What happened to absolute return funds?
With mixed performance, should investors look for the escape hatch?
Launched some 10 years ago, absolute return funds were supposed to revolutionise investing. Touted as the panacea to risky equity funds or expensive capital protected bonds, regardless of market conditions, these funds were structured to deliver a positive return.
However, performance of some of the biggest stars of the sector has been mixed, with outflows growing and sentiment easing. So what went wrong, is the sector still a good bet, or should investors look for the escape hatch?
What is an absolute return fund?
Described by some as hedge funds for small investors, the aim of such funds is protect the capital value of assets, while at the same time consistently achieving positive returns regardless of market conditions. They do this by promising a return of cash and a particular percentage return that is uncorrelated to traditional equity and fixed-income markets.
While they deliver a lower return than equities, they also tend to fall less than equities during periods of market stress, and can be a good diversification tool.
“One of the big pluses of these funds is that they offer easy access to diversification for investors,” says Paul Kenny, head of investments with Mercer, noting that this can be difficult and complicated for investors to do themselves.
They often use complicated strategies to do this. One of the most well-known such funds in the Irish market is the GARS fund, from Standard Life, now Aberdeen Standard Investments. It uses a combination of traditional assets (such as equities and bonds) and investment strategies based on advanced derivative techniques, to create a highly diversified portfolio. It can take long and short positions in markets, securities and groups of securities through derivative contracts.
Some of the strategies used of late include going long on Swedish krona v Euro and Italian v German interest rates.
The funds typically promise a return over cash of about 3 per cent over a rolling three-year period. Aberdeen Standard Life’s GARS product has a target return of 5 per cent over cash gross over three years.
Other options in the sector include the Aviva Irl BlackRock European Absolute Return Strategies Fund, the Concept K fund, offered by Friends First, and Invesco’s Global Targeted Returns Fund, offered by Zurich, and the BNY Mellon Absolute Return Bond Fund, sold via New Ireland.
They can also be more expensive than typical funds.
“Compared to equities and bonds, which are accessed on a passive basis quite cheaply, they are a higher cost fund,” says Kenny. “So it’s very important then that trustees/investors are happy with these funds.”
Have they delivered?
First things first; it can be tempting to consider such funds as one asset class, but absolute return is really a catch-all term for a vast array of different strategies.
“It spans multi-strategy funds, global macro funds, systematic/data driven trading funds and long/short hedge funds to name a few. Given that, it is not meaningful to talk about their performance as a group,” says Mary Cahill, head of global investment selection with Davy.
Unsurprisingly then, Kenny describes their performance as a “bit of a mixed bag”.
“The experience for some investors has been positive, and for others more disappointing,” he says. Data tracked by Mercer shows that many of the funds in the space have delivered as expected, with Kenny noting that, over the past three years, about one third of funds have been under the target, while about two thirds have over-performed.
“Accordingly, we think this type of fund has delivered on the whole, with some exceptions,” he says.
For Cahill, some of the better performing funds include Old Mutual GEAR, which employs a long/short equity strategy, and JP Morgan’s Global Macro Opportunities Fund, which employs a global macro strategy. Kenny points to the LGIM Diversified Fund, which some Irish pension schemes are invested in.
However the fund that Irish investors may be most familiar with – and may have invested heavily in – is the Aberdeen Standard Investments GARS.
It has been one of the poorest performers in the recent past. It is down by 2.1 per cent in the year to April 30th, down 2.3 per cent a year over three years, and up by just 0.6 per cent over five years.
“It’s had at least five years of woeful performance. To my mind that is long enough to judge. It’s expensive and not delivering,” says Ralph Benson, founder of Moneycube, adding that it is the fundamental premise of the fund – offering cash plus 5 per cent – that “doesn’t stack up”.
“I certainly think that there was a sense that this was something that could solve everyone’s problem,” he says.
The fund was actively marketed in Ireland and drew many investors, but its poor performance means that €50,000 invested in the Standard Life GARS in June 2015 is worth something like €45,310 now “and that’s before any adviser charges you’ll have paid on top”, says Benson. He notes that had you taken the plunge and simply grabbed a bunch of global stocks, you’d be sitting on something in the region of €55,243 now.
If you look over a longer five-year period, your €50,000 invested in this GARS would be worth about €50,175 now, again before fees; whereas investing it wholly in global equities would see you sitting on about €78,928.
Benson draws attention, in particular, to the performance over the last few months, when global markets have become more volatile. The fund is down by 4.5 per cent in the last six months.
“So GARS investors didn’t weather recent market turbulence as well as more straightforward multi-asset funds,” he says.
What’s behind the underperformance?
For Kenny, it is funds that have had less directional exposure to markets, and which have run more relative value trades, such as positioning one stock versus another, which have not been lifted by the “rising tide of equity markets”.
The size of the funds can also be a factor. GARS, for example, experienced rapid investment, growing to over £55 billion (€65 billion) at its peak in August 2016 – although outflows means it stood at £39 billion (€45 billion) as of the first quarter of this year. The fund saw outflows of almost €11 billion in 2017 alone.
But growing so large may have impacted on its success; when GARS grew to a certain level of assets under management for example, Davy started to divest out of it.
“It is important to monitor this [assets under management] to ensure that size is not hindering their ability to employ their strategy and leading to deterioration in performance,” advises Cahill.
With regards to GARS, Chris Nichols, investment director with Aberdeen Standard Investments, says it is the recent market conditions that have proved challenging.
“For portfolios, such as GARS, that allocate across a broad range of asset classes, a market that strongly favours just two asset types while leaving others somewhat rudderless is both unusual and challenging to navigate,” he says.
“GARS is built from investments that we expect to perform over a three-year time horizon and we are confident that the positions we have identified will bear fruit for the fund in due course.”
Invest in future?
While the headlines might lead an investor to shy away from absolute return funds, that shouldn’t necessarily be the case.
“I absolutely think there’s a place for these funds, but there are a couple of things investors have to bear in mind,” says Kenny. “They have to assess them over the full market cycle, and they have to understand that they do have active manager risk in there, and that active managers are not going to call things right all the time.”
Cahill agrees that they do make sense. “Investing in the asset class is important at all times but particularly so coming into a bear market,” she says, given that their returns are uncorrelated to traditional markets. But, she warns that you need to be diversified not just across your portfolio, but also within the absolute return bucket.
“Any one absolute return fund shouldn’t form 100 per cent or indeed a large part of your portfolio,” she says, adding that “emphasis should be placed on constructing a portfolio of absolute return funds that is uncorrelated”.
When it comes to choosing a fund, she recommends investors look at both the quantitative and qualitative aspects, such as the people behind a fund, and if there is much movement.
For the average investor however, choosing the right fund is not always obvious.
“The problem is it’s very difficult to judge them,” says Benson, noting that while some funds have delivered decent results for people, “it’s very difficult to know what’s going on in the ones you’re picking, because the strategies are so opaque and shift all the time”.
Investors may also be unclear about what they’re buying into.
“One of the misconceptions about these funds is that they cannot lose money and many investors haven’t appreciated the fact that these funds take risks in order to achieve their target return,” says Cahill. Investors should expect periods of negative performance in the short term, she says.
“But, in the medium to long term, given the techniques they employ, they should generate performance for an investor portfolio in times when traditional asset classes are challenged,” she adds.
So what to do?
If you’re invested in a poorly performing fund such as GARS, you might be deliberating as to whether or not you should sell out. Kenny warns that “past performance is not a guide to future performance so poor past performance by itself should not be a reason for replacing one of these funds. Good managers can go through periods of poor performance”.
Aberdeen Standard Investments says GARS remains a “compelling proposition for which there remains significant client demand”.
“Given multi-asset remains a fast-growing market segment and the strength of franchise ASI [Aberdeen Standard Investments] has established in this field, it’s not unreasonable to assume a return to a more normalised flow profile over time,” says Nichols.
When it comes to making a decision on selling or not, Benson suggests looking at your tax position first. You may not want to necessarily crystallise a tax charge. “But that doesn’t really apply [for GARS]), because almost everyone who’s invested will be sitting on a loss,” he says.
The other consideration is whether or not you’ll face exit penalties. GARS, for example, applies exit charges on a sliding scale, declining by 1 per cent a year from 5 per cent to 1 per cent in year five, and to zero from year six onwards.
“However, exit penalties can be reduced from five years to three to zero years depending on what you negotiate with your financial adviser,” Nichols says. And you can avoid such charges altogether by switching funds now. The exit charges in the new fund will continue to decline on the sliding scale as above.