The IMA Targeted Absolute Return sector has been the subject of significant comment and debate over recent years.  The column inches dedicated to the subject certainly demonstrate that many investors are sceptical towards the concept and/or usefulness of the sector.  We argue that the sector contains a number of attractive investment vehicles that merit consideration at either the core or periphery of investors’ portfolios.  However, the extreme range of mandates and objectives incorporated within the category means that it is often unhelpful to frame the analysis of the funds, or the decision to make a portfolio allocation, in the context of this IMA sector and it is especially important for each fund to be considered and measured relative to its individual approach and target.

In part, the opprobrium towards the sector results from grouping funds around a desired outcome rather than any particular investment strategy or focus.  There is substantial diversity of mandates even in the more traditional, input-defined investment categories and this is only multiplied when grouping all strategies seeking to achieve positive returns in any market conditions, with a maximum timeframe of three years.  One outcome of such diversity is the likelihood that strategies with more rigid styles or asset class or geographical exposures will struggle in adverse environments.  For example, emerging market (EM) equities and bonds endured a torrid period in 2013 and such a backdrop was challenging for the strategies in the peer group that focus primarily on the area; of over 50 funds in the sector, fewer than 10 recorded negative returns in 2013 and around half of these focused on EM equities or bonds.  When they are placed within a sector with an “absolute return” label, it is then easy for the naysayers to point to them to support the view that the concept is invalid.  In practice, as with all peer groups, it simply means that the sector comprises a wide range of styles and fund manager abilities, reinforcing the importance of understanding and judging the funds on their own merits.

Even allowing for these factors, however, many funds within the sector have yet to prove to investors their ability to deliver performance in different market conditions and in particular to be uncorrelated to the direction of underlying equity or credit markets over time. This is partly because a significant number have been launched since the last crisis in 2008 and the only meaningful blip in most markets since then was the sharp but short-lived weakness in the third quarter of 2011, when the peripheral Eurozone crisis triggered substantial downturns in global equity and credit markets. It is nevertheless instructive that more than three-quarters of funds in the sector endured negative performance in the third quarter of 2011 while an even greater proportion rose in value over the more positive market conditions of 2013, when UK equities rose 21% and higher-yielding corporate bonds also performed well.  As a result, scepticism will rightly persist unless and until more funds in the sector prove to investors that it is a credible ambition to preserve and even grow capital when many other, more mainstream, investments are struggling.

When researching the funds in the sector, our starting point is understanding fund managers’ approach to risk.  We look to understand their tolerance for performance volatility from the overall portfolio and, where relevant, from individual positions.  We combine this with a practical understanding of how they combine positions in their fund and the degree to which potentially offsetting positions are incorporated, to build expectations of the likely path of performance delivery.

Long/short equity funds are a large part of the sector and we help summarise this analysis by considering them on a spectrum of “market neutral”, “conditionally directional” and “directional”.  This helps understand their potential sensitivity to underlying equity markets and the degree to which this might adjust over time.

It can be challenging to find attractive funds that are truly market neutral, in part because it is difficult to add meaningful value consistently through relative value trades.  However, Absolute Insight Equity Market Neutral and Kames UK Equity Absolute Return are two funds where we have confidence in the managers’ ability to deliver attractive performance while minimising their sensitivity to equity market moves (in either direction).  They are managed in very different ways; the team members at Insight each contribute a number of pairs trade ideas to the fund that reflect their detailed stock analysis, while hedging unwanted risks from each position.  In contrast, the co-managers of the Kames fund, David Griffiths and David Pringle, use the top-down themes and stock research of the group’s UK equity team and have demonstrated unusual skill in building a portfolio that combines thematic insights with their best stock ideas, without introducing persistent sensitivities to equity markets.  Over the past three years, the funds have delivered relatively low annualised daily volatility figures, especially in the context of the diverse peer group, and this is indicative of the outcome investors should expect from such strategies.  Their approaches lead to relatively steady but modest performance that is rarely spectacular but is less sensitive to the direction of equity markets than other long/short equity strategies.  Historically, I have used such funds as core holdings in low-risk strategies.

At the other end of the scale, “directional” funds are those that should be expected to maintain healthy net exposure to equity markets over time, even if the extent of this exposure varies.  These strategies are typically more sensitive to the direction of equity markets and rely upon stock selection to mitigate downturns.  They can offer greater positive performance potential, albeit with more volatility, and this was evident in 2013 when the CF Odey Absolute Return fund posted a total return of over 45%, supported by strong stock selection.

The “conditionally directional” funds are those that have at times incorporated significant positive or negative net exposure to equity markets, depending upon their managers’ views.  This is a broad swathe of funds with different risk tolerances and, if successful, they should be correlated with broader equity markets over shorter-term time periods, but less so over the longer term.  Henderson UK Absolute Return, managed by Ben Wallace and Luke Newman, exemplifies such a profile.  They combine stock analysis with analysis of global investment markets, and their positive outlook for equity markets in 2013 led to a large net position in equities and, consequently, a very healthy return.  This followed a period when their lower conviction had led to much less directional equity risk and therefore more subdued performance and volatility figures.

In highlighting the structural differences even between the long/short equity funds within the sector, this article has sought to illustrate the diversity of the sector and the importance of selecting an individual strategy that fulfils the required role in an investor’s portfolio.  Other strategies include multi-asset funds, of which Standard Life Global Absolute Return Strategies (GARS) is by far the largest, and absolute return bond funds.  In each case, our analysis is similar but requires greater consideration of correlations and relationships between asset classes, given their more multi-faceted investment universes.

Performance information sourced from Morningstar Direct

Article written by Anthony McDonald , Senior Investment Analyst

This article featured in Professional Adviser Magazine, January 2014