12/06/2008

What is the point of retail 'absolute return' funds?

You can’t have failed to notice the flurry of activity that has accompanied the launch and marketing of a series of retail funds with names such as ‘targeted return’ funds, or ‘absolute return’ funds. Advisors and intermediaries often ask me what the point is of these new products. Additionally, given mis-selling scandals of the past and a confusing shift in the nature of regulation, many express reservations about recommending these complex and seemingly untried products to their clients. I thought I would take this opportunity to explain what absolute return strategies are all about and how they could be of benefit.

Retail savers and investors want savings that grow, without giving up their current lifestyle. They mainly seek to preserve their lifestyle after retirement or possibly to save for life events such as their children’s education.

Unfortunately, the pressures and expense of everyday life, from housing to raising children, often prevent investors from making substantial savings during their early working lives. However, once they’ve advanced their careers and potentially paid off their mortgages, they may have more disposable income available to save for retirement or other life events. Unfortunately, by that point, available time left for investments to accumulate has dwindled as their children may be approaching university age or retirement is looming. In addition, traditional investment strategies gradually shift focus from growth to preservation since there is so little time left before the funds are required. This is unfortunate as during these latter years the savings can be much larger and therefore a growth bias would be particularly valuable. However, growth usually means volatility, the exact opposite of what is desirable when they will soon have to start paying out for a child’s education, retirement or other financial goal.

That’s essentially the problem. One potential answer would be to find reliable ways of benefiting from long-term equity returns, while minimising volatility. This is where retail investors and savers can benefit from advances in fund management made on behalf of large institutional pension schemes. Moving the investment focus from relative outperformance against standard investment indices, to an ‘absolute return’ focus is the first step. The goal of finding high levels of stable but meaningful long-term returns requires a truly diversified approach based on an absolute return target, rather than a relative performance target based on a traditional benchmark.

The strategy rests upon robust and repeatable investment processes, combining dynamic allocations to traditional assets, with more advanced sources of market returns accessed using derivatives. The fund manager roams dynamically across asset classes, investing in those likely to generate the best return over a given period. This results in a fund that offers the possibility of positive performance in a variety of market conditions. One way these funds can move between asset classes is to employ carefully constructed derivative positions, which helps to avoid the high costs and taxes of dealing in conventional assets.

Derivatives can also be used to generate returns by ‘harvesting’ proven stock selection expertise of a traditional asset class managers, even if the absolute return manager thinks an asset class might fall. For example, if the US market falls 5% over a given time period, but our US fund manager’s portfolio only falls 2% due to their stock selection skills, we can convert the 3% outperformance into a positive return by investing in the fund manager’s portfolio alongside an index future to guard against market falls.

In addition, the short-term performance-measurement cycles of traditional investment strategies mean that opportunities have arisen for those fund strategies willing to take asset allocation decisions over longer time horizons.

How does this work in practice? One example would be when credit spreads became unrealistically tight a couple years ago. We knew that they would eventually correct, we just didn’t know when. However, having a long-term investment mandate gave us the conviction to take a short position on corporate bonds. This position did not pay anything for several months until spreads widened dramatically last summer.

Another example would be our position invested in equity market implied volatility. Investors are familiar with volatility as a feature of investment markets, but few realise it is possible to invest in, and benefit from, expected equity market volatility through variance swaps and carefully constructed option strategies. We did just this when equity markets were placid in the expectation of higher future volatility. Our position paid out in the third quarter of 2007, as markets gyrated in response to the credit crisis. This further protected the portfolio from the negative short-term effects of equity exposure.

These are just two examples of the way that absolute returns strategies with longer performance measurement periods can exploit rich seams of returns that are closed to investors with shorter time horizons.

The result of the various elements that make up an effective absolute return strategy is relatively straightforward—positive long-term returns with low levels of volatility. This stability will enable investors to deploy their savings for maximum effect and ultimately, such a strategy could represent an excellent option for retail savers and investors.

Tam McVie, Investment Director – Mutual Funds, Standard Life Invesments

This was published in Professional Adviser on 12th June 2008.

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