The turbulent events of August should be a “wake-up call” to investors who think that a traditional long-only equity portfolio can stand up to the potential for greater volatility, according to JP Morgan Asset Management’s Talib Sheikh.
The FTSE All Share dropped by just over 10 per cent in the first 24 days of August after investors were panicked by slower Chinese growth, a devaluation of the yuan and the potential for an interest rate rise in the US. It has recovered somewhat since but is still more than 4 per cent down from where it started the month.
Performance of index since 1 Aug 2015
Source: FE Analytics
Sheikh, manager of the JPM Multi Asset Macro fund, said: “Investors should be scrutinising correlation in their portfolios. August ought to have been a wake-up call with both equities and bonds falling together. We expect markets to continue to experience volatility and bouts of illiquidity.”
“Relying on long-only beta in traditional markets to deliver returns through the increasingly high volatility in today’s global markets is not enough anymore. We believe volatility is likely to remain, while returns from traditional long equity and fixed income are likely to trend lower.”
“In this environment, investors need to think about diversifying their long-only exposure in order to achieve positive risk-adjusted returns; for example, by increasing exposure to relative value, derivative and volatility strategies.”
JPM Multi Asset Macro is yet to establish a three-year track record, but our data shows that since launch in February 2013 it has a correlation of 0 with the FTSE All Share. Its total return over this time has been 30.94 per cent, compared with the All Share’s 14.45 per cent.
While this is impressive, absolute return funds are often examined at over longer time frames. We’ve look back over the IA Targeted Absolute Return sector to see which funds have had the lowest correlation to UK equities since 1 January 2011.
This is a shorter period than we’d ideally use but many of the sector’s member have short track records. However, it does cover the down market of 2011, the rising years of 2012 and 2013, the relatively flat 2014 and the rollercoaster that has been 2015 so far.
It’s also important to keep in mind that correlation data is backward looking and that past performance is not a guide to what might happen in the future.
FE Analytics shows that that 15 member of the peer group have a correlation to the FTSE All Share of less than 0.25 since the start of 2011. They can be found in the below table.
Source: FE Analytics
Eight funds had a negative correlation, which means they have tended to rise when the index has fallen (but also vice versa) and suggests they could be appropriate when looking to hedge exposure to UK equities.
BlackRock European Absolute Alpha is the fund with the lowest correlation, at -0.22. The fund, which is managed by Vincent Devlin and Stefan Gries and takes long/short exposure to European equities, has returned 22.25 per cent over the period in question.
However, only two of the funds with negative correlations have beaten the FTSE All Share’s 33.99 per cent total return over this time: City Financial Absolute Equity and Old Mutual Global Equity Absolute Return.
David Crawford’s five FE Crown-rated City Financial Absolute Equity fund has a 0.08 correlation to the FTSE All Share and is up 123.26 per cent since the start of 2011. The long/short equity fund might not be for the cautious investor, however, as our data shows its annualised volatility and maximum drawdown have been roughly in line with the index’s over recent years.
Earlier in the year Crawford told us that he was planning to make greater use of his short book across 2015, as he believed “some companies aren’t as good as the market thinks they are”. This certainly helped in the turbulent third quarter of the year, when the fund was the highest returning member of the Investment Association universe.
Old Mutual Global Equity Absolute Return, managed by Mike Servent, Amadeo Alentorn and Ian Heslop, is market-neutral portfolio of global equity stocks and aims for positive returns over rolling 12-month periods. Our data shows it has posted a negative 12-month return in just three of the past 60 months.
The fund, which has made 43.81 per cent since 1 Jan 2011, has recorded annualised volatility of just 5.12 per cent over this time as well as encountering a maximum drawdown of 4.56 per cent. In the 56 months since the start of the period, it’s made a positive return in 40 of them.
Performance of funds vs sector and index since 1 Jan 2011
Source: FE Analytics
Of course, not all investors will want to have a negative correlation to UK equities and instead want their absolute return funds to have as little correlation, positive or negative, as possible. These funds are likely to be ones where the historic correlation has been as close to zero as possible, although past performance is no guide to the future.
Threadneedle Absolute Return Bond and LO Funds Absolute Return Bond are the two funds with the correlations closest to zero, at -0.04 and 0.03 respectively, but this is to be expected given they focus on fixed income.
One notable name is CF Eclectica Absolute Macro, which is managed by the respected Hugh Hendry – who attracted attention after making his hedge fund clients a significant return in 2008 despite crashing global markets.
Hendry had been seen as one of the more bearish managers in the market but at the end of 2013 announced that he had become more positive in his outlook. He also conceded that his performance in the previous years had been disappointing because of his cautious positioning: something which may explain its 9.27 per cent total return since the start of 2011.
Others have beaten the All Share, however.
Schroder Absolute UK Dynamic has a correlation of just 0.16 to the index but has outperformed it with a 48.45 per cent gain. The fund is run by the FE Alpha Manager duo of Paul Marriage and John Warren, taking a long/short approach to UK equities with a bias towards small and mid-caps.
It has made a positive return in four of the last five full calendar years, although it was down 8.58 per cent in 2014. Over 2015 to date it’s up 11.86 per cent, compared with a gain of just 1.11 per cent in the FTSE All Share. Despite its focus further down the market-cap spectrum, the fund has been less volatile than the All Share over recent years, as well as having a lower maximum drawdown.
FE Alpha Manager Barry Norris’ FP Argonaut Absolute Return, meanwhile, has a correlation to the FTSE All Share of 0.19 and its total return since the start of 2011 has been 81.89 per cent. The four FE Crown-rated fund also takes a long/short approach and invests across a range of asset classes.
Performance of funds vs sector and index 1 Jan 2011
Source: FE Analytics
Norris recently criticised the absolute return sector, saying too many funds are prioritising low volatility over returns and aren’t offering the portfolio diversification benefits they are supposed to. His fund is one of the most volatile in the sector, as can be guessed from its returns, and as the graph shows has a significant fall over recent weeks.
“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,” he told us.
“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.”