shorter-time horizon – emphasising capital preservation – are more suited to investors that have already achieved the growth they need, or perhaps are looking for diversification. These might replace a traditional allocation to government bonds.

In the same vein, a fund with a shorter-time horizon can help smooth returns in any portfolio, regardless of the overall investment objective.

When markets are rising, it can be difficult to establish whether a fund’s performance is based on a rigorous application of its process, or whether the managers are simply benefiting from broad exposure to beta.

But when markets are volatile and trends keep changing, there is a clear opportunity to discover whether the funds are managed in a way that can generate positive returns through difficult times.