Absolute return funds like Old Mutual Global Equity Absolute Return, FP Argonaut Absolute Return and Schroder European Absolute Target have provided investors with a return that is lowly correlated to both bonds and equities in the past, according to data from FE Analytics. 
The IA Targeted Absolute Return sector has been one of the most popular with UK investors since the EU referendum, as many predict upheaval and uncertainty in markets for a long time to come and are seeking funds that can protect their portfolio.
Bonds have risen 17.8 per cent in 2016 so far while equities have climbed 11.4 per cent. Concerns at the start of the year over a slowdown in China seem to have been eased for now, while the quick resolution David Cameron’s resignation and a falling pound boosting exporters have all helped UK stocks.
Yet despite this surprising outperformance, absolute return funds – which typically aim to make a return in any market conditions - have remained popular.
Performance of gilts and equities in 2016
Source: FE Analytics
This may be because investors are still concerned about the potential for a significant equity market correction in the remaining months of 2016 while bond yields remain at all-time lows and, according to some, could see their multi-decade bull run come to an end.
Indeed, a number of commentators have warned that there is no longer any appeal to buying government bonds, because at current prices you are guaranteed to lose money if you hold them until maturity while their lofty valuations offer little cushion against an equity market fall.
With more investors become concerned by the risk of a fixed income correction, we take a look at the absolute return funds that have negatively correlated, lowly correlated and strongly correlated to the bond market.
Those with a low correlation to bonds
Within the IA Targeted Absolute Return sector there are some that have displayed an inverse relationship with bonds, meaning that as bond prices have fallen they have tended to rise.
Adrian Hull, senior investment specialist within Kames’ fixed income team, said: “UK gilt futures are now at record highs, as is the long end of the UK gilt market, and the total return for some gilts year-to-date has been over 50 per cent.”
“But these heroic gains mean investors are now paying 50 per cent more to get twice as much risk in terms of duration, which has moved out to 28 years for 50-year gilts.”
Over a five-year period, the funds most negatively correlated to bonds include the Schroder Absolute Return Bond and Absolute UK Dynamic funds, Smith & Williamson Enterprise and Premier Defensive Growth.
Performance of funds vs gilts over 5yrs
Source: FE Analytics
As the above graph shows, none have followed the same trend, with all returning less than gilts over the last five years. However, all have made positive returns over three and five years.
The most negatively correlated to government bonds is the Schroder Absolute Return Bond fund, run by Bob Jolly, Gareth Isaac and Paul Grainger.
The £110m fund aims to make a positive return over rolling 12-month periods, in all market conditions, but failed to achieve this in 2015, 2011 and 2008.
In the sweet spot
In a recent note, Hawksmoor’s Jim Wood-Smith said: “These are not normal times, and we believe the traditional model of a balanced portfolio that consists of a mix between high quality bonds and equities is a dangerous approach because the performance of the two asset classes is becoming increasingly positively correlated.”
Indeed, both have been rising steadily in tandem this year and. while this has created returns for investors, there is a fear that what goes up together must come down together.
As such, there are a number of absolute return funds that are lowly correlated to both equities and government bonds over five years, as the table below shows.
Source: FE Analytics
T the closer to zero a fund is, the less correlation it has, while negative numbers mean it is inversely correlated.
The closest to zero for both bonds and equities over the last five years is the FP Argonaut Absolute Return fund, run by FE Alpha Manager Barry Norris.
The £352m fund has outperformed UK government bonds over the period, returning 50.73 per cent, but is 16.54 percentage points below the FTSE All Share.
However, it has only been slightly less volatile than the FTSE All Share and has a higher maximum drawdown than the UK stock market at 21.23 per cent, which may prove off-putting to more cautious investors.
One member of the above list that has a performance profile more in line with what would be expected from an absolute return fund is Old Mutual Global Equity Absolute Return.
Managed by Mike Servent, Ian Heslop and Amadeo Alentorn, this $7.5bn fund made a positive return in 2010, 2011, 2012, 2013, 2014 and 2015 but is down over the year to date. Over the past five years, its annualised volatility has been 4.86 per cent and it has witnessed a 4.48 per cent maximum drawdown.
The managers build the portfolio to be market neutral, so they do not take bets on the market’s direction and instead focus on stock selection criteria such as dynamic valuation, sustainable growth, analyst sentiment, company management and market dynamics. It is well respected by analysts and holds a place on the FE Invest Approved List.
Those with a high correlation to bonds
The Bank of England announced it would buy gilts as part of its latest changes to monetary policy, which included lowering the base rate to 0.25 per cent and a new round of quantitative easing.
Shilen Shah, bond strategist at Investec Wealth & Investment, said: “As with the previous APS programme, the BoE has indicated that it is aiming to buy gilts evenly across the curve, with the central bank not focusing on any specific maturity band.”
This measure could send the price of gilts even higher than its already inflated value, creating more value in the short term.
For investors looking to take advantage of this in the absolute return space, there are some funds with more of a correlation to bonds, and Schroder ISF Asian Bond Absolute Return is the highest of those over a five-year period.
Performance vs gilts over 5yrs
Source: FE Analytics
The $516m fund, run by Rajeev De Mello, has a 0.65 correlation to gilts and has returned 33 per cent over the five-year period, compared to the 44 per cent provided by a UK government bond.
However, with a correlation of 0.65 this sis not considered ‘high’. Other funds with a correlation to gilts between 0.25 and 0.7 include GAM Star Keynes Quantitative Strategies, Jupiter Absolute Return, Newton Real Return Newton Global Dynamic Bond.
