Absolute returns can be a solution

Sam Liddle

Sam Liddle

In the years prior to 2018, investors had not needed to be particularly smart about the way they invested to preserve the capital value of their investments.

Bond markets rose, as did equity markets so a straightforward 60/40 equity/bond split would have preserved capital and given investors some growth to boot. 

This environment can breed a sense of assumption – commonly known as ‘the mother of all mistakes’ - and 2018 provided a unique set of circumstances which left not a single asset class in positive territory (in terms of real return) by year-end - even in 2008 that did not happen.

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Some investors looking for positive returns have been drawn higher and higher up the risk scale in search of income and/or growth.

This phenomenon was also seen in absolute return funds. You do not have to search the news too hard to find recent reports warning that some absolute return funds were taking too much risk, and therefore potentially subjecting investors to major and unexpected losses. 

Quantitative easing had allowed investors to hide in higher risk strategies, reaping the rewards while not having to take the pain.

This cannot be sustained in an environment of tighter monetary policy.

As a result, the absolute return sector is suffering an identity crisis with fund performance varying wildly across the sector. In a sector of over 120 funds, there are more than 40 different benchmarks. and 28 funds with no benchmark at all.

This prompts the question: ‘what is absolute return?’

To my mind, an absolute return fund should have several key characteristics.  

Firstly, it should start with cash: after all, the purest form of absolute return is compounding interest. Every investment beyond cash should offer a compelling excess return potential for an appropriate level of risk.

If there are relatively few opportunities that meet those criteria, it is sensible to hold higher weights in cash and near-cash instruments.  

Employing “patience” as an investment strategy seems an under-used practice but reverting to managed cash when valuations in other asset classes are untenable, and simply waiting until they become compelling seems the pragmatic approach when seeking absolute returns with avoidance of the worst excesses of short-term market volatility.

This is important because of the impact significant drawdowns can have on long-term returns.  

The greater the amount lost, the higher the gain required to break even. While a 10 per cent loss in any one year would require an 11 per cent gain to break even, a 30 per cent loss requires a rise of 43 per cent to break even.

In other words, even relatively short-term losses can have a lasting impact on long-term returns. Avoiding these losses is a vitally important feature of any fund that claims to be ‘absolute return’ in nature.

Floating Rate Notes have proved effective for this purpose. When UK interest rates fell to 0.5 per cent and then to 0.25 per cent, it seemed likely that at some point, the future direction of travel would be upward. In this scenario, it made sense to buy AAA Floating Rate Notes as the major part of a cash management strategy.