The Investment Association Targeted Absolute Return sector has been one of the top sectors for investment inflows over the past few years, primarily driven by retiring baby boomers and pension freedom reforms implemented in 2015.
The reasons for this are two-fold: firstly, low returns among annuities and other ‘traditional’ retirement investments, and more retirees using pension freedoms to run drawdown portfolios.
However, it has also been one of the top fund sectors to receive criticism.
These funds have been called opaque, difficult to understand, and criticised for not meeting their objectives. In particular, some of the larger funds in the sector have been attacked for lacklustre performance over the past year.
The sector has also drawn attention from the Financial Conduct Authority (FCA). In the FCA’s Asset Management Market Study, released in June, it echoed the criticisms above while also highlighting absolute return funds not measuring themselves against stated benchmarks in fund marketing, and charging varying performance fees on top of the ongoing charges figure (OCF), thereby making comparison between funds difficult.
In light of these drawbacks, it’s no surprise that advisers and their clients find the sector confusing.
Why are absolute return funds proving so popular with investors post-retirement?
The main reason is sequencing risk.
Below (see figure 1) are two examples of an investor in retirement using their investment fund to provide an income. One investment has a smooth return profile, while the other is more volatile and with some negative returns early on.
Importantly, both have the same average compound return over time.
Figure 1: Return profile comparison
If this were an accumulation investor, then the final portfolio would be the same in both cases.
However, let’s say an investor is drawing 4 per cent from the portfolio each year to provide for a post-retirement income.
The impact on the portfolio value at the end of each year can be seen in Figure 2.
Figure 2: Drawdown portfolio comparison
In this 4 per cent drawdown case, the final value of the portfolio with volatile returns is roughly 27 per cent lower than the portfolio generated by those with smoothed returns.
Hence, the order of investment returns clearly matters for decumulation investors. Here we are experiencing sequencing risk, or as it’s also known ‘pound cost ravaging’.
Should an investor experience a long period of low returns in their fund, then the long-term income generation of the fund may be permanently impaired.
What are absolute return funds?
The key criteria for being an absolute return fund is that it must state, within its objective, a time horizon for when it will deliver a positive return.
In-keeping with sequencing risk, by aiming for a positive return over a defined time period, sequencing risk can be reduced, akin to smoothing the investment returns as illustrated above.
However, what is confusing for investors is that beyond this definition, the fund strategy can be anything. It could be a long only multi-asset fund, or a long short equity or bond fund or, like some of the larger and well-known funds, multi-strategy and using a significant amount of derivatives to target very specific exposures.