How absolute return can help diversification

The sudden decline in investor demand for these strategies saw inflows to the category more than halve from the month before, slowing from £297m in January to £127m. 

The dramatic nature of February’s dip in investor interest naturally invites speculation as to whether the Targeted Absolute Return sector has peaked in popularity. 

Most investments are the result of an evaluation of two competing considerations: return versus risk. The alternative assets within an absolute return fund generally hit a sweet spot within that dynamic – lower volatility than higher-risk and higher-yielding equities, but higher returns than lower-risk and lower-return fixed income. 

It is worth examining these effects in some detail.

 With such headwinds, many investors will be considering a change to their portfolio allocations to anticipate cyclical shifts

Monetary tightening is the bête noire of bond investors, as rising rates equals an erosion of returns from fixed income instruments. Alternatives, however, may offer meaningful outperformance when interest rate hikes are weighing on the bond market. 

Comparing the core bond market (using the 10-year UK gilt curve and the Barclays Global Aggregate Bond index) with alternatives (via the HFRI Fund of Funds index), the latter on average outperforms the former by 15 per cent when rates are increasing. This rises to 34 per cent during the tightening cycle seen in the two years or so before the 2008 global financial crisis.

A similar comparison between the alternatives market and the FTSE 100 Total Return index shows alternatives outperforming UK equities by an average of 23 per cent in equity bear markets, peaking at 56 per cent in the sustained equity sell-offs at the beginning of the millennium. 

Over the past 25 years we have been in either a rising interest rate market or an equity bear market for more than 50 per cent of the time, making the alternative investments that underpin the absolute return approach a potentially valuable option for investors seeking protection against market risks that, if not ever-present, are never far away. 

But investors should not adopt a wholesale replacement of core equity and fixed income instruments with alternatives. The absolute return approach envisages the addition of alternatives to core portfolios to seek to mitigate against extreme volatility while protecting returns. 

Using the same data sets referenced above, it is estimated that from January 1990 to December 2016, a traditional core investment portfolio consisting of 50 per cent fixed income and 50 per cent equities would have yielded median 10-year annualised returns of 7.1 per cent and median 10-year annualised risk of 7.2 per cent. 

Replacing 15 per cent of those assets with an alternatives portfolio would have had only the most marginal effect on returns, of -0.3 per cent to -0.5 per cent, while offering meaningful reductions in volatility. This would be a 21 per cent decrease in volatility for funds in which the alternatives portfolio has been added at the expense of equity allocations; and a 7 per cent reduction for funds with an equal distribution to equities and fixed income.

With rates near historic lows, credit assets expensive and the US already embarking on a tightening trend, fixed income assets look less attractive. Similarly, equities are at or close to historic highs and market confidence in an anticipated boost to stocks has been deflated in light of difficulties faced by the Trump administration in achieving its legislative goals in healthcare.

With such headwinds, many investors will be considering a change to their portfolio allocations to anticipate cyclical shifts.

For this reason, February’s apparent decline in interest in absolute return strategies is not early evidence of a sustained shift away from the sector.

Investors concerned about managing equity and fixed income market risks have a consistent body of evidence at their disposal, making the case for this approach to managing volatility without compromising on returns. 

Brendan McCurdy is head of EMEA portfolio strategy, strategic advisory solutions, at Goldman Sachs Asset Management