In a previous article, I discussed the importance of investing a portion of a portfolio in alternative strategies, such as market neutral funds and absolute return funds. I mentioned that alternative strategies mitigate risk as they have lower correlations to traditional asset classes (stocks and bonds).
In this article, I will explain another alternative strategy - absolute return funds. To gain a better understanding of these funds, I will define the term “absolute return.” Simply put, it is the return an investment has earned over a period, which could be in the form of income (such as dividends and coupon payments), capital appreciation or both. The term “absolute” is primarily used to distinguish from relative return measures which are primarily used by traditional mutual funds. Let’s discuss how absolute return funds work and how they differ from traditional mutual funds.
The Strategy of Absolute Return Funds
The funds employing an absolute return strategy seek to generate positive returns in all market conditions. In other words, they do not rely on the direction of the underlying stock or bond market. Unlike a traditional mutual fund that uses a long-only strategy and aims to outperform a benchmark (hence, we use relative return), absolute return funds seek to generate positive returns by employing a myriad of investment strategies, such as short selling, derivatives, leverage, arbitrage, pair trading etc. By utilizing any of these strategies, the funds aim to generate positive returns with lower volatility.
Unlike traditional mutual funds, absolute return funds do not track a benchmark. However, these funds always try to outperform the return on short-term government bonds. For example, the yield on T-Bills was 2% in the last six months. If an absolute fund cannot generate at least 2%, then it would be considered as underperforming.
Having said that, there are some fund companies that try to outperform the returns on short-term government bonds plus a spread (say 700 basis points). For example, Putnam Investments offers four types of absolute return funds, with each one attempting to outperform by a spread of 100, 300, 500 and 700 basis points, respectively. (For more from this author, see: An Introduction to Asset Allocation.)
How Do They Benefit a Portfolio?
To understand the benefits of an absolute return strategy, let’s explore this scenario. Suppose an absolute return fund in your portfolio earned a 3% return over the past year. At first glance, it would appear that the performance of the fund is weak and does contribute to your return objective. However, when comparing its results to the performance of stocks and bonds, which returned -10% and -5%, respectively, the absolute return fund provided protection during the market downturn.
As the example above illustrates, because of the benefits of diversification, including absolute return funds in your investment portfolio can mitigate risks.
Growing Popularity But Lacking Results
Absolute return funds have grown in popularity in the recent years and were the best selling fund category in 2015 and 2016, according to the Investment Association, which tracks all types of funds. The success of the funds was driven by heightened global macroeconomic uncertainty. On the other hand, the return of the sector was lackluster in 2016 at 1.06%, compared to the FTSE All Share Index’s 7.47% return, as per data from FE Analytics. The below chart shows the top 20 absolute return funds on the basis of three-year returns.
Source: FE Analytics
As the funds use complicated trading strategies, one should hold onto them for a longer duration. As per recent data from the Investment Association, absolute return funds posted double-digit negative returns in the short run. Many analysts believe that these funds have made unrealistic promises. Adrian Lowcock, managing director of Architas, told FT.com last year, “I think it’s unrealistic to expect any fund to perform all of the time no matter what it does.” He added, “It’s not realistic to have a higher than cash return without the volatility - it’s having your cake and eating it.”
Despite the diversification benefits that absolute return funds offer, there are many advisors who refrain from recommending them to their clients because they are very difficult to understand. One will find it very hard to even understand the holdings of these funds as they have exposure to multiple asset classes, currencies and geographic regions.
Another drawback of absolute return funds, like other alternate strategies such as market neutral funds, is that they can be expensive for investors.
The Bottom Line
As indicated in my previous article, I believe that a certain portion of your assets should be allocated to alternative strategies. Absolute return funds can be allocated as a satellite to the core portfolio of traditional asset classes to help protect an investment portfolio from severe losses during market downturns. As always, investors or clients should consult with their financial advisor to determine the most appropriate absolute return fund for their situation as these funds can be complicated and difficult to understand. (For more from this author, see: What Is Tactical Asset Allocation.)