Absolute Return Funds are not the Holy Grail of Investing

After a painful decade for both equity and property investors the concept that you can invest in a risk-asset fund whose main objective is to generate a positive return each year irrespective of the direction of the stock markets has significant attractions for both the investor and advisor. The investor may not get all of the returns that a fuller stock market recovery offers but then he/she is supposed to be protected from significant declines. The advisor gets to sell a product with much less danger of it blowing up on the client. A potential win-win if you like! But there is no free lunch in markets and it is best for both client and advisor to fully understand the pros & cons of absolute return funds.

Following the implementation of European-wide UCITS III legislation in the mid 2000s (undertakings for collective investments in transferable securities), UCITS can facilitate many alternative investment strategies including the use of derivatives which were not previously open to traditional long-only funds. Following on from UCITS III, the Irish Financial Regulator recognised the increased investment scope of UCITS in Ireland.

As a direct consequence of the greater flexibility of UCITS III, absolute return funds have made significant in-roads into the Irish investment landscape in the past few years. Most of the life companies in Ireland now offer absolute return funds and the choice includes such funds as Standard Life’s GARS Fund, New Ireland’s BNYM Global Real Return Fund series and Aviva’s Blackrock Absolute Return Fund among others.

And the attractions of absolute return funds are understandable. Equity returns have been negative in aggregate since early 2000 and the psychological effect of two bear markets in equities within the space of ten years has made the advisor’s job of long term investment planning a thankless and largely fruitless one. This together with the bursting of the property bubble and minuscule returns on bank deposits has left clients utterly confused about where, and in what, to invest.
For all practical purposes, absolute return funds can be classed as a sub-category of hedge funds and their stated mission in life is to provide investors with a positive return over and above cash deposit rates i.e. they are trying to both protect capital and deliver a positive return irrespective of market conditions. They use the markets to achieve their aims and, with the flexibility to use derivatives and ‘hedge’, they aim to take advantage of rising markets and to protect capital in declining markets.

But investors and advisors need to be mindful of the risks. Absolute return funds are a risk asset and the pursuit of an absolute return is an aim and not a guarantee. In the same way as there is success and failure in the hedge funds arena, advisors and investors should expect variations in performance and disappointments among absolute return funds. For this reason, it may be better to own a selection of absolute return funds rather than tying your fortunes to any single fund.
While the allure of positive returns greater than cash deposit returns with limited downside is strong, the difficulty lies in delivering on those aims. The long term returns in equity and property markets accrue to the owners of those assets. Hedge funds are not ‘owners of assets’ but more ‘traders of assets’ and, in that regard, have to scalp other investors in a zero sum game. I say a ‘zero sum game’ because equity markets do not generate returns on a short term basis and the ‘trading of assets’ is the pursuit of returns over short term intervals. Equity markets generate returns, in the main, as corporate profits grow and that does not happen on a timeline consistent with trading markets.

Long term returns from the equity markets have been circa 9-10% per annum over the past 100 years. That equates to circa 0.8% per month. If you are trading markets then you have higher costs in addition to the risk of missing the returns by jumping into and out of assets. The risk is high that the manager of hedge fund loses the poker game and obtains a negative return. And without an asset to show for it, the loss is a permanent one. In contrast, a traditional equity fund can lose value but the fund still owns assets where the value can recover in time.

Absolute return funds are not ‘traders of assets’ to the same extent as hedge funds. But nor can they be considered ‘owners of assets’ in the way traditional long-only equity funds are. In that regard, absolute return funds could be considered a half-way house.

Over the years, the accepted targeted annual return within the hedge fund industry is in the order of 7-8% per annum after fund management fees. This makes sense as the greater costs within hedge funds (2% annual fee plus 20% of the return above a target rate) means that , in aggregate, their returns must be less than the long run 9-10% returns from equity funds (which have substantially less costs). Unlike hedge funds, absolute return funds are not trying to benefit from the downside in markets but to protect capital in declining markets. But, like insurance, the use of derivatives costs money and is a drag on returns. And the lower the likely nominal returns, the more costs matter. Unlike stock market quoted funds, where distribution costs are negligible, the costs of distribution in unquoted funds, like unit-linked funds in Ireland, can seriously alter the equation from a client perspective. Hence, a targeted annual return of perhaps 7-8% from an absolute return fund, or 5-6% after distribution costs, is perfectly acceptable in a low interest rate environment such as the one we have today. So, the advisor in particular needs to understand and communicate that the client returns are likely to be of this magnitude over the medium term if he/she is to avoid client misunderstanding and disappointment. Some absolute return funds will do better and some will do worse but, in aggregate, I believe the above is a reasonable guideline.

As I said earlier, there is no free lunch in markets. Absolute return funds, like hedge funds, corporate bond funds and alternative assets such as the precious metals, timber, water and infrastructure plays have their place in a well diversified risk-asset portfolio with the aim of owning a range of uncorrelated risk-assets and obtaining a smoother risk/return profile. But there is no justification for absolute return funds being sold as a sole holding in a risk-asset portfolio.
In 1999, I well remember the push into 'tech funds' in Ireland at the peak of the global technology bubble. Role forward to the property bull market and by late 2006 geared property funds were one of the stronger selling investment products. To protect clients, the advisor needs to remind him/herself that the insurance companies and banks are not there to help the investor but to help themselves. Absolute return funds are not the Holy Grail and blind faith in them will leave the door open to a further round of client disappointment.
 

Rory Gillen
19th November 2010