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Fund Selector: Two absolute return myths

Fund Selector: Two absolute return myths

Having worked in the real world for 10 years before joining an asset management firm, there was much to get to grips with.

The jargon was pretty daunting, but having been a business journalist I knew that every industry has its own lingo and that everyone loves an acronym. The aspect that took most getting used to was the notion of sometimes patting oneself on the back when losing clients’ money.

Of course it’s obvious to me now that performance must be relative and that a manager with a limited toolkit, and/or defined investment universe, must be judged against the market and his/her peers.

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But the notion of absolute returns was one I immediately warmed to. After all, it’s clearly what clients ultimately want.

However, it seems that a decade or more after the first handful of Ucits absolute return funds launched, there remains a number of misconceptions surrounding what investors should expect.

The two myths I come across the most are as follows:

1. Absolute return funds should be negatively correlated to risk assets

While some absolute returns are market-neutral (ie they ensure, as much as possible, that returns are not driven by the direction of the market), most are structurally net long. This means that, in the absence of any stockpicking skills, they will make money in a rising market and lose money when it falls.

This isn’t ‘cheating’, it is based on the logic that markets generally go up over time, so why not benefit from that? Plus, the manager has the option to dial up and down that market risk if they have conviction on the outlook.

The point is that absolute return funds may sometimes be negatively correlated to risk assets, through skill or by having, for example, a pronounced style or sector bias, but generally they will lose money in major sell-offs.

The trick is to lose considerably less money than the market. Compounding is the key to generating absolute returns.

2. Derivatives add risk

The world’s first derivatives were agricultural commodity futures that allowed farmers to offset some of the financial risk they took in planting crops without knowing what wheat prices would be at harvest time.

For an absolute return fund manager, derivatives are primarily useful in reducing market risk in a portfolio – for example when there may be more long ideas than short.

Unfortunately, there have been some cases – exclusively in the unregulated hedge fund world – where speculative, rather than hedging, derivative positions have gone badly wrong, leading to some entrenched negative sentiment over their use in any investment strategy.

However, while most investors are comfortable with the notion of using derivatives to hedge foreign currency exposure back to sterling, they remain uncomfortable with the practice of using other derivatives to improve risk-adjusted returns.

Clearly, there’s more to understand when analysing absolute return funds than their long-only peers. Track records are generally shorter, peer groups are smaller (if they exist at all), strategies are more complex and variable, and gauging performance is more nuanced.