Absolute return promises – easy to make, but hard to keep.
“Do not expect high returns without high risk.
Do not expect safety without correspondingly low returns.” — William Bernstein, “The Four Pillars of Investing” (2002)
The promise of generating stable returns in both up and down markets feels like an attractive strategy for investors to adopt, and ‘absolute return’ funds have certainly attracted large sums of cash since the credit crisis. Yet the reality of being able to deliver on this promise is far from convincing: strategies are varied, complex and hard to compare; fees are high, relative to sensible alternatives; and correlations to underlying assets – such as equities and bonds – are higher than might be expected. A surprising proportion of funds have delivered absolute losses to investors over horizons of one year and even over three years. At the end of the day, there are no risk-free returns above cash returns.
Absolute returns – a marketing man’s dream
The combination of short-term market uncertainty, human nature and an immediately attractive sounding moniker is a marketing man’s dream. The investment industry has been masterful at constructing and selling such products, not least ‘absolute return’ products.
[drizzle]We know that markets are always uncertain and that short-term market losses are a normal part of investing. We also know from behavioural finance research that human beings feel twice as much pain from losses than they feel pleasure from upside gains. In some older investors, this emotional asymmetry can be even more pronounced. This deep-seated behavioural trait has a tendency to result in investors over-paying for both downside protection, such as insurance, and gambling-like activities. It is perhaps worth remembering that a 35 year-old man who buys a lottery ticket on a Monday has more chance of dying during the week than winning the lottery!1 Products that put the two together – such as structured products and absolute return funds – tend to sell like (expensive) hot cakes.
It is always worth remembering that there are no risk-free returns to be conveniently collected above the so-called ‘risk-free rate of return’ delivered by cash (and even that bears inflation risk and the risk of the bank failing). Any such returns would be quickly pocketed by the vast number of extremely bright and hardworking professional investors and the relentless computer-driven trading algorithms employed by many.
So what are ‘absolute return’ strategies?
Absolute return funds employ active management strategies that seek to deliver positive (absolute) returns in any market conditions, i.e. up, down or sideways. Obviously the definition needs to define the horizon over which these positive returns are expected. Targeted returns are sometimes – but not always – stated relative to cash returns.
UK equities have delivered after-inflation absolute returns over every 30-year period from 1900 to 2015,2 but investing in them is not classed as an absolute return strategy. The term is thus relative. The Investment Association (IA), which represents the fund management industry in the UK, sets this horizon at a maximum of three years in order to qualify for its absolute return badge. However, it is worth noting that the IA states that:
‘[It] recognises that there is a wide expectation among consumers and advisers that funds in the Targeted Absolute Return sector will aim to produce positive returns after twelve month periods.’
Traditional, systematic approaches – such as the portfolios we offer our clients – tend to invest in a diversified portfolio of predominantly global bonds and equities, where assets are owned directly (e.g. shares and bonds) rather than via derivative positions, no leverage (borrowing) is used and only ‘long’ positions are held i.e. assets are owned and held. On the other hand, absolute return funds have the ability to go both long and short (i.e. where they sell assets they do not own with the hope of buying them back cheaper, if and when they fall in value), employ leverage, use derivatives and invest in non-traditional assets. This extra freedom gives them scope to position their portfolios in a more flexible manner to generate returns; it also provides more opportunity to get it wrong. The diversity and complexity of these strategies can be mind-boggling, thus making the comparison between funds with similar objectives particularly tricky.
Testing the promises using UK data
Let us take a quick look at the implied promises made by absolute return funds offered to retail investors in the UK. The high level analysis below uses the Investment Association’s absolute return fund category, called the IA Targeted Absolute Return sector. By way of background, in June 2016 net inflow into these funds was £221 million, whereas equity funds suffered withdrawals of around £2.8 billion in the month, most likely due to concerns about Brexit and consequent portfolio repositioning. In eight out of the twelve months to July 2016, the sector had the highest monthly net retail inflows3. The astute reader will identify the dangers of such a return chasing/risk avoiding, buy-high-sell-low strategy. Given that a high proportion of retail assets are managed through advisers, it does beg the question of the quality of advice being given.
Reviewing short-term outcomes
We do not normally review short-term performance data as it constitutes noise, but in this case we wanted to do so to make a point: market timing is exceptionally difficult as markets move on the release of new information, which by definition is random. The year (2016) started badly with equity market falls driven by panic over the perceived slowdown of the Chinese economy. The Times, for example, had this scaremongering headline on 16th January:
‘Markets suffer their worst start to the year since Great Depression’
From December 2015 to April 2016, Targeted Absolute Return funds were the best-selling funds of any IA sector. By March the headlines had changed; an example from USA Today read as follows, on 6th March:
‘Stock storyline shifts from “worst start to year” to “not too bad”…’
Prior to the Brexit referendum in the UK, doom and gloom returned, and subsequent to the vote, according to The Guardian on 24th June:
‘Brexit panic wipes $2 trillion off world markets’
It then changed its sentiment a month later with the headline on 11th July:
‘US stock market closes at record high, rebounding from losses after Brexit’
The point to be made is that trying to respond to past market events or to second-guess the market’s response to future events is extremely difficult and investors risk being whip-sawed by market noise and media hyperbole. An investor with a long investment horizon can afford to – and should be determined to – stay the course and simply remain invested, rebalancing his or her portfolio back to its original strategy when needed, thereby avoiding needless timing decisions and considerable transaction costs. With all the freedom of absolute return funds come the dangers of excess activity and emotionally-driven decisions.
Nearly all asset classes have delivered positive returns in the first half of 2016, as the figure below illustrates. We have also provided data for a simple 60% global equity, 40% global bond portfolio (i.e. a basic traditional portfolio) for comparison. As one can see, the IA Targeted Absolute Return sector hardly covered itself in glory, despite all its flexibility.
The wide dispersion of returns within this IA sector suggests that