By Adrian Hull
What a difference in bond market expectations from July this year to the end of November. Ten-year gilts touched 0.5% and 10-year US Treasuries, 1.36% – and within a few months both were up to 100 basis points cheaper. When beta markets rally hard, investors question absolute return investing and when they sell off they relish it. But it is exactly these sorts of moves that has created a deep universe of absolute return funds. Their success however, should be measured by delivery against the fund objective and not relative to the market.
Absolute return funds have become increasingly popular in the past few years as investors look for alternative sources of return to diversify their portfolios away from long-only bond funds. But as absolute return bond funds hit the mainstream, it’s crucial for investors to understand the varying aims – and risks – of these “all weather” funds – to perform in all market conditions.
Absolute return bond funds seek to provide positive returns across a range of market conditions. They are often viewed as an alternative to traditional bond funds because of the “go-anywhere” fixed income asset approach and their ability to hedge (or remove) market directionality. Their performance is typically measured against cash or a cash-related benchmark such as LIBOR, and they should produce a return profile that is different to traditional bond funds.
While there are many different types of absolute return strategy, at their core is achieving market neutrality. A market neutral strategy aims to hedge out investors’ exposure to a particular market (beta) and deliver an investment return that depends on the manager’s skill (alpha). In essence, market-neutral portfolios aim to control risk and protect against the eventuality of falling markets, while still allowing managers to generate positive returns through stock selection. Of course this will mean that investors are not exposed to market gains. The lack of market beta means a market neutral fund should have a very low correlation with the underlying market and therefore provide portfolio diversification. We believe the most effective way to achieve consistent positive returns and low volatility is through a market-neutral strategy. This approach, in our view, is most aligned with what investors expect to get from their absolute return bond funds. We believe it is the approach that is more likely to deliver a consistent return profile rather than strategies that employ higher risk with higher volatility and more market exposure.
Delivering positive returns for investors from a market neutral strategy requires some key elements; understanding market exposure, correlation, volatility as well as stock selection. By understanding the component drivers of returns managers’ selections in stocks, sectors or themes are able to add value relative to the underlying market. This requires the fund managers to have a proven and repeatable investment process that allows them to outperform in a variety of market conditions. Making the most of opportunities throughout the market cycle should, therefore, lend itself to fund managers with a pragmatic (or neutral) style and ones with adaptability to the changing economic environment. The value of the market neutral approach becomes clear in times of market stress. Falling markets sort the “men form the boys”. There have been a occasions where funds have seen losses in a couple of months of twice their annual objectives This is when you find out which funds have really adopted market neutral approaches and which have material directional bias in portfolios.
In order to achieve their targets, absolute return bond funds typically use a broad range of techniques to generate returns from bond markets, including the flexibility to use derivatives to control risks such as market exposure, and also to move between sectors and markets in response to changing market conditions.
With record low rates on deposits and sea change in valuations in government bond markets we believe that absolute return bond funds offer investors a better alternative to cash deposits and a safe alternative to higher duration bond funds. Portfolio construction needs to provide deep daily liquidity which continues to be a key consideration for investors. However it’s important to recognise that, while even the most conservative absolute return bond fund may be a ‘low risk’ solution, it can never be ‘no risk’. That’s because performance typically depends on the skill of the managers in exploiting opportunities, albeit within a tightly controlled risk framework.
Adrian Hull is a senior fixed income investment specialist at Kames Capital
