Fad or permanent feature?

ABSOLUTE RETURN FUNDS first emerged in South Africa in the early 2000s. These products were introduced in response to investors’ renewed focus on downside risk and capital protection following the dot.com-induced market crisis that unfolded in the late Nineties. With assets under management now standing at over R106 billion, what was initially considered to be a fad by many appears to have stood the test of time.

In the South African context, absolute return funds can be best described as multi-asset class portfolios that focus on shorter-term risk reduction and capital protection, as well as on beating inflation over the longer term.

Such funds normally have dual stated objectives. First: earn a return in excess of inflation over the longer term. That’s typically inflation plus some fixed percentage over rolling three-year periods. Second: preserve capital, –“no negative returns over rolling 12-month periods”.

The exact wording of the objectives differs from provider to provider but always encompasses the above criteria. It’s critical investors are aware those are purely investment objectives and that absolute return funds in no way guarantee either capital protection or the targeted return. As our report shows that means those portfolios can, and do, lose capital and/or underperform during extreme market conditions.

How well have absolute return funds been able to preserve capital?

Towards the end of the 2000s South African investors, along with the rest of the world, experienced a severe market correction. Graph 1 shows that under those conditions many absolute return funds were unable to protect capital over the short term and actually delivered negative overall annual returns during that period.

The blue bars show (on a monthly basis since 2002) how many funds in the survey have delivered negative 12-month returns. The red line indicates the level of the ALSI over the same period.

Do absolute return funds reduce risk?

What absolute return strategies do achieve is remove some of the volatility of returns investors faced when investing in traditional balanced portfolios. That must naturally come at the expense of upside growth. Our risk-return “scatter plot” (graph 2) compares the risk return profile for absolute return funds (grouped by return objective) to balanced portfolio returns. The comparison is based on five-year returns.

The scatter plot shows that both moderate and aggressive strategies (represented by the clusters of blue and green dots) have been successful in reducing the overall risk, as defined by standard deviation of returns, when compared to typical balanced portfolios (orange dots). At the same time the majority of absolute return managers have also earned a lower return than balanced portfolios. Finally, aggressive mandates (blue dots) have largely achieved higher returns but with higher volatility than their more conservative peers (green dots).

A returns’ analysis of South African absolute return funds supports the above commentary

Graph 3 helps us understand how these funds performed against inflation over the time period since 2002. The blue bar represents the dispersion of the managers’ returns, against inflation with the top of the bar representing the best performer’s annual return and the bottom of the bar the poorest for that year. The yellow square shows the median return for all the participating funds for the same period.

Two observations are immediately evident from this diagram:

* The annual returns delivered by absolute return funds were substantially lower for 2002, and again in 2007 and 2008, when compared to other years. Both periods are characterised by a sharp downturn in equity markets. On the other hand, absolute fund returns delivered during the equity bull run of mid-2000s and from early 2009 to April 2010 were remarkable when compared to inflation plus objectives. That indicates the returns on absolute return funds can be closely linked to the performance of equity markets and that year-on-year volatility in returns can be expected, despite the risk-reduction measures adopted.

* At least half the participants were unable to beat inflation in 2002 and again in 2008. Recall during both periods SA’s headline inflation peaked at double digit levels. In 2007, most funds did beat inflation but delivered much lower returns than in the previous five years, in many cases not achieving their inflation plus objective – albeit over only one year.

Those outcomes over the past few years have led to renewed focus on the appropriateness of absolute fund benchmarks, particularly over shorter periods. Investors can expect to see some revisions to certain absolute return fund benchmarks in the near future.

While our analysis of returns has been carried out over one-year periods to demonstrate that, depending on strategy employed and conditions, investors could expect some degree of short-term volatility of returns, the true objective is generally to beat inflation plus a fixed percentage over rolling three-year periods. A particular manager’s performance or ability should therefore only be assessed over those longer periods.

Strategies adopted by absolute return managers

If you follow the performance of specific managers within the survey it’s interesting to observe how some managers have been able to consistently deliver annual returns in excess of their inflation plus objective, while the fortunes of others have been much more closely linked to the equity markets. Those results can usually be explained by identifying the strategies the managers adopt when constructing their portfolios.

Unlike the balanced portfolio sector, absolute return managers aren’t as peer focused when constructing their portfolios. Absolute return managers therefore adopt a number of strategies in order to achieve their objectives. You can broadly categorise managers according to the strategies they adopt, which in turn informs the investor of the type of return profile to expect.

The most conservative absolute return managers will usually invest the core of their portfolio in shorter term fixed interest instruments with low volatility and predictable returns. Some make use of inflation-linked bonds in order to construct their portfolios, thereby mitigating inflation risk. Those managers will invest in other asset classes as and when they identify short-term opportunities outside the fixed interest sector in order to generate higher returns.

Those managers who target higher – but still moderate – returns will invest across the main asset classes and will include meaningful levels of equities in their portfolios. They’ll then make use of derivatives to hedge some of the downside risk introduced by the equity component. Those portfolios will therefore participate in equity performance: however, the cost of the downside protection serves to mute returns when compared to similar, unhedged portfolios. Due to their equity exposure such managers do run the risk of delivering small negative returns over the short term, especially during extreme equity market conditions.

The most aggressive absolute return managers target returns of inflation plus 6% or even 7%. Those managers typically have a far higher net exposure to equities than their peers and their portfolios more closely resemble conservative balanced portfolios. Naturally, investors should expect the highest degree of short-term volatility from such managers, with a stronger probability of negative returns over the shorter term due to equity market volatility.

Those strategies are broadly defined and aren’t mutually exclusive. Absolute return managers can make use of combinations of all the above strategies at various points in time as they feel appropriate. However, they’ll have a natural tendency to migrate back to their core strategy over time. It’s therefore imperative the investor understands the absolute return fund objectives and is aware of the strategy adopted by their absolute return manager in order not to be exposed to unwanted surprises when equity markets reverse or when inflation peaks.

How have such strategies fared over time?

We have selected and grouped managers from the survey who best represent each of the three broad strategies described above and calculated the median annual return over time for each of those strategy groupings. Those returns are shown in graph 4.

This graph clearly demonstrates how the most conservative of the strategies delivered the most stable return profile and has preserved capital. However, that strategy has also delivered lower overall returns. The moderate risk strategy has participated in the positive returns delivered by equities and was able to protect capital during the market crisis in late 2008. The most aggressive absolute return strategies have provided higher overall returns than their peers, as expected, but failed to preserve capital during the latter half of 2008 and again early last year.

Conclusion

There will always be a place for absolute return portfolios in the investment universe, as certain investors are unable to tolerate the volatility of returns – or potential loss of capital – a typical balanced portfolio may introduce. However, as we’ve seen above, these products encompass a broad range of objectives and strategies and investors must be aware of what they’re buying into. Investors should understand the underlying asset mix and not just the real return objective. That may also provide an indication of where managers are setting high objectives to attract investors, who will subsequently be disappointed by poor performance, or where managers are setting low hurdles to earn high performance fees.

While these strategies offer a degree of downside protection under unfavourable conditions, that’s not guaranteed, and it depends to a large extent on the strategy the manager adopts. The return objective largely dictates the strategies implemented by the managers and selecting the absolute return manager with the highest return objective may result in the investor not experiencing the degree of capital protection or the return profile he anticipated at the time of investing.

MONICA MATTHEWS

Alexander Forbes

MATTHEWS currently heads the manager research capability at Alexander Forbes Asset Consultants. She’s been employed in various roles within the retirement fund industry for the past 16 years. She’s a qualified actuary and a CFA charter holder.