Fund Selector: Applying absolute return

In most environments, broad changes to asset allocation are gradual rather than swift.

In addition, structural changes to the exposure within each asset class may well go unnoticed, as the headline allocation will remain constant.

A case in point has been our recent reintroduction of absolute return mandates into our lower-risk portfolios within the UK equity sector.

The rationale behind the decision is quite simple: a modest reduction in the risk appetite.

We consider absolute return funds that derive their value from an equity market to be equity exposure, in spite of the manager’s aim to avoid the full movement of the market or its beta. In contrast alternatives exposure, in our view, includes mostly non-equity-orientated strategies.

The absolute return sector often comes under scrutiny given its stated aim, which is, according to the Investment Association, to deliver “positive returns in any market conditions”. And this is still the case even though an overhaul a couple of years ago meant the sector is now called Targeted Absolute Return and its definition has the proviso “but returns are not guaranteed” added to it.

Yet there are some excellent managers within the peer group who exist in this area.

In this instance I shall discuss those with a UK mandate. For a start, it is not a homogenous peer group, unlike long-only UK equity investing where the target is almost always to beat the benchmark.

For absolute return managers the target is to provide just that, but the periods over which managers wish to be assessed will often differ, as do hurdle rates and performance targets.

Investors in these products need to be comfortable with their return expectations and understand the limited-equity beta exposure, which can result in a significant opportunity cost if the market rallies. Of course, the opposite scenario is the reason one would invest in such a strategy.

One of the most prominent criticisms levelled against the absolute return sector is high costs.

The products are often relatively expensive, although the managers would argue this is justified.

In particular, performance fee hurdle rates, which are often set above a cash benchmark, can appear lucrative for the manager, especially in the prevailing low-rate environment.

Moreover, it is difficult to assess the real cost of these strategies as the industry standard, ongoing charges figure (OCF), does not take into account performance fees, unlike the old total expense ratio (TER).

Indeed, in our assessment of the peer group the OCFs look reasonable, although the TERs provide a very different picture.

Overall, in our view, there are some exceptional managers in the space where the fee is justified. These include Henderson UK Absolute, Threadneedle UK Absolute Alpha, BlackRock UK Absolute (under new manager Nigel Ridge) and Kames UK Equity Absolute Return.

James Calder is research director at City Asset Management