Published 6 November 2009
I was prompted to write this Corner by the number of clients who have asked me in the recent past about Absolute Return funds (in this case mutual funds not Hedge funds which I’ll discuss at another time).
It is relatively easy to understand why funds which primarily are designed to provide smoother returns are proving popular, it is far more difficult to make a cross sector comparative assessment of one fund with another. When reviewing different investments in this sector you will often find that you are not comparing like with like, in fact you can find yourself comparing different with very different.
Another problem you will encounter is the lack of funds that have even have a medium term track record. Of the 43 Absolute Return funds that you can access on the Barclays Stockbrokers Funds Research Centre there are only four that have been in existence for five years or more. I know that past performance is no guide to the future however the lack of performance history certainly makes a comparative historical judgement more difficult.
What are Absolute Return funds?
These funds have a common investment objective "to provide returns in all market conditions" and as such they are grouped under the 'Absolute Returns' Investment Managers Association (IMA) sector.
They attempt to achieve this objective in different ways which include investment in many different forms of securities which can include equities, derivatives, Gilts, corporate bonds, exchange rate instruments, collectives and cash. The vast majority also have the ability to go short as well as long. The ability to "short" (i.e. make money if the price of the security in question falls) is the main weapon in the managers armoury in their quest to provide positive returns no matter how the different markets perform.
Searching for Absolute Return funds
Let us look at some real life examples to illustrate how these funds work. To find them go to the Investment Choices tab and select ‘Funds’ and then ‘Funds research’ from the left hand menu.
Figure 1: Selecting the IMA sector
On the fund ‘Factsheet Search’ page select the option for ‘all UK retail funds’ and then ‘Absolute Returns’ from the IMA sector using the drop down menu. At the time of writing this returned 43 funds.
Funds in focus
For the purpose of this article I will look at three highly rated funds; Baring Absolute Return Global Bond, BlackRock* UK Absolute Alpha and Threadneedle Absolute Return Bond. I have already stated it is difficult to compare one fund with another in this sector, but I think there are two measures that may help your selection process as they have mine; namely the Financial Express Crown Ratings and the funds ‘Beta’.
The above funds all have at the time of writing a Financial Express rating of three Crowns. The Crown Ratings assess funds not only on their absolute performance but also, very importantly in this context, on their consistency and the risk taken. You will see a full explanation of these ratings by clicking on the rating icon on the search results page.
Figure 2: Rating icon
In simple terms a triple Crown Rating means that Financial Express regards the fund as being in the top 20% of their sector over the last three years. The other measure you may find of assistance in a comparative assessment is the funds ‘Beta’ which you will see on the Fund Performance page of the Fund Factsheet (see very bottom of Fund Factsheet page - see Figure 3).
Beta measures the volatility of the fund price compared to the market in general - a measure of 1 is in line with the market, greater than 1 then the fund is more volatile than the market and below 1 less volatile. So as the consistency of these funds is one of the key objectives the fund would need to have a Beta of less than one, as in the case with all three of these funds.
Figure 3: Beta
You will see that from the performance figures that the funds in question have also delivered to date in terms of their absolute returns. They all show growth over one, three and five years. They have also achieved this growth, as their Beta’s would suggest, in a relatively consistent manner. You can see this by using the charting tool to show all three funds against the FTSE 100, for comparison purposes say over a five year period.
Figure 4: Comparison to the FTSE 100
The pattern of the growth is the important thing to note here. Where the FTSE 100 (blue line above) shows the usual ups and downs you associate with the equity market the Absolute Return funds have in the main been far more consistent. It is also important to note this growth has been achieved in very different market conditions both in the bear market pre March 2009 and the bull market (or is it a bear market rally?) we have seen since. To date these funds have achieved their target of positive performance irrespective of market conditions whereas if you look at other funds in the sector some have clearly failed.
However, as I mentioned above, past performance may not be repeated and is not a guide to future fund performance. You should bear this in mind when making any investment decisions.
It is not surprising that we have seen a significant growth in the number of these funds over recent years. Their objectives of smoother returns in any market conditions are after all very "user friendly". You could also argue that recent market conditions have also enhanced their appeal. Pre March 2009 they were seen by some to be a safer haven than direct equity investment and now after the markets have recovered strongly (the FTSE 100 has moved from a low of 3,512 on 3 March to over 5,100 at the time of writing) they are seen by some to be a temporary shelter from a market they see as fully valued. However as always a word of caution - not only have you got to be selective when it comes to fund selection as some Absolute Return funds have patently failed to deliver on their mandate, but also in general terms there is a price to pay and it is not just in their annual management charges which are slightly higher than average (see the first page of the Fund Factsheet).
Generally speaking although they tend to outperform in falling markets, they will also tend to underperform when the markets start to rise. You can see this theory turned into practice by comparing the same graph of the three funds compared to the FTSE 100 but this time over different time horizons. Over three years the Absolute Return funds clearly outperform the index however if you show the same graph but restrict the period to six months (from the time the markets began to recover) although returns have remained positive all three funds have unperformed the market by a significant measure.
Figure 4: Comparison to the FTSE 100
You may feel, as I do, that Absolute Return funds have a part to play in your portfolio especially at times when you feel the markets are fully valued. If however as a self directed investor, you feel reluctant to delegate the authority to manage some of your money to a fund manager you could think about taking a leaf out of their book.
If for instance you are a traditional investor and you invest in mainly FTSE stocks and feel that the markets are above fair value at present then you may consider using a derivative yourself. For instance in this situation you could go short on a FTSE 100 contract for difference (CFD) to hedge the risk - if the markets go up your portfolio will benefit and the loss created by the CFD would be allowable to offset against any Capital Gains Tax. If the FTSE falls then your portfolio might suffer but the CFD will rise. This will provide insurance for you against a falling market and very effective use of your capital as the CFD will provide gearing of x20 for the FTSE index. (In other words £1,000 will give you £20,000 of exposure). However, even when using a CFD in this manner, as a hedge against risk, you have to be aware that you are investing in a leveraged environment and you can quickly lose more than you originally deposit. If you wanted a similar arrangement but wanted to restrict the loss to your original deposit then this could be achieved by using a Turbo or covered warrant, further details of which can be found by selecting the links below.
Good Luck with your investing!
*Please be advised Barclays Bank plc holds a 19.9% stake in BlackRock Global Investors, following the sale of Barclays Global Investors to BlackRock Inc. Barclays Wealth may continue to produce research recommendations on funds which have appointed BlackRock Ltd. as Investment Manager. We are ensuring we meet our regulatory obligations to manage potential conflicts of interest effectively by ensuring robust information barriers (Chinese Walls) are in place, which serve to protect the independence of our research process.
Page last updated: 06 November 2009