The Case for Absolute Return Investing
The introduction of the Undertakings for Collective Investments in Transferable Securities (UCITS) III regulations for mutual funds in Europe in 2003 coincided with a period of poor equity market performance as well as low interest rates and government bond yields. These conditions prompted a surge of pan-European investor interest in absolute return funds, which has taken total assets in this relatively new and burgeoning sector to around €100bn at end August 2007, according to recent estimates by Moody’s Investor Services.
Dedicated fixed income-based absolute return bond funds account for one third of this total across around 60 funds. While the rapid growth in the development of absolute return products has largely been a European-led phenomenon, there are now clear signs of other regions, including Australasia, Asia and, to a lesser extent, the US, being interested in the benefits that this investment approach can offer.
Equities, both public and private, undoubtedly remain the portfolio cornerstone for individuals and institutions with long-term investment horizons. But, for shorter time frames, investors, pension trustees and advisors face the risk that the timing of entry to and exit from markets may dominate return outcomes.
Away from equities, if one looks at fixed income and non-government debt, recent market turbulence have shown the potential pitfalls of under-diversified portfolios (private individuals), ratings-led investments (CDOs), re-investment risk (money market funds) and credit-heavy/long-duration funds (total return funds).
As an example, over the past 20 years, five-10 year US bond indices have outperformed equivalent Treasury Bills by approximately 3% a year. The cost of this excess return, however, has been that these indices have produced negative returns in approximately three out of every 10 months and in two of the past 20 years.
What investors need is less volatile returns than they get with equities but something more appealing than locked-up deposits. Absolute return fixed income investing seeks to produce healthy excess returns over the risk-free rate but with a reduced frequency and severity of negative returns.
The term ‘absolute return investing’ doesn’t have a fixed meaning and, like so many terms in finance, can mean different things to different people. At its most literal, it encompasses all funds that are not benchmarked against a market index, such as the S&P 500 share index or the Lehman Aggregate bond index in the US or the FTSE-100 index or the FTSE-Actuaries All-Stocks Gilt index in the UK. It encompasses funds investing in all types of assets and using all manner of strategies to generate positive returns in base currency terms.
Funds that short individual physical securities invest in highly illiquid or non-traded assets and/or employ significant leverage should be referred to as hedge funds or alternative investment funds, while the classification of ‘absolute return fund’ should be used only for funds whose assets are overwhelmingly invested in tradable securities and currencies and that do not use borrowing to leverage returns or short individual physical securities.
Existing absolute return funds use a range of strategies to achieve positive returns regardless of market conditions: some focus on a single asset class, such as fixed income or a specific asset class within a geographic region, e.g. the UK equity market. Others take a wider remit and invest in all available asset classes and regions.
Whatever the individual strategy, the fund will contain the manager’s best asset allocation and/or stock selection ideas. To utilise these ideas, the manager may gain access to markets through a combination of physical assets, such as equities, bonds and property, as well as related financial derivatives.
The use of financial derivatives, such as futures, contracts for difference, options and swaps, allows the manager to gain exposure to the underlying assets and express views on their future direction without physically holding them. The manager can take advantage of expected positive returns by taking long positions in assets, markets or individual holdings in the normal way, while complementing these investments with selective short exposures to assets or markets that are forecast to decline value. Buying the short positions back at a lower price at a later date generates additional profit for the fund.
Although these funds can employ a wide range of strategies and are relatively unconstrained; they nevertheless operate with common features.
Absolute return funds typically operate with fewer constraints than other funds (i.e. total return funds), with the greater breadth of opportunity producing a potentially superior risk-adjusted return for a given level of manager skill.
Unlike total return funds as an example, absolute return funds are typically constrained by an overall risk budget rather than by simple limits to sector exposures. This approach permits managers to make strategic and tactical allocations based on fundamental macro and micro economic criteria rather than arbitrarily imposed constraints such as weightings.
Total return funds, for example, are typically benchmarked against an intermediate maturity or broad-based bond index, giving a ‘neutral’ duration of between four to six years, while absolute return funds are benchmarked against short-term interbank deposit indices. As a result, much of the excess return generated by total return funds over Treasury Bill or cash represents that of the asset class (Beta) while absolute return funds have the risk-free (cash) rate as their benchmark, resulting in all excess returns representing added value (Alpha).
This transparency permits more effective manager monitoring and facilitates performance-based fees, which help align client and manager interests.
We believe that diversification across a wide range of fixed income markets and currencies, which captures many different themes and strategies, holds the key to successful absolute return investing. Guidelines and restrictions need to be formulated to permit managers the maximum degree of freedom to exploit market opportunities while maintaining the risk of loss to an acceptable level.
The issue of portfolio constraints and manager freedom has become less contentious as trustees have become comfortable with non-traditional techniques. One of the most rapidly growing sectors has been the so-called ‘130/30 equity fund’ where such techniques are used by traditional long-only managers to maximise the returns generated by their research process.
Most important, however, is the control of risk. Risk control is not merely an issue of possessing the latest system and calculating the statistics, but of understanding how individual exposures can produce outcomes away from expectations, and ensuring that the overall portfolio is sufficiently diversified at all times.
Within the fixed-income and currency absolute return product space, Augustus considers there to be six distinct sources of excess return or alpha:
Positions are scaled based on our conviction in the investment view and cross-checked against statistical risk analysis to ensure that the portfolio does not become over-exposed to any single factor.
In addition to diversification across asset classes, we attempt to diversify the portfolio further by combining short- and medium-term trades with strategic exposures to themes, which are expected to play out over periods that may span several years.
Examples of such trades include default protection bought on US sub-prime mortgage-backed bonds in the summer of 2006 using single-name credit default swaps (CDS) and three-year options on the slope of the US yield curve bought in spring 2007.
It is important to understand the nature of returns likely to be generated by the particular approach outlined above. This is not managing a deposit account with the aim of generating a fixed margin over money market rates each month. These products are designed to generate (net of fees) 2-3% per annum over cash through the life of an investment cycle (typically three to five years). From an investment perspective, this approach means that there is no compulsion to enter into ‘carry trades’ (investing in high yielding bonds and currencies) at poor levels nor is there pressure to scale up positions to meet a constant target level of risk. There is an overall risk budget and allowable limits, such as a maximum of 25% in convertible bonds, but we are not constrained by sector weightings like total return funds are. From a client perspective, this should ensure a low degree of correlation of returns with traditional asset classes.
The diagram below illustrates the correlation of the UCITS III absolute return bond fund that is sub-advised by Augustus since its inception in May 2004, versus the major asset classes. This highlights the fact that we take an active approach to absolute return management rather than a passive credit-beta type approach.
Absolute return funds are becoming an established alternative to traditional asset management techniques. Their application for pension funds is a useful adjunct to other asset classes for a range of liability and funding profiles.
When assessing firms’ abilities in this type of product, trustees and their advisors need to have complete confidence that the manager and administrator have sufficient expertise to cover the whole range of assets in the chosen investment universe, as well as the knowledge and systems to evaluate, transact and administer modern financial instruments.