Investors should step away from traditional assets such as bonds and equities given toppy market valuations and turn to the IA Targeted Absolute Return sector instead, according to Psigma’s Rory McPherson (pictured). 
In an article published last week, McPherson questioned whether investors should “even bother” with traditional assets any more given the lacklustre growth environment and central banks’ inability to bolster the economy.
“A traditional ‘60/40’ mix (with 60 being the percentage in equities) has yielded a return of nearly 8.5 per cent a year for the last 35 years against a backdrop of a 2.6 per cent inflation rate,” he pointed out.
“That translates to an increase in capital value of over 17 times before inflation and almost 7.5 times in real terms: this can’t go on forever.”
Most major equity indices have seen strong returns since the start of the year – even the weakest-performing, the MSCI Europe ex UK index, has returned 14.22 per cent in 2016.
performance of indices in 2016
Source: FE Analytics
The falling pound has been responsible for a large proportion of equity gains seen by UK investors in 2016. However, another factor has been the latest switch from bonds into stocks, after fixed income yields took yet another tumble earlier in the year.
While McPherson says these traditional assets are “tired”, he says there are still a few options for investors who are looking to explore the alternatives space but are unwilling to buy into illiquid assets such as private equity, infrastructure or physical property.
“When it comes to buying investments that won’t go down at the same time as traditional bonds and equities, the options are cash and volatility,” he said.
“Cash is cash obviously and you don’t get a return, but it’s better than going down. Volatility would be owning the VIX index [often known as Wall Street’s ‘fear gauge’] which is always going to go up on a day when equity markets go down.”
“If you think equity markets and bonds are going to go down at the same time, if you can own that in some way, shape or form, then you would do very well.”
McPherson says there are three methods of carrying this out: either by owning options personally, through owning a fund that trades volatility or through owning a vehicle that buys volatility futures.
Given that this method will only work if there is a sell-off though, he believes that holding targeted absolute return funds that are benchmarked against cash currently represents investors’ best bet for diversifying across asset classes.
“We have alternative managers who are positioned very bearishly but use some complex instruments that we can’t really own ourselves outright,” he continued.
“We own the Odey Odyssey fund which is run by Tim Bond – he’s about 80 per cent net short on European equities and is using options to do that. He has some gold exposure as well.”
“So, if the equity market was to sell off, you would do very well because he benefits when it goes down.”
McPherson has paired this offering with BNY Mellon Absolute Insight, which FE Alpha Manager Sonja Uys has managed since 2009.
The £760m fund aims to provide both growth and income through a fettered portfolio of funds – it is benchmarked against cash (3 Month GBP LIBOR minus 0.125p per cent) and aims to outperform by 4 per cent over rolling five-year periods before fees.
“Being benchmarked against cash is important to us because we want our alternatives to be alternative and not be benchmarked against bonds or equities,” McPherson continued.
“Keeping them honest is good. There are quite a lot of different things going on within that fund but, when you look at what’s going on underneath the surface, it’s just quite a boring fund that grinds out very solid returns. It has been very solid this year, so that’s one of the funds we own.”
Performance of fund vs benchmark and index over 3yrs
Source: FE Analytics
However, not everyone believes that being benchmarked against cash is positive. Given that the average fund within the IA Targeted Absolute Return sector has a clean ongoing charges figure of 1.1 per cent (the average OCF in the IA UK All Companies sector is 0.9 per cent), an aim to provide anything above cash can often leave minimal returns at best once charges are taken into account.
An FE Trustnet article published in August found that 44 per cent of funds within the sector also charge a performance fee which, according to some investors, is difficult to justify during rising market periods.
McPherson agrees that high charges and performance fees are indeed important factors to consider and warns that investors should really get underneath the bonnet of a fund before buying into it.
“There’s a big swathe of different types of funds within the alternatives space that are benchmarked to cash and some are priced like hedge funds. Some are much more reasonable and some are going to be much riskier as well,” he said.
“It is key to know that you’re not buying a wolf in sheep’s clothing that might have a cash benchmark but it’s going to behave like equities.”
“The fees are going to be higher than those you find in traditional asset classes but, if they’re doing something different such as using options, we think it’s worth paying the premium. But, for your steady eddies, we would want to make sure the fees we’re paying are pretty low, which is something we target.”
BNY Mellon Absolute Insight, which accounts for approximately 3 per cent of Psigma’s balanced portfolio model, has a performance fee of 10 per cent.
While McPherson says that this is justified given the nature of the fund, FE Alpha Manager David Coombs told FE Trustnet earlier this year that any fund that charges a performance fee for beating cash is “outrageous”.
“When funds take performance fees for any positive return or for beating cash when cash is sub 1 per cent, I think it’s outrageous. I can’t put it any stronger than that, it’s dreadful,” he said.
“I also think that when interest rates were 4 or 5 per cent, that was almost like a free hit for absolute return funds.”
“Just to generate 1 or 2 per cent of performance above cash, I’m not saying it’s easy, but that should be what the fund does. You shouldn’t get a performance fee for beating cash by 1 or 2 per cent.”
However, McPherson says that as long as the fund’s structure is aligned with investors’ interests and that there is a high watermark, performance fees can actually reduce the overall charges that are being paid.
He also says that it is down to investors to reduce their exposure to targeted absolute return assets during raging bull markets so that they don’t pay performance fees for the funds to do well in less challenging market environments.
“I guess I would come back to the point of being very clear on what you’re buying. With these funds, the name isn’t always what it says on the tin and you really have to drill into it,” he explained.
“Some of them do have high correlations to equity markets and they charge a performance fee so, to us, it doesn’t make sense to own them because they’re not giving us diversification.”
“The ones that are genuinely not correlated to equity markets, their background shouldn’t matter to their performance.”
“It’s our job to recognise that, if we are in a raging bull market, then we should own less in something which is going to protect in a sell-off.
“Now though, where we feel we’re pushing up at pretty high levels of valuations, we need something that’s going to perform well if equity markets sell off.”