InvestmentsNov 10 2016

Absolute returns see a surge in demand

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Absolute returns see a surge in demand

When one considers the market environment investors have found themselves in, however, the increased demand for absolute return funds does not come as much of a surprise. We have been in a risk-off environment for some time, global equity valuations are stretched, bond yields are low – with some government bonds now in negative return territory – and we are seeing increased market volatility.

As economic growth remains uncertain in many economies, and interest rates remain at record lows, a number of retail clients are seeking downside protection. Events throughout the year, such as the UK voting to leave the European Union, have served to exacerbate this further.

Against this backdrop, the search by investors for alternative return solutions, which can provide an added benefit of lower volatility, is more prevalent than ever before. The risk-off environment has fuelled investor appetite for such solutions and in fact the Targeted Absolute Return sector has been the best-selling UK retail sector for six of the first eight months of 2016, according to statistics from the Investment Association.

In short, absolute return investing simply means offering the potential for positive returns regardless of the market environment. This makes them different to many other funds, which in some periods can still outperform a benchmark, but produce negative returns. Absolute return funds also aim to provide returns with a lower rate of volatility than traditional markets. These funds can act as a complement to traditional asset classes such as equities, fixed income and cash, as they can achieve uncorrelated returns. They are therefore an important source of diversification for a balanced portfolio.

There is still a common misperception that many absolute return funds are the same as hedge funds, being high risk and using derivatives and leverage to produce returns. While some do use sophisticated instruments, absolute return solutions come in many different shapes and sizes and with varying strategies, risk profiles and objectives. Some are long-only bottom-up funds, while others might use a combination of long and short positions and some may take a systematic approach.

Having an increased number of funds to choose from is positive, giving more opportunities to better match a fund to a client’s specific risk profile and needs; however, there are considerations that need to be taken into account. Importantly, the difference between funds within the sector means that looking at the sector-wide performance of these products can be misleading; it is impossible to make general assumptions about the performance or attractiveness of the sector as a whole.

It is also important to understand that positive returns are never guaranteed. Advisers must get under the bonnet of these funds to find out about their specific profile, time horizon and aim, to ensure they are considered in line with a client’s needs.

One example of a clear and straightforward approach to absolute return investing would be a long-only multi-asset fund with an aim to provide good absolute returns with low downside risk. The focus of a fund such as this would be for sustained capital preservation and to beat inflation – providing a positive real rate of return with low risk, and with returns characterised by low volatility. This type of strategy requires a disciplined approach by the fund manager, such as avoiding overvalued assets and increasing exposure to assets that appear to be ‘cheap’. 

A targeted absolute return strategy will look to target a specific amount above cash rates, for example Libor plus 3 percentage points. A multi-asset target absolute return fund would invest in a range of traditional asset classes, and might take long and short positions in markets, using derivative techniques to create a diversified portfolio. 

In the current environment investors are increasingly looking for innovative solutions to tackle challenging markets. A completely different guise of absolute return investing to the long-only, stock selection model is a systematic market neutral strategy, which has the ability to target a certain level of volatility by taking both long and short positions in global equities using computer-based strategies.  

For example, a systematic ‘style’-based investing model will minimise an investor’s exposure to unwanted stock-specific risks by investing across stocks that convey certain characteristics. A risk-adjusted allocation across different investment styles will also produce low correlations to traditional asset classes.

Some absolute return funds will focus on a particular asset class, for example property or bonds. A pan-European real estate absolute return fund might invest on both a long and short basis in real estate securities covering that geography, focusing on stock specific valuation opportunities – investing long in stocks a manager believes are undervalued and shorting companies the manager deems to be overvalued or with poor growth prospects. An absolute return bond fund, similarly, might invest in an unconstrained way across credit rating bands globally, with the ability to go short rates and credit to provide downside protection, setting risk limits within this. These types of funds might suit an investor wanting diversification and low correlation to other asset classes.

These examples go to show that there are many different approaches to absolute return investing. While the current market environment makes these types of funds appealing and more relevant than ever, it is important that the correct type and style of investing is selected for the specific need and risk profile of an investor. 

Rob Thorpe is head of UK intermediary at BMO Global Asset Management

Key points

Absolute return investing simply means offering the potential for positive returns regardless of the market environment.

A targeted absolute return strategy will look to target a specific amount above cash rates.

Some absolute return funds will focus on a particular asset class, for example property or bonds.