Your IndustryMay 12 2016

How absolute return funds can help reduce risk

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How absolute return funds can help reduce risk

There are no guarantees with investment. While absolute return funds do aim to perform positively, regardless of the direction in which markets are heading, they do not guarantee returns.

Alex Hogan, press and digital media officer for the Investment Association, puts it this way: “The IA Targeted Absolute Return sector contains funds which aim to deliver positive returns in any market conditions.”

This won’t always mean an exceptional outperformance on the upside but the advantage is an aim of protection against the downside and diversification of risk.

It also won’t always mean positive performance over a given time-frame. Some funds in the IA Targeted Absolute Return (Tar) sector currently are in negative territory over the past year according to data from FE Trustnet.

However, many of these funds are targeting a three-year positive return, not a one-year return; the numbers, therefore, do not always tell the whole picture when it comes to absolute return funds.

Diversification

Gavin Haynes, managing director of Bristol-based Whitechurch, states: “While they do not provide a guaranteed return, there are a number of funds within the IA Targeted Absolute Return (Tar) sector that have produced attractive risk-adjusted returns.

“The key advantage is they can provide added diversification to a portfolio invested alongside traditional asset classes.

“They can also reduce the cyclicality and volatility of a portfolio. At a time when investors are nervous over the traditionally lower-risk fixed asset class, some of the lower-risk funds in the Tar sector can provide an alternative for cautious investors.”

The advantage of these funds comes down to two main factors: capital preservation and diversification Adrian Lowcock

Absolute return fund managers aim to produce risk-adjusted returns by employing the flexibilities allowed to them since 2007, when the Ucits III regime came into force, to help manage the volatility.

Most funds use hedge fund-style strategies such as shorting, aiming to make a profit on a falling market or stock.

Fund managers can also use financial instruments such as contracts for difference to provide a limit on the downside, as a kind of insurance against the possibility that the company’s share price will fall.

To the extent that the short positions match long positions, the fund will generally be hedged (protected) against falls in the market, says Randal Goldsmith, senior analyst for Morningstar’s manager research team.

Spreading the money invested over a wide range of asset classes, investment strategies and financial instruments in this way can help reduce the risk of an absolute return fund and therefore of an investor’s overall portfolio.

Capital preservation

Furthermore, while diversifying to mitigate volatility, careful investment across a range of asset classes and geographies can provide steady long-term growth through capturing positive returns.

Adrian Lowcock, head of investing for Axa Wealth, says: “The advantage of these funds comes down to two main factors: capital preservation and diversification.” He determines these as follows:

■ Capital Preservation: absolute return funds are not as volatile as pure equity or bond funds, and can make money in rising and falling markets, which leads them to be more cautious and drive slow, positive returns.

■ Diversification: being able to invest in a wide range of assets and use tools to profit from falling markets or rising markets means they can be excellent diversifiers as well as good funds to access when a sector might be looking expensive.

During times of significant market volatility, as we have seen over the past two to three years, a fund that can aim to capture the upside potential and minimise the downside potential has been an attractive proposition for investors.

Popularity

Indeed, retail investors have been pouring into the absolute return sector recently, the Investment Association’s sales trends suggest (see table).

Over the past year, the Tar sector has been top of the monthly pops five times, notably in February and March this year, when total retail sales were at their lowest ebb ever.

According to Mr Hogan, this indicates clients and their advisers realise how rough the markets are, and are expecting 2016 to continue being a turbulent year.

IA Sales Trends - best and worst selling sectors

Top SellingWorst Selling
Mar-16Targeted Absolute ReturnUK
Feb-16Targeted Absolute ReturnUK All Companies
Jan-16Europe Excluding UKUK All Companies
Dec-15UK Equity Income£ High Yield
Nov-15UK Equity IncomeGlobal Emerging Markets
Oct-15Targeted Absolute ReturnProtected
Sep-15UK Equity IncomeProtected
Aug-15UK Equity IncomeAsia Pacific Excluding Japan
Jul-15UK Equity Income£ Strategic Bond
Jun-15Targeted Absolute ReturnProtected
May-15UK Equity IncomeUK All Companies
Apr-15Targeted Absolute ReturnUK All Companies
Mar-15Europe Excluding UKUK All Companies

It appears many investors have sought some alpha in risk-diversified absolute return funds, not wishing to be in a fund where performance is to some extent correlated to the performance of an index.

Mr Lowcock adds: “The popularity of Tar funds highlights many investors had taken on more risk in their portfolios than perhaps they had realised.

“The effects of the financial crisis continue to linger as investors become risk averse very quickly, but take longer to regain confidence.”

The size of some of these funds is also an indicator of the wave of money washing towards them. For example, since its launch in 2008, Standard Life’s GARS fund has garnered £26.2bn worth of investors’ money.