Dispelling the myths surrounding absolute return funds

Absolute return funds claim they can generate attractive positive returns in any environment and protect capital during market drawdowns. To do so they employ sophisticated investment strategies and can go long and short.

Their returns, so the argument goes, are mainly driven by the individual manager’s investment skills rather than by the performance of an asset class, for example equities. Their returns should show a low correlation over time to traditional markets.

Public opinion on absolute return funds is mixed.

On the one hand, most professionally managed super funds allocate a share of 2 per cent to 5 per cent to absolute return funds. This share is expected to grow to 5 per cent to 10 per cent over the next few years as the sector becomes increasingly mainstream.

On the other hand, absolute return funds have a bad reputation with the public, perhaps fuelled by sensational stories. They are said to be highly risky and speculative. They are also said to put companies in trouble through short selling their stocks and adding volatility to the markets.

What is the truth about these opinions?

Firstly, it is important to note that any fund manager can call themselves absolute return managers. It is not a protected title.

Secondly, there are a lot of absolute return managers. Depending on the source used, there are between 10,000 and 12,000 absolute return funds globally. Some of these funds are very risky, a lot of them do not have the skills needed to survive and will eventually disappear.

Investing with single absolute return funds can be a risky business.

Investing in a fund of funds is a first step to limiting this selection risk.

Fund of funds are similar to mainstream managed funds in that they pool investment money and allocate it across a number of different fund managers.

However, their goals are different.

Managed funds measure their success relative to a benchmark, for example, the S&P/ASX 200.

If the index is down -15 per cent and the managed fund is only down -10 per cent, in relative terms the managed fund has outperformed the index by 5 per cent and the manager considers it a success. The investor, however, has still lost 10 per cent and will not be happy.

Funds of funds have absolute return targets that they aim to reach if the market is up or down; for example, a 10 per cent absolute return target regardless of whether the S&P/ASX 200 is 15 per cent up or down.

So can fund of funds deliver on their promises?

To analyse the skill of the industry as a whole we look at the HFRI Fund of Funds Index constructed by Hedge Funds Research.

This index is commonly used to assess the performance of absolute return funds of funds. We compare their performance to that of the MSCI World Total Return Index, a widely used index to measure the performance of global stocks.

Overall funds of funds seem to be delivering on their promise.

Going back to 1990, the HFRI index (net of all fees) generated better returns than the MSCI World (9.8 per cent versus 4.5 per cent) for much lower risk (volatility of 5.5 per cent versus 13.6 per cent).

More importantly, when global markets lost almost 50 per cent of their value between March 2000 and March 2003, the HFRI Funds of Funds index protected capital and generated a positive return.

The performance of the MSCI World shows how important it is to protect capital; to reach its previous all time high, the MSCI World index had to generate a net return of almost 100 per cent, and it only reached that level in March 2007. That meant no performance for almost seven years.

More recently, between June 2007 and February 2008, the international equity markets lost 9 per cent (and so did the S&P/ASX 200).

Funds of hedge funds generated a positive return of 1.6 per cent.

Not a great return per se, but clearly they have been protecting capital.

We compared the performance of the fund of funds industry to the 10 worst months for equities since 1990. Funds of funds generated positive returns in three out of the 10 months. Only in two months did funds of funds lose more than 2 per cent.

So in single months funds of funds may well be negative, but much less so than equities. Furthermore, managers tend to adjust quickly to a different environment and generate positive returns again.

Clearly, absolute return funds of funds should not be judged based on short-term performance.

So, the case is clear-cut and investors should put all their money into funds of funds… Well, not quite.

The global bull market across all asset classes between 2003 and 2007 led many absolute return managers to believe they were exceptionally talented.

The latest market disruptions and disappointing results for many managers served as an eye opener and will help clean up the environment.

Fund selection is critical to the success of any fund of funds. The difference between the best and worst performing fund of funds is huge. Products labelled as absolute return fund of funds typically contain very different things and hence perform very differently.

Times like these give the investor the opportunity to separate the wheat from the chaff.

The compelling argument for not putting all money into any one asset class, including absolute return funds, is diversification.

Markowitz proposed in his modern portfolio theory that rational investors should build a portfolio of securities that are selected based on expected levels of risk, reward and correlation to the portfolio.

The result is a portfolio with attractive risk-reward characteristics that do not depend on any one security.

This is diversification in a nutshell.

At any time investors should be comfortable not only with the potential upside of their portfolio but, more importantly, the potential downside.

It is easy for all investors to benefit from an environment of rising markets. Listed and non-listed equities, commodities and property will perform well.

But what happens in a recessionary environment?

As discussed earlier, global equities fell by close to 50 per cent between 2000 and 2003. Cash and bonds are the obvious safe assets.

Just like superannuation funds, ‘mum and dad’ investors should add absolute return fund of funds to the list. Over time, they show an ability to protect capital and have better upside potential.

Nobody knows how severe the current crisis will be and how long it will last.

The signals we get indicate that the environment will further darken before things improve.

Now is not the time to be a hero, allocations to defensive investments should be increased.

Invariably, there will be some managers satisfying some of the myths but, by and large, the myths are just that — myths.

Urs Alder is the head of institutional business at Man Investments Australia.