Regulatory developments have broadened the investment tools available to fund managers. Specifically, the UCITS III framework allows funds to use limited leverage and to employ derivatives for active investment purposes. This has driven an exciting phase of product development, one thrust of which has been the launch of a large number of absolute return funds.
These products are clearly of interest to pension funds that are seeking new ways to diversify their assets and lower overall risk. However, the wide variety of funds available has led to some confusion about how they should be classified. We seek in this article to clarify some of the key questions surrounding these products.
Defining absolute return
Absolute return can mean any product seeking to deliver positive total returns over the medium term, irrespective of market conditions. The returns are likely to be modest, and will be unlikely to keep up with relative return funds in bull markets, but the appeal is their aim of being relatively reliable. As such, they are equally useful investments at any stage of the market cycle, even though their profile is automatically raised in periods of risk aversion.
This broad definition of absolute return encompasses hedge funds as well as their regulated cousins. For the purposes of this article, however, we will limit our discussion to regulated funds.
Apples and pears
There are many different approaches in the burgeoning universe of UCITS III absolute return products, and this has caused some confusion when attempts have been made to classify the products for comparison and asset allocation purposes. Among the most popular approaches are:
■ Portable alpha. Here, a fund manager builds a portfolio exactly as he would for a relative fund, aiming to outperform a given index. Then, using a swap, the performance of the index is effectively subtracted from the performance of the portfolio, resulting (on the assumption that the manager has succeeded in outperforming) in a residual positive return equal to the value added by the manager.
■ Pairs trades. In this instance, the manager pays no attention to a benchmark index but instead selects a number of ‘pairs’ of investments. These might be shares in company A and company B, both of which operate in the same industry. The aim is to pick the stocks such that company A outperforms company B, and to invest long in the former and short the latter. If the companies are relatively similar, the opposing positions should largely nullify the part of the stocks’ performance that is attributable to the market, leaving the fund with the difference in performance between the companies’ shares.
■ Cash enhancement. This approach involves splitting the fund into two parts. The first is a portfolio of short-dated bonds designed to give a return roughly in line with cash. This portfolio is then used as collateral for a number of modest derivative strategies designed to reflect the fund manager’s views and expected moves in markets. As long as these views are correct, the derivative strategies should augment the cash-like return of the short-dated bond portfolio, delivering a positive total return modestly in excess of cash over the medium term.
Each of these approaches relies on fund manager skill to generate the returns, but the investments made could theoretically be in any asset class. It is important to remember that whatever the asset class, reflecting the fund manager’s views in the portfolio involves taking investment risk. As such, none of these approaches are risk-free and there is no day-to-day capital guarantee.
Obvious as it seems, it is perhaps also worth stating that a fund with a higher performance target is likely to take more investment risk. However, a well managed fund with prudent risk controls should be able to limit prolonged drawdowns.
A useful diversification tool
The fact that potentially any asset class can be used in absolute return investing has led to some debate about product classification. For example, where should an absolute return fund driven by views on equity markets fit in an asset allocation model? It could be expected to display some correlation with equity markets, but this correlation may be limited. And its performance objective and the profile of its returns are likely to be completely different to those of a relative return equity fund.
Indeed, the performance objective is likely to be much more similar to an absolute return fund powered by views on interest rate and currency markets. However, in this case, the performance will probably be somewhat correlated with bond markets rather than equities.
By way of illustration, the table below shows the correlation of an absolute return bond fund with various asset classes. This is an absolute return product that uses interest rate and currency markets and therefore displays some correlation with government bonds. Its correlation with equities and with high yield and emerging market bonds, meanwhile, is negative, and it is reasonable to assume that the correlation with absolute return products based on these assets would be very limited.
