BlackRock Absolute Return Bond, Premier Defensive Growth and Standard Life Short Duration Credit are three of eight funds that have won a spot on FE’s Approved Funds list in its latest biannual rebalance. 
The three funds are to replace Absolute Insight, which has now been removed due to bouts of recent negative returns.
Other lower-risk funds that have been added to the list include Standard Life Short Duration Credit and Aberdeen UK Property. However, Charles Younes (pictured), research manager at FE, says the repositioning of the shortlist was not an active bid to increase caution overall.
“We have looked at funds that have done very well because of the value trade and asked, ‘shall we buy into the performances we have seen over the last six months, or do we look through to the funds that have the fundamentals to perform well over the long term?’ We don’t make bets in terms of being cautious or aggressive,” he explained.
“Many funds have done very well over the last six months, but it’s about finding the funds that have the propensity to do well regardless of the relative value trade.
“So we really focus on the FE Alpha Manager ratings, the crown ratings over three years and not just what has happened recently.”
Last year’s aggressive growth/value rotation was partially the result of expectations for fiscal policy – chiefly in the US – and tapering of ultra-loose monetary policy elsewhere, with widespread belief that it will lead to a global inflationary boost and brighter growth prospects.
Performance of indices over 1yr
Source: FE Analytics
This has led to several funds with strong long-term track records falling behind some of their value-driven peers over recent months, many of which have struggled for a number of years as quality investing remained in vogue.
Simultaneously, the IA Targeted Absolute Return sector has come under fire from industry commentators over the past few months, given that several of 2016’s worst-performers all reside in the sector.
While the latest rebalance of the FE Invest Approved list may seem somewhat contrarian at first glance, Younes says the introduction of three ultra-defensive funds is a view on cash as opposed to the absolute return sector itself.
“Instead of holding 20 to 30 per cent purely in cash or short-term government bonds, we decided to hold absolute return funds with very, very low levels of volatility and very strong risk management processes so they can control the volatility and increase downside protection,” the research manager explained.
“We have looked at the probability of an absolute return fund achieving a positive performance by enduring a bit more volatility, so essentially looking at the Sharpe ratio of the absolute return sector. We feel like the odds are in our favour.
“So, over the last few months we have tried to identify funds with a very low volatility range over the previous years and to understand - from a risk management point of view - how they manage to control volatility so well within their process.”
Paul Smith’s five crown-rated Premier Defensive Growth fund is a prime example of a fund with a favourable approach to risk management, according to the FE Research team.
Added to FE’s Approved Funds list in the latest rebalancing, it has achieved a positive Sharpe ratio (which measures risk-adjusted returns) of 0.06 over five years and, over the same time frame, has a maximum drawdown (which measures the most money lost if bought and sold at the worst possible times) of just 1.19 per cent.
It has achieved a total return of 23.22 per cent since launch compared to its sector average’s return of 17.45 per cent and has done so with significantly lower levels of volatility. However, it must be noted that the sector holds a wide range of mandates with different investment aims.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
“The team has designed a very bespoke process that is able to manage the risk around the different structural themes,” Younes said.
“By maintaining this simple structure, it is very easy to model its risk. It doesn’t really depend on markets and it’s very easy to control because it has a pre-defined investment maturity, as well as investment risk.
“It’s very easy to model so it’s very easy to understand from a risk management point of view.”
In the past, some funds within the IA Targeted Absolute Return sector have come under fire for the complexity of their portfolio structures, which can make it challenging for the end investor to determine whether the fund is performing as it should be or not in any given market environment.
As such, the FE Research team has added BlackRock Absolute Return Bond fund to the list, which has also been chosen for the simplicity and clarity of its investment process, as well as its strong risk-management track record.
“BlackRock has a large team of fixed income portfolio managers analysing holdings from across the globe. The main portfolio manager [Ian Winship] says there are some gains to make out of the current relative value trade, for instance,” Younes continued.
“It is based on the conviction that the main portfolio manager has on certain ideas, as he allocates some of his risk budget to the underlying portfolio manager working on each area of the fund.
“From the overall portfolio point of view, he has a ‘value at risk’ budget, and depending on how much conviction he has on the ideas of the underlying manager, he allocates some of this risk budget. So it’s very easy to control and to manage from a risk point of view.”
Over five years, the £906m fund has achieved a neutral Sharpe ratio as well as a maximum drawdown of 1.64 per cent. Over the same time frame, it has returned 8.52 per cent compared to its LIBOR GBP 3 Months benchmark of 2.86 per cent, which it aims to beat over 12-month periods. It has a five-year annualised volatility of 1.29 per cent compared to its average peer’s volatility of 1.92 per cent.
The third low-volatility fund that has replaced Absolute Insight is Standard Life Short Duration Credit, which is managed by Daniel McKernan and FE Alpha Manager Mark Munro.
The £255m fund aims to provide income and growth through a portfolio of investment-grade credits, none of which have a rating below BBB. It actively avoids interest rate risk and looks to maintain its duration exposure at around two years.
“We don’t want to play the duration game, we just want a manager to be good at picking the right credit. So for us, it made sense for this fund to be selected,” Younes said.
Over five years, the fund has returned 24.78 per cent compared to its IA Sterling Corporate Bond sector average’s return of 33.14 per cent. However, it has done so with a top-quartile maximum drawdown, downside risk (which measures a fund’s susceptibility to lose money during falling markets) and annualised volatility.
Performance of fund vs sector over 5yrs
Source: FE Analytics
“When selecting these funds and putting a small amount of money in them, it was a case of finding vehicles that return slightly more than cash by having just a 1, 2 or 3 per cent volatility,” Younes concluded.
“If they can achieve this level of volatility while managing to deliver a performance of 2 or 3 per cent, and therefore providing a Sharpe ratio of around one, we will be satisfied.”
The full list of FE Approved Funds’ latest rebalances are shown below.
