Multi Asset

Trading places

Trading places

It all starts with a definition—what are absolute return funds? The answer is far more subjective than one might think and is inherently tied to what an investor is seeking, rather than just what a fund is aiming to deliver.

Sonja Uys, portfolio manager at Insight, says today a myriad of absolute return offerings exist. Some are primarily return-seeking strategies that feature high volatility, while others target low standard deviations with a bent towards capital preservation. This, she says, is because such funds are an investment approach, not a homogenous asset class; consequently, investors need to consider their allocations to different products based on their intended usage.

“They are a set of diverse strategies that share the common virtue of aiming to deliver differentiated returns from traditional bond and equity investments and therefore can be used as a tool to enhance returns or reduce risk. These diverse strategies not only have different objectives, but also different return drivers and investment characteristics.”

It is not enough to focus on the common objective that absolute return strategies share: that they must produce a positive return. Some will aim for positive returns over a 12-month period, while others will have a much longer time frame—allowing for much greater volatility, and drawdowns, in the shorter term. Uys prefers to focus on how absolute return funds have flexible mandates that can go long or short— thereby doubling a traditional long-only investment universe; they can hedge risks and have the potential to make money in a falling market. By using cash as a benchmark, every idea in such a fund is an active investment, Uys notes.

The freedom that such flexibility affords has led a plethora of strategies and funds, focusing on a huge range of asset classes with wide-ranging objectives, to emerge, necessitating greater scrutiny by investors, she says. “You need to examine a fund to ensure it has the characteristics you are looking for; what do you want the fund to do? For example, in an equity market neutral strategy with stringent stop/loss and risk management, you could expect to see lower returns but also lower volatility. On the other hand, an emerging market debt long/short strategy could be higher in volatility but also in returns. There is no single box you can put absolute return funds into.”

Absolute return funds can range from multi-strategy to managed futures, long/short equity, or even short-biased funds, among a host of others that may rely on directional beta for their returns and therefore can have sharper drawdowns with sudden, unexpected market movements. Others feature a rigorous focus on downside protection and risk management, with tight constraints on what risks are acceptable in any given market condition, says Uys.

With the ongoing uncertainty of the current investment backdrop as markets vacillate between risk on and risk off, interest has increased in the type of uncorrelated returns absolute return funds can offer. The addition of differing absolute return strategies to a portfolio has the potential to alter its shape and dynamics, dampening volatility or offering diversification benefits through an uncorrelated return profile, Uys explains.

Multi-asset portfolios can leverage the uncorrelated aspect of their underlying holdings and also offer diversification benefits. Absolute return strategies can therefore play a role. While Uys prefers to classify absolute return portfolios as an approach, rather than an asset class, they can sit alongside more traditional holdings in a portfolio and act to improve diversification or enhance the overall portfolio’s risk profile. Uys points out that absolute return strategies do not tend to feature high equity beta while many multi-asset portfolios take active, long-only views within defined volatility targets. “That’s not absolute, that’s relative.” But this means absolute return strategies, appropriately chosen, can complement market-driven holdings within a multi-asset portfolio.

Whether investors are considering absolute return strategies as a standalone investment, or as a component of a multi-asset portfolio, clear analysis—ensuring a portfolio bears the characteristics that align with the investor’s objectives—is key. Part of this will mean being aware that the management team and process, rather than the asset class or investment universe, may well have a more significant role in shaping the portfolio. “Absolute return strategies cannot easily be lumped together, leaving investors to rely sometimes on the strength, reputation and history of the team and process managing the fund rather than its design.”

These considerations include looking for experience both in managing mutual funds and executing complex alternative strategies and an operational infrastructure capable of managing multiple compliance, transparency, trading and risk-management components. 

Against the current macroeconomic backdrop and amid ongoing volatility, Uys believes absolute return funds, as well as diversified multi-asset portfolios, will continue to grow in popularity.

NOT ALL ABSOLUTE RETURN STRATEGIES ARE THE SAME

Among the most common strategies used by absolute return portfolios today are relative value strategies, which are typically not accessible for more limited traditional strategies. These aim to offer a diversified source of returns independent of returns generated by an overall asset class. For example, a relative value strategy might focus on European equities relative to U.S. equities. Using index instruments, it is possible to be “long” European equities and “short” U.S. equities.

By structuring positions to ensure the size of each “leg” offsets the other, the portfolio’s overall exposure to the broader asset class is neutralized. The position will deliver a positive return if the fund manager’s view eventuates, in this example if European equities perform better than U.S. equities, regardless of the overall market performance.

The manager seeks to mitigate risk typically by putting in place a specific profit target for the position alongside what is known as a stop-loss control level should the position performance drop beyond a stated level. 

“Long/short” relative value strategies enable the fund manager to increase a portfolio’s exposure to an asset that is attractively mispriced or has stronger performance catalysts relative to another similar asset. However, such strategies may increase the amount of leverage in the portfolio and, if the price of the underlying assets moves in the wrong direction, leverage will magnify the impact on the portfolio.

This article is from the Multi-Asset Special Report Summer 2016.

An absolute return strategy is an unconstrained investment approach and performance is measured against a goal that reflects portfolio construction focused on risk management and is designed to deliver positive returns in changing market environments. Traditional “relative return” funds are managed to and measured against broad-based benchmark indices, rather than against “absolute” measures of principal risk.

Main risks: Equities are subject to market, market sector, market liquidity, issuer, and investment style risks to varying degrees. Investing in foreign denominated and/or domiciled securities involves special risks, including changes in currency exchange rates, political, economic, and social instability, limited company information, differing auditing and legal standards, and less market liquidity. These risks generally are greater with emerging market countries.

Investment advisory services in North America are provided through four different investment advisers registered with the Securities and Exchange Commission (SEC), using the brand Insight Investment: Cutwater Asset Management Corp. (CAMC), Cutwater Investor Services Corp. (CISC), Insight North America LLC (INA) and Pareto Investment Management Limited (PIML). The North American investment advisers are associated with other global investment managers that also (individually and collectively) use the corporate brand Insight Investment and may be referred to as “Insight” or “Insight Investment”. CISC and CAMC are owned by BNY Mellon and operated by Insight.

Views expressed are those of the author(s)/manager(s)/advisor(s) stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. This information should not be construed as investment advice or recommendations for any particular investment. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Insight and MBSC Securities Corporation are subsidiaries of BNY Mellon. ©2016 MBSC Securities Corporation, 225 Liberty Street, 19th Fl., New York, NY 10281.