Ignis’ chief investment officer, Chris Fellingham, points out that with yields remaining close to record lows, particularly in genuine AAA assets, the market’s next significant move can only really be in one direction and therefore investors need to consider including absolute return products in their fixed income portfolios.
“Markets no longer reward a bias to a particular investment style. Instead, styles and processes need to be flexible, with portfolios adjusted to suit prevailing market conditions. Managers need to invest pragmatically, focusing on the outcome their mandate requires them to deliver.”
“Well-managed absolute return funds benefit from having fewer constraints than long-only strategies and use additional tools, such as shorting, meaning they should be able to deliver superior risk-adjusted returns,” he says.
However, absolute return funds have come under a lot of criticism in recent years as many of the funds in the sector failed to live up to what investors believed would be positive returns year in and year out.
Fellingham admits that the sector has had a chequered past, stating that many funds have relied heavily on beta and failed to manage downside risk properly. This rightly led investors to question how equipped traditional long-only managers were to manage absolute return strategies.
“We believe that to deliver absolute returns properly, alpha and beta must be separated and downside risk must be carefully managed. This is particularly the case in the fixed income space. When assessing fund options, investors should be looking at the return per unit of risk taken rather than just the return.”
Going forward, Fellingham believes that allocations are likely to be based more heavily on this risk/return analysis and that it is only funds offering the most attractive potential returns available within prescribed volatility brackets that will be selected.
He adds that increased risk awareness has also led investors to look closely at where performance comes from – is it a manager’s high-beta play or genuine alpha? It is important to separate the two and carefully allocate to each. By doing this, the alpha segment is portable and can potentially be applied to any benchmark.
Fellingham suggests that investors should look at an absolute return fund’s tracking error (or annualised risk) and consider whether it is being maintained within a prescribed range, as this measure, combined with the fund’s annualised return, could lead to a favourable information ratio.
This unit of measurement is reflective of the return per unit of risk taken, as well as the skill of the fund manager, and an information ratio above 1 indicates that the fund offers an attractive level of risk/return.
Similarly, Fellingham believes that an absolute return fund’s correlation with other asset classes should be considered, stating that a fund with low correlation, as well as a steady return profile, can be a good portfolio diversifier and help reduce overall risk.
The philosophy of separating alpha from beta and focusing on downside risk management has been key to the success of Ignis’ leading Absolute Return Government Bond fund.
However, Fellingham explains that this is just the start of the fund’s approach to achieving absolute returns, at a low level of risk.
“The team’s process relies upon two things: proprietary technology to give an edge, and a greater focus on pragmatism in portfolio construction.”
“Our proprietary approach in government bonds is to focus on ‘forward rates’ (the price of borrowing money for certain periods in the future). This allows us to move beyond the traditional ‘duration-based’ approach and average yields.”
“Instead we are able to accurately reflect our macroeconomic views through carefully constructed positions at different points of forward rate curves and across different markets. The uncorrelated nature of these positions brings important diversification benefits, reducing the overall risk of the fund.”
Whether fixed income exposure is achieved through long-only or absolute return products, current market conditions, and those for the foreseeable future, mean investors must increasingly focus on return per unit of risk taken.
The best results will be delivered by allowing skilled managers the flexibility to invest in a pragmatic way to maximise potential within a carefully controlled risk range.
Click here to learn more about absolute return investment strategies, with the FE Trustnet guide to absolute return.
This article was written in collaboration with and is sponsored by Ignis Asset Management.
