Comparisons between apples and pears

It is nearly impossible to compare an absolute return fund with a given index, because they rarely have an index against which they are benchmarked.

Many aim to outperform cash, and each fund has different strategies and objectives.

Adrian Lowcock, head of investing for Axa Wealth, says: “Some funds could be targeting 3 per cent above Libor over three years, while another is targeting 3 per cent over five years.

“The strategies each fund uses will be different so some funds will be affected by different events and therefore perform at different times.”

Therefore, it is unfair to do a straight performance comparison against an index.

Say your client is interested in a UK equity-based absolute return fund. The natural instinct of an investor may be to compare the performance of the main market against the fund over a given timeframe.

There are myriad approaches funds can take, such as running directional strategies or market netural positions Steve Kenny

However, because the fund may be using shorting to protect against the downside on a given market, the upside potential may be capped and therefore look less attractive.

Yet an investor should not just look at the general market return to provide a comparison; they should also look at how the fund manager has mitigated risk on the downside - quite often, an absolute return fund will have not fallen as far as the market during times of economic stress.

Like for like

Moreover, the nature of the funds themselves makes comparisons difficult. One cannot just pick on the basis of performance, as the make-up of each fund means comparing a ‘good’ performer against a ‘bad’ performer could be like trying to compare a top-class Cannondale bicycle with the new BMW 7 Series.

Indeed, a brief look at the Investment Association Targeted Absolute Return sector shows there is a broad sweep of performance. Over the past 12 months to 25 April 2016, the 88-strong sector average was down 0.8 per cent.

That doesn’t look like a stellar return, given within this sector you have several funds that have achieved what seems to be outstanding performance.

For example, over the past year to 25 April, the City Financial Absolute Equity fund returned 21.8 per cent and the Polar Capital UK Absolute Equity fund returned 18.4 per cent against the sector average.

But while these outliers may attract attention for their strong outperformance, they cannot be compared with other funds in the sector.

“What makes comparing them difficult is the fact they have no specific individual return targets, so there is no common benchmark”, says Steve Kenny, director of wholesale business for Kames.

Without a common benchmark, funds cannot be compared with other funds in the sector. Mr Kenny continues: “There are myriad approaches funds can take, such as running directional strategies or market netural positions”, which means they perform differently to peers in certain environments.

How can you compare a UK absolute equity fund with a fund such as the BlackRock Emerging Markets Absolute Alpha fund, or the JPM Global Macro Opportunities fund? Some funds might only invest in equities or bonds, while others may invest in the whole range of available instruments.

James Crossley, head of retail distribution for Jupiter, adds: “The difficulty here is there are so many ways to compare funds, and a diverse range of instruments to use from equities to bonds, to long only or long/short, to derivatives and so on.

“In short, the issue is that you are not always comparing apples with apples.”

He highlighted the different categories for absolute return funds from ratings agency Morningstar, as an example of how diverse is the range of funds.

 Source: Morningstar/Jupiter

But even if funds could be grouped into rough sub-sectors, Randal Goldsmith, senior analyst on Morningstar’s manager research team, says: “Even if you created a sub-group of UK equity absolute return funds, a market neutral fund can behave differently from a long-biased, or flexible beta fund.”

Perennial problem

Lack of comparability is a perennial problem. Gavin Haynes, managing director for Whitechurch, explains: “The disparity of funds within the Investment Association Targeted Absolute Return sector makes it very hard to compare performance.

“There are significant differences in risk/reward profile of absolute return funds.”

As as far back as 2012, when it implemented a review following calls for sweeping changes to its absolute return sector classification, the Investment Association had acknowledged the “ongoing heterogeneity” of the sector.

It agreed it needed to “reduce any ambiguities” regarding the nature of absolute return funds, and to establish a framework to make it easier for investors to find information on such funds.

Therefore, in a 2013 paper outlining the conclusions of the review, the IA (then the Investment Management Association), changed the name of the sector from IMA Absolute Return Sector to the IA Targeted Absolute Return.

At the time it claimed: “Introducing the word ‘targeted’ emphasises there is no explicit or implicit guarantee associated with this sector.”

The IMA pledged: “We will monitor the sector closely with a view to determining whether groupings of funds with sufficient communality of objective and timeframe are large enough to merit the creation of sub-sectors where sub-sector performance comparisons and averages may be appropriate.”

According to Mr Goldsmith: “In general, comparison could be improved by grouping funds with similar portfolios, using a risk-adjusted measure such as the Sharpe ratio, and comparing over a meaningful period - ideally more than 5 years.”

But whatever the metric used, the IMA’s sector review document states simple performance comparisons are a no-go area. “We will continue to discourage performance comparisons between what remain a diverse group of funds in the sector”, the document went on to say.

Therefore, Mr Haynes says it is imperative to look at each fund “on its own merits and have a good understanding where the funds will invest and what strategies will be employed”.