While many financial institutions have moved on from the dark days of the crisis, a poster child of fund management during the period has struggled to shake off how it failed to live up to expectations.
Absolute return funds, marketed as producing positive performance whatever the financial weather, largely failed investors during and immediately after the crisis. As markets tumbled in late 2008 and chaos abounded in the years that followed, not only did these funds fail make significant positive returns – they charged their investors for the privilege.
Some of them even went so far as banning their clients from withdrawing their assets. It was an understandable move for managers fearing even further losses but garnered little support for those trapped in an expensive situation.
Some managers pointed to having lost less than their benchmark index, as it tumbled down with equity markets, but this was of little comfort to those with pensioners to pay.
This perceived failure of absolute return funds precipitated the massive shift towards passive investing after the crisis.
Active management might have been worth the money in more secure times, but as the road ahead seemed uncertain investors did not want to take the risk.
Ordinarily, these fears might have been unfounded and active managers – including those running absolute return strategies – might have risen to the top and earned back some lost trust, but for the lifeline thrown to global capital markets.
In early 2009, central banks in the UK, US and Europe opened the floodgates, letting through billions of pounds, dollars and euros to ensure that economies stayed afloat.
Almost all involved – investors, banks and all their counterparties – were tremendously relieved and stock markets went on to recover their losses thanks to this quantitative easing (QE).
EXTERNAL INFLUENCES
Absolute return funds, however, could have done without the lifesaving cash injection. They had not counted on the mechanism, which had not been used (outside of Japan) in decades and it was unlikely to have been part of their modelling.
Many of these funds, which are designed to perform at their best in tough conditions, found that the rug had been pulled from under them. Instead of being able to ride the waves of volatility or seek out mispriced assets, QE acted as a placid tide that lifted all boats.
While QE did not sink absolute return funds, it washed away their ability to outperform.
In the 10 years since the start of 2009, the 19 European funds labelled as ‘absolute’ or ‘real return’ by Morningstar Direct were in positive territory on a cumulative basis at the end of 2018. The top performer made more than 54%. The problem has been that growth assets have done remarkably well, thanks mainly to QE. The MSCI World index rose almost 10% on an annualised basis during the same period.
Tom Wake-Walker, investment consultant at Redington, says that absolute return funds did not do as badly during the crisis as people thought, although he admits that “since 2008, their returns have been disappearing”.
Yet growth assets have had their best rally in more than 20 years. “These funds, compared to those with beta-heavy returns, have looked sub-par since the crisis,” WakeWalker adds. “QE has suppressed their opportunity set across all asset classes.”
People have knocked absolute return over the past 10 years, but now is when you want to be in it.
Barry Kenneth, Pension Protection Fund
Might it be a strange time, then, for fund giants such as BlackRock and JP Morgan to be launching new absolute return strategies? These two titans of the sector, along with some smaller US and European investment houses, have released new funds in the past couple of months with an aim to produce returns “uncorrelated to markets”, according to marketing material. Aon’s liquid alternatives principal, Matthew Towsey, says markets have experienced low volatility and interest rates in the years since the financial crisis. “Equities have risen around 300% over that time and pension investors took a pro-equity stance. But things are changing.”
Of the 95 funds active in Europe that were labelled ‘absolute’ or ‘real return’ by Morningstar Direct, just 19 ended 2018 in positive territory. The worst lost more than 16%, while the best gained just 3.9%. However, just seven of them were behind the 8.71% loss made by the MSCI World index during the year.
In 2018, markets shuddered with bouts of volatility in February, October and December along with large moves in currencies in Argentina and Turkey and big changes in yields in places like Italy.
Geopolitical tensions – something investors are unable to control – have had a significant impact on market movements, causing equity and currency markets to rise and fall at a moment’s notice. Add to that the removal of QE from the world’s largest markets and investors could be in for a wilder ride than they have seen for some time.
“2018 was particularly bad for absolute return strategies,” Wake-Walker says. “There was no place to hide, but it is the wrong time for investors to be moving out.”
Towsey adds that in this type of environment alternatives and absolute return funds should come into their own. “They can go long or short and strategies such as market neutral can make a profit in rising or falling markets, so we would expect to see an increase in allocation.”
Some of Europe’s most sophisticated investors have already moved.
MAKE THAT CHANGE
“As we enter the end of the cycle, valuations are high and markets are becoming more fragmented and volatile, we are making use of absolute return strategies,” says Barry Kenneth, chief investment officer of the £32bn Pension Protection Fund (PPF).
The Irish Strategic Investment Fund has also allocated close to €1.8bn (£1.5bn) to the strategy, according to reports, while some UK local authority pension funds are moving into actively managed funds.
Kenneth says there are two reasons why the PPF predominately uses these strategies. “We believe there are more alpha opportunities as markets become more fragmented and that solely investing in beta is not optimal in this environment,” he adds. “And we use it as a tool within the asset class to manage volatility versus our benchmark, without having to divest from it.”
Aon’s Towsey says that in 2019, there will be a deeper understanding from investors as to how these funds can be used than they had before the crisis.
“In the early days of hedge funds, they pr0duced higher returns than equities and lowered portfolio risk, but over time the volatility within hedge funds has been reduced, so returns are lower,” he adds. “The average hedge fund is now closer to bond-like volatility with commensurate levels of return and should primarily be used to reduce equity risk.”
2018 served as a “watershed” for what “normal” means for markets, according to Towsey, ushering in a new macro environment featuring high volatility and the potential for mis-pricings.
“Strategies that should do well include merger arbitrage, where spreads are still relatively healthy, along with macro and market neutral strategies,” he says. “Equity long-short is also an interesting case, as these funds can participate in the upside, but potentially limit losses in down markets, and should be considered as a part of a holistic equity allocation.”
Absolute return should do well in a volatile environment when there is lower beta and higher alpha around, according to Kenneth at the PPF.
“Using an absolute return strategy, you get protection if there is a downturn in the markets and this improves your sharpe ratio. You don’t need to get the whole uplift of the market, but if it goes up or down you can toggle in and out of your absolute return strategies.”
For Kishen Ganatra, European strategic research director at Mercer, absolute return strategies are the most unconstrained form of liquid investment.
“It loosens the shackles,” he says. “If you think it is a good time for active management, this is where you should be.” But manager selection is crucial.
HUNTING HIGH AND LOW
“In this sector, there is massive dispersion and given the number of strategies and managers, there is no guarantee any one will do well,” Ganatra says.
He adds that the range of strategies available to investors had grown to encompass those using pure risk premia and offering better liquidity.
“When introducing a strategy that relies on investor skill, being diversified in a range of strategies is the best bet,” Ganatra says. “There are good reasons why some strategies will struggle, while others will do well at certain times.”
Most funds that are adopting the absolute return moniker in 2019 are close to market neutral, says Wake-Walker. Few are taking the outsized positions that were common during the crisis and are therefore less exposed to market movements.
Some managers did not do well over the crisis as they might have been in a certain strategy, over-leveraged or not diversified enough. Lessons have been learned and managers are stress-testing their portfolios more thoroughly.
Tom Wake-Walker, Redington
Fees are coming down, especially as some managers have underperformed, says Towsey, “but sometimes it is worth paying for alpha – some managers are able to capture it in many different market conditions.”
Close to two years ago, Aon launched an emerging managers programme, seeking out firms with new ideas in niche markets, but running less than $500m in assets. So far, the results have been encouraging, according to Towsey.
With all this in mind, should investors be making larger allocations to absolute return funds – maybe the whole portfolio?
Not according to the PPF’s Kenneth.
“It is not an appropriate way to access every asset class,” he says. “It lends itself better to asset classes like equities for portfolio construction reasons, to manage volatility versus our benchmark index, as well as alpha opportunities.
In an asset class like emerging market debt, it is the appropriate way to invest in the strategy regardless of the environment, due to its idiosyncrasy.”
Investors also need to be aware that these strategies are seeking to outperform the market and creaming off the alpha from a market of beta, which will still make up the majority of their portfolios.
With such a wide range of unconstrained approaches, it is not easy – or often helpful – to simply measure one fund against another, or what might seem like an appropriate benchmark.
Investors need to work with managers to understand exactly what they are investing in and – most importantly – what they should expect in a range of market conditions.
ROAD TO REDEMPTION?
As global markets have the safety blanket of QE taken away at a time when factors from the outside world are causing volatility, absolute return could be on the path to mass market redemption.
Wake-Walker at Redington believes investment managers learned some tough lessons during the crisis and many of those that performed poorly decided to leave the sector entirely.
“Some managers did not do well over the crisis as they might have been in a certain strategy, over-leveraged or not diversified enough,” he says. “Lessons have been learned and managers are stress-testing their portfolios more thoroughly.”
For Kenneth at the PPF, now is the sector’s time to shine.
“People have knocked absolute return over the past 10 years, but now is when you want to be in it,” he adds.
