Investing Basics: Absolute Return Funds

The active vs passive conundrum is likely to remain a hotly debated topic in investment circles; can active management deliver better investment returns over the long term, net of their higher fees, than low cost passives and trackers? Christian Leeming considers absolute return funds

 
Fund nomenclature still has a lot of the ‘old City’ about it; but with a little experience it is usually possible to work out from a fund’s title how it is constructed (e.g. equity, bond, multi-asset) what it aims to deliver (e.g. income, capital growth) or where it is geographically focussed (e.g. China, Emerging Markets, BRIC); but what is an absolute return fund?

Unlike relative return funds, which compare their performance to a particular benchmark, absolute (sometimes ‘total’) return funds aim to achieve a positive return over a defined period of time irrespective of whether stock markets are rising or falling; put simply it is the actual increase or decrease in the value of an investment.

In a paper entitled The Loser’s Game, academic Charles D Ellis likened the challenge facing absolute return fund managers to that of amateur tennis players; he argued that investing had become so highly professional, that it was difficult for investors, professional and DIY alike, to perform better than the market average over the long term.

Technology has played a big part in creating transparent and efficient markets, meaning that fund managers can no longer hope to succeed by picking big winners; Ellis contested that success came from playing the ‘loser’s game’, a description he applied to those baseline sloggers that triumphed by dint of making fewer mistakes than their opponents – keeping the ball on the court and waiting for the other player to put it out when going for a big winner.

‘aim to achieve a positive return over a defined period of time irrespective of whether stock markets are rising or falling’

When applied to absolute return fund management, this approach suggests paying very close attention to risk, although individual managers often have their own ‘game plan’.

Managers employ a range of techniques that traditional mutual funds do not, including short selling, leverage, futures, derivatives and arbitrage; bets that the price of a stock will rise – going ‘long’ – are often balanced by ‘shorting’ those that are predicted to fall in pursuit of consistent returns at potentially lower levels of risk.

Detractors would say that the description as ‘absolute’ implies that the fund is incapable of making losses when in fact it comes with the capacity for loss like any other fund.

What is short selling?

Often associated with hedge funds, short selling (‘shorting’) is not common in fund management outside of absolute return funds.

Shorting is effectively borrowing an asset you don’t own, and then selling it with the aim of buying it back more cheaply when it’s price falls; sell Acme Plc for £1.00, buy it back at 90p, and you’re 10p up, minus any fee agreed with the party that ‘lent’ you the stock.

Short selling comes with more risk than buying a stock, because losses are potentially unlimited, but that is the expertise expected of the absolute return fund manager.

By balancing baskets of long and short positions, the fund performance can be less correlated to overall market volatility; profits or losses in this scenario are delivered by the relative movements in the prices of these underlying stocks rather than the direction of the market itself.

This ‘market neutral’ strategy is a key feature of absolute return funds when compared with traditional ‘long only’ stock market funds which are diversified to help alleviate stock-specific problems, but can do little to limit the effects of a widespread fall in the value of the market other than retreat to cash.

At a time of great economic, political and social uncertainty absolute return fund managers will be diligent in assessing the risk to their portfolios of a whole range of potential scenarios and possible outcomes; when considering a fund see how it is prepared for a rainy day – many will hold investments like government bonds or gold, to ‘hedge’ against a whole range of bad market scenarios.

The cost of such ‘insurance’ is that returns on such investments may be poor, thereby diminishing the absolute return in the title of the fund.

When seeking to make fewer mistakes, their opponents in this context are other absolute return fund managers; key to achieving an edge can be the ability of the fund manger to overcome behavioural biases to ensure that they respond to new market information and opportunities in a way that is proportionate and in line with the objectives of the fund.

‘short selling (‘shorting’) is not common in fund management outside of absolute return funds’

Alfred Winslow Jones is credited with forming the first absolute return fund in New York in 1949 and in recent years they have become one of the fastest-growing investment products in the world; an absolute return fund should be able to comfortably beat cash and deliver the expectation of stable returns and diversification which has made them extremely popular as equity markets have appeared to be nearing the top and bond yields near the bottom.

According to a recent FE Trustnet study, the best absolute return fund – the Premier Multi-asset Absolute Return Fund – would have protected investors 86% of the time in the nine years since markets rallied following the global financial crisis; funds in the Investment Association (IA) Targeted Absolute Return sector have on average made positive returns in 77 months over the last nine years with 31 negative periods.

Those considering an absolute return fund should shop around – many of these funds do different things so it is worth doing some research; some have aggressive objectives, and that can come with more risk than some investors may be comfortable with.

Fees are another consideration, as they can be relatively high when compared with other types of managed funds. Find more information here.