Choosing managers with a staunch attitude to risk and avoiding those that have achieved double-digit returns over short time frames are the best ways to steer clear of pitfalls in the IA Targeted Absolute Return sector, according to the fund-of-funds team at Sarasin & Partners.
Alistair Campbell and Jamie Fletcher, who deputy manage all four of the firm’s fund-of-fund portfolios, have increased their exposure to alternatives over recent months after rotating out of some of their fixed income holdings.
In their flagship Global Strategic Growth fund, for instance, their alternatives weighting currently stands at 25 per cent, which includes both alternatives to equities and fixed income, as well as market-neutral strategies.
This is despite the fact that targeted absolute return and market neutral funds received an influx of negative press last year, as many of the worst-performing funds in the Investment Association universe had these mandates.
According to data from FE Analytics, in fact, four of the worst performers within the IA last year all resided in the IA Targeted Absolute Return sector, while a further three were in the bottom 10 for their returns in 2016.
Performance of worst-performing funds in the IA in 2016
Source: FE Analytics
“We have seen the big four offenders from last year and we aren’t invested in any of them,” Campbell said.
“Firstly, if your performance going back before last year was too good to be true – people were chasing 15 to 20 per cent returns – you need to question whether that is down to skill or luck, and whether that return is repeatable. For us, we weren’t confident that it was.”
When it comes to the worst-performing funds in the IA Targeted Absolute Return sector last year, a majority of them had indeed achieved stellar returns during 2015.
For instance, the worst-performing fund in the sector last year – Barry Norris’s Argonaut Absolute Return fund – returned 11.86 per cent, more than doubling the performance of its MSCI Europe ex UK benchmark and quadrupling the return of its average peer.
In 2016, however, it was down 25.63 per cent while its benchmark returned 18.62 per cent. In an article published earlier this year, the manager explained that holding historic winning trades and avoiding picking from the very bottom of bear markets led to this underperformance.
Similarly, James Hanbury’s Odey Absolute Return fund doubled its average peer in the sector in 2015 with a total return of 7.6 per cent but, last year, lost 17.85 per cent.
Performance of funds vs sector in 2015
Source: FE Analytics
“One fund in the sector we do use that we invested in recently is Jupiter Absolute Return,” Fletcher said.
“We feel his process is much more robust and systematic than many of his peers, so we think he can keep generating the performance that he has going forward. I would agree that some funds haven’t covered the sector in glory.
“I think a big difference between the underperforming funds and something like the Jupiter fund is the attitude to risk. With the funds that have done badly, they are generally funds that have really high conviction ideas and, if they think something is going to happen, they have all of their bets facing in one direction.
He added: “James Clunie at Jupiter is completely different in that sense. He will look at his portfolio and, if he sees that he has a slight tilt towards value in one area, for instance, he fears that he could get quite hurt by deflation so will start to buy things to balance this out. He calls them ‘imperfect hedges’, so he might just buy gold or bonds to balance out the risk there.”
Over Clunie’s tenure, the four crown-rated fund – which aims to generate an absolute return over rolling three-year periods – has returned 18.34 per cent. It has done so with a maximum drawdown, which measures the most money lost if bought and sold at the worst possible times, of 1.87 per cent.
The manager has achieved this through a portfolio of mostly global equities, 79 of which are currently long positions and 113 of which are short. However, he is also able to hold other assets such as corporate debt or core government bonds.
These investments are chosen using a bottom-up stock selection process, although macro themes are used to control risk and ensure the overlay of the portfolio is sensible.
Performance of fund vs sector and benchmark under Clunie
Source: FE Analytics
Outside of the Investment Association universe, another vehicle the fund-of-funds team likes is the Ireland-domiciled KLS Zebra Global Equity Beta Neutral fund, which is $157.2m (£126.1m) in size.
Launched in July last year, it aims to generate long-term absolute returns through its market neutral portfolio of global equities.
“It’s definitely one that gives us diversification. It’s managed by Roger Ibbotson, who is an academic in the States. He came up with the theory of popularity; you have all the different styles within equity that we have heard of such as value, growth, momentum, etcetera,” Campbell said.
“Rather than looking at markets this way, he came up with the idea that unpopular stocks tend to outperform the popular stocks. It’s not necessarily in the sense that, by being popular they’re expensive; a popular stock would be one that everyone is talking about. It will be in the papers all the time, it will be traded a lot. It is basically putting that into practice.
“He found it also works well if you take into account fundamentals, so essentially he is looking to go long stocks with strong fundamentals but have been forgotten about. Then he will try to short stocks that have poor fundamentals but everyone is talking about them.
“Ibbotson himself has a five or six-year track record and he has returned 6 to 7 per cent per year on an annualised basis.”
As a house, Sarasin & Partners is currently neutral equities but underweight fixed income. When it comes to their alternatives exposure, Campbell and Fletcher believe it is important to combine funds that offer market neutral strategies with those that are well-diversified and aim to achieve positive, steady returns over the long term.
“The reason these funds are in portfolios to start with is diversification. These aren’t meant to be the superstars earning you 20 to 25 per cent per year, in fact we’d be quite worried if any of these funds were doing that,” Fletcher said.
“It’s more that you want to see them protecting you in down markets and hopefully providing that quite boring and yet reliable return. This is what we’re after rather than shooting the lights out.”