Investors should beware absolute return funds targeting ‘low volatility’ as these often result in paltry returns, according to Argonaut’s Barry Norris, who says they’d be better splitting their allocation between a passive fund and cash.
Norris, who is an FE Alpha Manager, heads up the £165m Argonaut Absolute Return fund, which has been the third most volatile fund in the 53-strong sector over three years as well as third highest returning over the same period.
Demand for absolute return funds has exploded in recent years and the IA Targeted Absolute Return sector’s most popular portfolio – Standard Life Global Absolute Return Strategies – is also the largest in the whole Investment Association’s 3,000-strong universe.
Of course, the IA Targeted Absolute Return sector is filled with a variety of different fund types such as multi asset strategies or long/short bond or equity vehicles as well as portfolios targeted at specific regions.
However, as Norris points out while this results in different risk and return profiles, the framework for analysing the attractiveness of these strategies is the same and involves the same opportunity cost.
Norris said: “The argument for investing in absolute return should be relatively simple: a consistent delivery of attractive returns, combined with a risk profile offering diversification from traditional long-only funds.”
“However, much of the investor attention surrounding absolute return strategies overly focuses on those funds displaying low volatility characteristics, which we argue by itself has no portfolio diversification benefits.”
“We are concerned the emphasis on low volatility in isolation often leads too many funds to only deliver mediocre ‘cash plus’ returns – without the actual safety of cash.”
The three most volatile funds in the sector are the CF Eclectica Absolute Macro, CF Odey Absolute Return and Argonaut Absolute Return, which have also been the top performing.
Performance of funds and sector over 3 yrs
Source: FE Analytics
A recent FE Trustnet study found that nearly two-thirds of funds in the IA Targeted Absolute Return sector have failed to beat cash ISAs for returns over the past three years.
As Norris (pictured) points out cash can still offer some growth in line with interest rates and, particularly in a low inflation environment, has little change in its underlying value.
“Cash is the ultimate low volatility investment. Unlike low volatility funds, cash never delivers a negative absolute return – unless in the unlikely event of the bank becoming insolvent.”
“Therefore, the risk/return analysis of cash as an asset class is always consistently strong, simply due to the absence of risk. But by far the biggest limitation of ‘cash plus’ low volatility funds is the absence of clear diversification benefits.”
“An investor may believe they are achieving diversification by selecting a range of low volatility funds, only to find all of the strategies selected are highly correlated to the stock market and/or each other.”
Norris thinks investors could likely replicate the same return profile by splitting their assets between cash and a passive fund tracking the FTSE All Share index, which he says would be much cheaper.
“While cash does not charge an annual management fee, or performance fee, this is not the case with the universe of low volatility funds. In fact, it is questionable whether it is appropriate for many low volatility funds to even apply the commonplace annual management charge.”
He says funds with a low standard deviation, a measure of historic volatility, means risk-adjusted returns, as measured by the Sharpe ratio, see much losses from their underlying charges as quoted by the annual management charge (AMC).
“For example, if a fund has a standard deviation of 2 per cent, is it really appropriate for it to apply 0.75 per cent AMC? Even in a year where the fund manager has demonstrated skill in converting risk into return, with the delivery of an admirable Sharpe ratio of 1, the AMC would likely consume nearly 40 per cent of the targeted return.”
“Our analysis of the IA Targeted Absolute Return sector reveals approximately one-quarter of funds have an AMC of at least half of the standard deviation. Even in a good year, this suggests fees will eat away at least half of the implied return.”
The 10 funds in the sector with the lowest volatility all have returned less than the sector average over three years with the two least volatile – Kames
Absolute Return Bond and Blackrock Absolute Return Bond also the lowest returning of the 10.
Performance of funds and sector over 3yrs
Source: FE Analytics
“The most attractive risk characteristic of an absolute return fund in our view is not low volatility, but achieving low correlation to risk assets and delivering returns in all market environments. After all, the least difficult skill in investing is providing a positive return at the same time as the market and everyone else,” Norris added.
In a coming article, FE Trustnet will look at the absolute return funds offering the lowest correlation to mainstream asset classes.