Demand grows for dominant strategy

Initially backed by pension funds, absolute return now dominates the retail space, boosted by pension freedoms and a growing desire for capital protection at the expense of growth.

However, as ever it is never that simple. Absolute return can mean different things to different investors. The IA sector itself, with its 113 products, includes funds aiming for downside protection and cash matching returns, more aggressive versions of these, or basic long/short funds. At the heart of it all is always, in theory, a lack of correlation to equity and bond markets.

The desire for this has seen the sector experience phenomenal growth – in both periods of risk-on and risk-off sentiment.

In 2016, as investors looked out towards political uncertainty and attempted to recover from surprise risk-off sentiment in the opening weeks of the year, absolute return strategies found their stride. The IA Targeted Absolute Return sector was the best selling sector in 2016, bringing in £5.1bn of net sales in what was a record poor year for fund groups as total net sales only hit £4.7bn.

This year, as risk markets recover from a turbulent 2016, sales have reduced but held up. The sector has seen £2.5bn of net inflows by the end of July, as the funds industry pulled in £23.1bn.

Given this demand, the space has come under the eye of the regulator. The FCA was at pains to warn fund firms it about its concerns with “potentially misleading” performance reporting from absolute return strategies in its final report of the asset management market study.

This came after its interim report last year highlighted that investors faced a “relatively high likelihood of negative performance”.

“We are concerned that many absolute return funds do not report their performance against the relevant target return,” the FCA says in its final report.

“We also agree that the wide range of charges and targets could be confusing to retail investors, and is unlikely to help investors compare performance even within the absolute return sub-sector.”

The products were consistently mentioned in the report, which also saw the watchdog decide to consult on new requirements concerning performance reporting.

The FCA adds: “An absolute return fund’s most ambitious target may be Libor plus 4 per cent. If we bring in such rules, their effect would be to make clear that, where the [fund firm] chooses or is required to display the fund’s past performance, it must show the past performance against Libor plus 4 per cent, and not against Libor alone.” 

Despite the scathing comments, the Investment Association says it had no plans to change the way it defines absolute return strategies, a debate that has only grown along with the size of the sector. Some fund buyers suggest the IA remove funds that repeatedly miss targets or incur losses for investors. 

This is not the only area where the sector faces issues. Its flagship product – in terms of name and size – has suffered. The Standard Life Investments Global Absolute Return Strategies (Gars) fund, whose UK-domiciled version has £23bn in assets, has disappointed investors. The strategy, targeting 6-month Libor plus 5 per cent on a rolling three-year period, has seen outflows hit £4bn in the past 12 months.

Much of this has been down to underperformance. The fund aimed for a return of 18 per cent in the past three years, but has barely provided more than 2 per cent. 

The strategy has been mimicked by Invesco Perpetual and Aviva Investors, as members of the once renowned team depart to launch replica products. Flows into these funds have been strong, with Invesco Perpetual’s fund more than doubling in size, and Aviva Investors’ increasing fivefold, in the past 18 months.

Even these products have not been free of criticism, however. 

Both Aviva Investors and Invesco Perpetual funds are set to underperform three-year targets, with the former recently losing team members and the latter hit by a downgrade from Morningstar following concerns over its team’s integration.

Taha Lokhandwala is deputy editor of Investment Adviser

Expert View: Fund selection

Rory McPherson, head of investment strategy at Psigma, says close monitoring of absolute return strategies is vital: 

“Absolute return is a massive catch-all sector and requires each fund being considered on a case-by-case basis, and it goes without saying that close monitoring is key.

“We like absolute return funds that offer us something that traditional assets don’t and help improve the mix of the portfolios we run. We favour managers who are benchmarked to cash and have very low correlation to both bonds and equities.

“We own the Jupiter Absolute Return fund, a long/short equity fund run by James Clunie. This isn’t particularly differentiating in itself, but the key reason we like it is its ability to use protection strategies to do well in choppy markets; when we need it most. We also like the BNY Mellon Absolute Insight fund, which helps dampen risk of other assets and grind out modest positive returns; playing the role of core bonds without the downside risk.

“There are several very good diversified growth funds out there that would also fall into the absolute return bucket, but we don’t own them. These funds can change their stripes very quickly, which can make blending them with other assets a very challenging job.”

Expert View: Absolute return fund performance

Gavin Haynes, managing director of Whitechurch Securities, says it is a tough time to deliver big returns: 

“It is proving a difficult time for this sector. With equity and bond markets having rallied in tandem since 2009, absolute return funds have lagged traditional strategies. With markets continuing to trade at elevated levels and low volatility, it is proving to be a tough environment to provide competitive returns. The sector has also recently come under criticism from the FCA over its use of inappropriate benchmarks and performance fees.

“I would argue that there are a number of funds that can produce attractive risk-adjusted returns. Investors need to remember that these funds are designed to grind out a return greater than cash and/or inflation. With bonds and equity valuations looking expensive, this is exactly the time when these strategies cannot be ignored to provide added diversification and ballast in cautious and balanced mandates.

“There are now more than 100 funds in the sector, but the disparity between funds makes it somewhat of an enigma. There are extreme differences in risk/reward profile. With five-year volatility ranging from 1-12 and five-year performance ranging from -7 per cent to 124 per cent, they require more research and are more complex than long-only strategies. It is important 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.”

Absolute return funds in numbers

£108bn

Assets under management in the IA Targeted Absolute Return sector

116

Number of funds in the IA Targeted Absolute Return sector

24

Number of times absolute return funds were mentioned in the FCA’s asset management market study final report

£4bn

Net outflows from the sector’s biggest fund: Standard Life Investment’s Gars strategy

6

Times the Targeted Absolute Return sector was the bestselling peer group in the past 12 months

70

Size of the multi-asset team behind the behemoth £23bn Gars strategy

Absolute return funds: Performance 

Top-10 funds by Sortino ratio over three years to September 12 2017

Top-10 funds by returns over three years to September 12 2017