Some IA sectors are a collection point for a particularly disparate range of funds.  Global Bonds, Specialist and Targeted Absolute Return take the award for the most eclectic mixes.  The IA requires funds in the Targeted Absolute Return sector to achieve a positive return, over a timeframe not longer than three years.  Over and above this outcome-based rule, funds can be invested in any asset classes and can operate in a host of different ways.

A (relatively) safe harbour

This sector always attracts more attention during periods of market turmoil, and for good reason.  We have been highlighting the merits of diversified multi-asset funds from this sector for almost a year, in anticipation of trickier times to come for risk assets.  It has certainly been a good year to test out the behaviour of these strategies and the three “Multi-Asset – Diversified” funds that we feature within The Adviser Centre (see below) have proved their worth in holding up better in the most difficult months.

A wide range of fund types

Within The Adviser Centre, we feature nine funds from the IA Targeted Absolute Return sector in our service and we ascribe them to five different categories.

Absolute Return Bond

Absolute Insight Emerging Market Debt - Recommended

There are several absolute return bond funds in the sector, but we have chosen to recommend just one fund, where the focus is upon emerging market debt.  As well as the skills and the experience of the manager, Colm McDonagh, we feature this fund because this asset class offers up a wealth of opportunities and actually generates a high(ish) yield!

Low yields are a huge problem for bond funds in general, as their management and operating costs are at risk of overwhelming the pitiful returns on offer.  This is a more recent and intensifying problem as we edge towards a “Negative-Interest-Rate-Policy” world, but we have for long been cautious about the merits of absolute return bond funds. Get on the wrong side of a duration call and, “poof!”, the hard-earned returns from low yielding assets can be wiped out in the wave of a central banker’s wand.  There are some good investors in this field, but whether such funds are of value within a retail charging structure is a valid question to pose.

Long/Short Equity – Market Neutral

Absolute Insight Equity Market Neutral - Established

Kames UK Equity Absolute Return - Established

These funds are at the cautious end of the spectrum in this sector and the low risk outcome is matched by modest performance progression in both cases.  As market neutral funds, they aim to minimise their sensitivity to market moves (in either direction) and generate returns through stock selection (long and short) and relative value strategies.

The Kames fund recently moved to our Established list because the firm wishes to discourage large flows into a strategy that has proved popular with institutional and retail clients.

Long/Short Equity – Conditionally Directional

Henderson European Absolute Return - Recommended

Henderson UK Absolute Return - Recommended

These fund types can incorporate significant positive or negative net exposure to their underlying asset classes, depending upon their managers’ views.  Whilst the long-term absolute return targets are firmly in mind, funds of this type can be correlated with market direction for periods of time and typically have a more volatile return profile.  Hence, investors should be prepared for periods of drawdown but can also expect higher returns through time from successful managers.

Multi-Asset – Diversified

Aviva Investors Multi-Strategy Target Return - Positive Watch

Invesco Perpetual Global Targeted Returns - Recommended

Standard Life Investments Global Absolute Return Strategies (GARS) - Established

Whilst these funds have differing processes and nuances, they are all built around a diversified range of investment strategies across all asset classes and currencies. In seeking to deliver positive returns over time, the managers also aim to control drawdowns by combining the strategies with reference to their correlations and/or their potential to offset risks in other parts of the portfolio.  Whilst they are not immune to rapid changes in asset class behaviours, their outcomes should not be dependent upon the direction of the main asset classes over time.  In this way, they set themselves apart from traditional multi-asset funds.

The Standard Life Investment’s GARS strategy has the longest track record and its behaviour in the testing conditions of 2008 is a good illustration of the benefits of this kind of strategy.  It lost a modest amount in that year (although with a sharp drawdown along the way), compared to the broad mixed asset sectors, which posted double digit falls.  We can also look at the summer of 2015 for a more recent example of behaviour of these fund types.  Our three featured funds delivered flat to modestly negative returns in the period between the beginning of June and the end of September, while the IA Mixed Investment sectors were much weaker.

Multi-Asset – Directional

Newton Real Return - Recommended

Funds of this nature maintain a healthy net long exposure to particular markets.  As a group, they are more sensitive to the performances of market indices but as a result, they have the potential to deliver stronger returns.  Newton Real Return fund is a multi-asset fund and should be expected to have structural net long positions in risk assets, with offsetting exposures and hedges that are adjusted in size according to the manager’s outlook.

How to select and use these funds

When assessing funds from this sector, risk should be the starting point.

• In which markets is the fund active? Is the fund equity-only, bond-only or multi-asset? This provides an indication of the type of risk that is incorporated in the fund.
• What is the extent of a manager’s directional exposure to the underlying asset class(es)?  What are the manager’s typical net and gross exposures? In the case of multi-asset funds, what are the factors and calculations motivating the blending of different investments?

These considerations help us to understand the degree to which, and the consistency with which, funds are exposed to market risks and the resulting impact upon their performance and risk profiles.

Performance aspirations and costs are other important considerations:

• Does the performance aspiration merit the risk and the cost of actually being invested, rather than being in cash?  On the other hand, is it overly ambitious?  If so, what risks are being taken to try and get there?
• Is the fund appropriate as a holding under retail cost structure?  Strategies with an institutional heritage simply may not have enough investment juice to overwhelm the retail cost headwind.
• Is there a performance fee and is it reasonable in the context of the fund’s aspirations and activities?

We have been supporters of “alternative” funds for many years and believe they can play either a supporting role in a portfolio, or a starring role, depending of course upon an investor’s objectives.  In spite of their more sophisticated nature compared to traditional funds, in our view the sector features funds that are worthy of consideration for more conservative investors, who prefer not to be exposed to the full force of a red-blooded, risk asset portfolio.  If you are after something racier, the sector has some funds for you as well, but be prepared for a bumpier journey on the way to achieving your absolute return.