After a disappointing 2018, the IA Targeted Absolute Return sector saw a vast improvement in performance last year with almost nine out of 10 strategies in positive territory.
Absolute return strategies have come in for much criticism in recent years as investors have increasingly questioned their mediocre performance against a backdrop of rising markets.
This has translated into outflows more recently with £4.5bn being pulled out of the sector during the first 11 months of the year, according to the Investment Association.
But last year the sector seemed to live up to its name as its average member made a gain of 4.38 per cent. However, it should be noted that the sector is home to a broad range of strategies, making such broad analysis challenging.
More detailed research by Trustnet found 86 per cent of the IA Targeted Absolute Return sector’s constituents made a return above zero in 2019, with just 17 of its 120 members posting a loss.
This marked a sharp turnaround from 2018, when just 16 per cent of total funds made a positive return.
As the below table shows, the percentage of the peer group recording positive returns last year was in line with 2017 and previous calendar years. These figures include funds from the sector that have since closed or been merged away, to avoid survivorship bias.
Source: FE Analytics
So, what made 2018 such a difficult year for absolute return strategies?
Adrian Lowcock, head of personal investing at Willis Owen, said that 2017 and 2019 were “very different markets” and, as such, he found it interesting to note that performance levels were similar. 
However, Lowcock (pictured) noted that performance was about more than just the strong performance of equity markets last year, given the broad range of strategies that call the sector home.
Instead, returns often reflect the managers’ ability to successfully forecast geopolitical events and economic growth and how they impact asset classes, the fund picker said.
“It is naturally easier to make money if asset classes are rising but that might disguise risks that the sector is taking and doesn’t show whether they are delivering the protection, which is a very significant part of the proposition,” he explained.
“The geopolitical situation in 2018 was very difficult to predict, events such as Brexit were high-risk binary situations. Likewise, investors were still trying to understand Donald Trump and trying to predict his next tweet was even riskier.
“In such situations, it was hard to make big calls.”
Tom Sparke, investment manager at GDIM Discretionary Fund Managers, said that his first instinct when considering the research was to look at the impact of equity beta on performance.
Sparke explained: “2017 and 2019 were excellent years for equity markets so it follows that a correlation with equity markets may be a factor.
“The overall IA Targeted Absolute Return sector has a correlation with stock markets – using the MSCI AC World index - of 0.67 and only 16 of the 100 funds with a three-year track record in the sector have a negative correlation to stocks.”
Correlation chart of funds relative to MSCI AC World over 3yrs
Source: FE Analytics
He added: “Many of the absolute return funds toward the highest end of this scale are unashamedly equity-based. Therefore, as equity markets fell at the end of 2018, many of these funds moved down with them instead of protecting capital in these times.”
Sparke (pictured) highlighted funds such as Threadneedle Dynamic Real Return and Smith & Williamson Defensive Growth and Brooks Macdonald Defensive Capital that had high correlations to the MSCI AC World index. 
With a score of 1 signifying that a fund has moved completely in line with the index, the Threadneedle fund had a figure of 0.91, while both the Smith & Williamson and Brooks Macdonald both had correlation figures above 0.8. (A correlation of -1 suggests that fund and index have moved completely in opposition to each other.)
Despite the seemingly high correlation with equity markets, Willis Owen’s Lowcock said there are still some strategies worthy of investors’ consideration in the sector.
The first he highlighted was the £6.4bn BNY Mellon Real Return fund managed by Aron Pataki, Suzanne Hutchins and Andy Warwick. Its first priority is capital protection and returns of 4 per cent above per annum over the long term.
“The team runs an unconstrained and flexible approach which initially uses Newton's thematic research to identify opportunities,” said Lowcock. “The fund invests in two parts: a core element which invests in shares and bonds with a long-term perspective and low turnover.
“Around the core they invest in cash, government bonds and derivatives in order to reduce risk. The underlying portfolio is composed of traditional shares, albeit with significant flexibility in asset allocation.”
Performance of fund vs benchmark over 3yrs
Source: FE Analytics
Over three years to 21 January, the fund has made a total return of 16.66 per cent compared with a 14.36 per cent gain for its LIBOR GBP 1m +4 per cent benchmark. It has an ongoing charges figure (OCF) of 0.8 per cent.
Another fund suggested by Lowcock is Janus Henderson UK Absolute Return, overseen by FE fundinfo Alpha Managers Ben Wallace and Luke Newman.
“They aim to add value through long-term fundamental research and via shorter-term trading opportunities,” said the Willis Owen fund picker.
“They take long positions in firms that can deliver earnings growth in excess of market expectations over the medium and long term while shorting stocks where earnings are priced in or where the terminal value is impaired.
“The approach is implemented within a set of risk limits that provide the managers with significant flexibility.
Janus Henderson UK Absolute Return has made a total return of 5.86 per cent over the past three years and has an OCF of 1.05 per cent.