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Wednesday, 28th November, 2018

Absolute Return funds have been cast into the spotlight again with news that sentiment for the asset class has taken a turn and some funds have experienced a ‘surge in outflows’.

There’s two points to make here: firstly, that the so-called ‘surge in outflows’ appears to be limited to a few larger funds and secondly, any asset class that has enjoyed a good run of popularity, topping net inflow charts for 5 years in a row in the case of Targeted Absolute Return, is likely to be toppled eventually.  

However, to take a view on a sector based on an average of overall performance or sentiment towards it is to not see the trees for the wood.  The Targeted AR sector is complex and often misunderstood.  For example, the 50 largest funds in the sector follow in the region of 38 different benchmarks, making comparisons largely impossible.

Markets have been particularly volatile this year and very few sectors have been immune to the effects.  This is where it gets interesting for absolute return investors trying to adhere to their stated objectives as it allows us to see who has the most risk on the table.

In this environment, the pursuit of growth while disregarding capital preservation seems like a reckless strategy.  Some assets look uniquely vulnerable and investors have to ensure that their absolute return fund is going to protect them in all market conditions.

Absolute return must mean just that.  It should mean ensuring every investment is made with an awareness of the downside risk.  Many funds hide behind the ‘rolling 3-year’ absolute return target, leaving investors to suffer significant volatility in the interim; there is always the danger that having waited three years, investors don’t get the absolute return they wanted either but it’s too late by then.

Instead, we at Church House target a positive return over rolling 12-month periods as we have since the Church House Tenax Absolute Return Strategies Fund was launched in 2007 and continue to invest on that basis.  To us, every investment beyond cash should offer a compelling reward potential for an appropriate level of risk.  If it doesn’t, we will hold cash or near-cash instruments, such as Floating Rate Notes.

Quantitative easing has, until recently, allowed investors to hide in higher risk strategies, reaping the rewards while not having to take the pain.  Recent volatility in markets has begun to expose this. Investors will need to be more careful about how they preserve the value of their wealth in future. In our mind, capital preservation should be viewed as a ‘must have’ and any return over cash a ‘nice to have.’

In 2017, sixteen funds in the sector lost money, in spite of a buoyant year for almost all asset classes. In the previous year, five funds saw drawdowns of more than 10%.  Investors should be just as concerned with high positive returns – after all, if an absolute return fund has risen 10-20% over twelve months, it could just as easily lose as much when markets turn against riskier assets.

This is just the funds we can see.  Elsewhere, the risks may not be so obvious.  Some absolute return strategies can be opaque and it can be difficult to see the risks without really looking under the bonnet.

For us, it’s the outcomes that matter rather than how they’re achieved or what they are compared to; fund selectors should look for a history of low volatility, low beta against equities in falling markets and a reasonable long-term annualised return (5% in the case of Tenax), rather than whether the fund is long-only multi-asset as opposed to a hedge strategy.  It’s what we do that matters more than how we do it.

Having a high allocation to equities within a portfolio seems sensible in a rising market (if that is a fund’s core objective), particularly when the potential for alpha is arguably more prevalent. However, in volatile and falling markets such as these, an allocation to low beta stocks seems a more compelling strategy.  Indeed, it could be argued that whilst past performance is not a guide to future returns, past beta could be a guide to future beta.

Furthermore, low drawdown in a volatile market should indicate the fund manager’s desire to preserve capital.  In the case of Tenax, drawdown currently stands at just 1.2% for every 10% the FTSE 100 index falls.

Capital preservation should be at the core of Absolute Return investing and this year’s markets have proved why.

The published article can be viewed here.