The demand for targeted absolute return strategies, designed to deliver positive returns regardless of market conditions, is clear. The sector was the best seller in nine of the 12 months to the end of November 2016, and is now home to almost £70bn, according to retail sales figures from the Investment Association.
In a well-diversified portfolio of traditional asset classes, most investment managers will now include an allocation to the Targeted Absolute Return sector or alternative investments, with the aim of providing returns uncorrelated to core holdings in equities and bonds.
The sector has, however, also been attracting attention for reasons less positive than its popularity. FE Trustnet recently reported that seven of the ten poorest-performing funds in the IA universe in 2016 were in the IA Targeted Absolute Return sector, with the worst down by a little over 25 per cent.
Managers will, inevitably, from time to time make the wrong calls, or ones that may pay off in the longer term but are painful in the shorter term, and some of the underperforming funds have previously been strong performers and may indeed return to the higher reaches of the performance tables.
Nonetheless, such sharp drawdown figures will be at odds with what many would expect from their targeted absolute return allocation. How then can investors seek to protect themselves against volatility, while also capturing upside?
The sector is home to a range of very different investment strategies, which also helps to explain the huge divergence in returns – in contrast to the losses by the worst performers, the best-performing fund returned almost 24 per cent in 2016.
Sector performance over 2016
Source: FE Analytics
The contrasting nature of targeted absolute return funds, ranging from single asset class investment through to complex hedge fund-style strategies, means there is plenty of scope for investors to diversify their exposure.
Analysis we have undertaken of performance and volatility among funds in the sector shows that, as with other asset classes, holding a blend of different strategies, rather than relying on a single fund, brings important advantages, helping to manage volatility, while maximising the potential for positive returns.
To demonstrate, let us look at a portfolio comprised of five targeted absolute return funds, all with very different approaches: City Financial Absolute Equity, a long/short equity strategy; Newton Global Dynamic Bond, a global bond strategy; Old Mutual Global Equity Absolute Return, a market neutral portfolio of global equities; GAM Star Discretionary FX, which holds global currencies; and our own VT iFunds Absolute Return Orange, which is a momentum-based strategy, tracking price trends in more than 30 asset classes globally.
Funds’ performance over five years
Source: FE Analytics
As our chart above shows, City Financial Absolute Equity achieved an annualised return of 11.7 per cent five years to 30 November 2016 – the strongest performance delivered by any of our five chosen funds – but with the highest volatility at 12.9 per cent and a Sharpe Ratio of 0.87. Meanwhile, Newton Global Dynamic Bond achieved the lowest annualised return, 3.6 per cent, but with the lowest volatility, 2.2 per cent and a Sharpe Ratio of 1.41.
However by combining these two funds and the three others in an equally weighted blend, we capture some of the upside from the higher-risk strategies while managing overall volatility. So the annualised five-year return is 7.3 per cent, with volatility of 4.8 per cent and a Sharpe Ratio of 1.42.
It is a similar picture over three years. City Financial Absolute Equity once more achieves the highest annualised return at 8.9 per cent, but again exhibits the highest volatility at 13.7 per cent. Conversely, Newton Global Dynamic Bond has the lowest annualised return at 1.7 per cent, but with the least volatility, 1.6 per cent. However, by combining these two funds with the three others – which are following global equity, currency and momentum strategies – our blended annualised return is 5.3 per cent, with volatility of 4.9 per cent.
Diversifying in this way, by holding funds investing with different styles and in different asset classes, should mean a lower level of correlation, so should one fund underperform over a short-term period the others should compensate. We believe this will reduce the risk of investors becoming disillusioned with their Targeted Absolute Return allocation, selling out at the wrong time and crystalising their loss – capitulation.
In our view, holding a combination of different strategies in this area can be as important as mixing large-caps, mid-caps and small-caps in your overall equity allocation.
There will, of course, be those who point out that there are already multi-strategy funds in the sector – the gargantuan SLI Global Absolute Return Strategies Fund, for example. It could be argued though that the complex, opaque nature of a fund like GARS makes it a single strategy of its own. Investors may also see advantages in investing in individual funds managed by specialist teams, rather than one fund with a single team.
The sector is home to talented managers using a broad array of contrasting styles in a range of different asset classes. We believe that investors will be well served by recognising the opportunity that presents.
We diversify our exposure to equities and bonds, so why would we not do the same with our targeted absolute return allocation?
Stacey Ash is director and investment manager at iFunds Asset Management. All views are his own and should not be taken as investment advice.