Download Going mainstream – how absolute return is moving into the

Going mainstream –
how absolute return
is moving into the
regulated market
Contents
1.
Foreword
2.
Executive summary
4.
Part One:
Defining our terms: what we mean by ‘absolute return’
7.
Part Two:
The rise of regulated absolute return funds in Europe
11. Part Three:
Factors set to drive absolute return demand
16. Part Four:
Employing absolute return in a portfolio
21. Part Five:
Evaluating absolute return strategies
24. Conclusion
Going mainstream – how absolute return is moving into the regulated market
Foreword
The concept of investing to achieve an absolute return has been around for over 60 years and
has enabled the global hedge fund market to grow to a total value of more than US$1.6 trillion
(EUR1.28trn)1. But it is only since 2002 that investors in Europe have been able to access
absolute return approaches through authorised investment vehicles.
So eight years on, are absolute return strategies still an ‘alternative’ investment or do they yet
rank with relative return approaches as mainstream investment choices?
In this paper, we want to provide an assessment of the role of absolute return investing in the
regulated investment market. We outline the different types of strategies that have emerged,
we look at the growth in the regulated market to date. We also put forward reasons why we
believe absolute return approaches are well placed to capture significant investor interest in the
next few years.
We also look to examine the role of absolute return strategies in a portfolio – and explore if they
can genuinely contribute to a better trade-off between risk and reward for investors. Finally we
look at due diligence and the factors that we believe must be made explicit if investors are to be
sure that an absolute return strategy has an appropriate and achievable investment objective.
We hope this paper offers useful insight into how absolute return funds have developed as a
sector over the past decade and how they can be best deployed in an investment portfolio.
Threadneedle Asset Management, June 2010
1
Hedge Fund Research Group, total industry figure for Q1 2010
1
2
Going mainstream – how absolute return is moving into the regulated market
Executive summary
This report aims to provide an overview of the regulated absolute return market: it assesses the
growth of the market to date, drivers that are likely to encourage inflows into the sector over
the next 10 years and explores how absolute return funds can be used most effectively within a
portfolio. Finally it assesses the factors that need to be taken into account to identify suitable
funds and fund managers.
1. Defining our terms; what we mean by absolute return
Absolute return investing refers to the discipline of targeting a positive investment return over a
given period of time, irrespective of market conditions. It is therefore distinct from a traditional
relative return approach that looks to outperform a market or asset class but has no commitment
to deliver positive returns. A range of strategies have been developed to achieve persistently
positive returns. The majority of these take both long and short positions on stocks/asset
classes/markets using derivative-based techniques. Common strategies include portable alpha,
pairs trading, cash enhancement and multi-asset investing.
2. The rise of regulated absolute return funds in Europe
Investors in the regulated European market have only been able to access derivative-based
absolute return strategies since the introduction of the EU’s UCITS III fund directive in 2002,
which permitted hedge fund-like investment techniques in regulated funds. This legislation
precipitated sharply rising inflows into absolute return strategies between 2002 and 2008 –
although there were marked outflows during the peak of the credit crisis.
Subsequently, net inflows have partially recovered as hedge fund managers start to use the UCITS
structure to distribute regulated versions of their offshore strategies. This trend is likely to continue –
particularly as European-based hedge fund managers now face the prospect of their own regulation
in the form of the EU’s proposed Alternative Investment Fund Managers (AIFM) Directive.
Within individual markets, there appears to be some correlation between stock market
uncertainty/volatility and levels of interest in absolute return strategies. In the UK, for example,
the IMA Absolute Return sector was the biggest-selling open-ended fund sector of late2008/2009 alongside corporate bonds and property. Initial breakdowns of the UCITS III market
suggest that the most prevalent absolute return strategies are long/short equity, credit/bondbased strategies and multi-strategy funds.
3. Factors set to drive absolute return demand
Absolute return funds currently only account for around 1% of UCITS-regulated assets. But
there are a number of factors now at play that could drive significant inflows into regulated
absolute return approaches in the next five to 10 years.
First, as low interest rates persist, absolute return funds may experience significant demand
from yield-seeking investors seeking capital preservation - especially as concerns continue
regarding sovereign debt. Second, stock market volatility has increased sharply. This may
increase the appeal of absolute return strategies both as a means of managing portfolio volatility
and actively profiting from periods of market downturn (ie through short-selling).
Third, as correlations between asset classes such as equities, bonds and commodities increase,
investors need to find new ways to diversify their portfolios. The low levels of correlation that
many absolute return strategies display with overall asset-class movements may – again – drive
investor interest.
Finally, the burden of investment risk is shifting from companies and the state to individuals as
pension provision shifts from a defined-benefit to a defined contribution model. As millions of
Europeans are forced to manage investment risks themselves, we anticipate that absolute return
funds will become increasingly important – especially among older workers and those in retirement.
Going mainstream – how absolute return is moving into the regulated market
4. Employing absolute return in a portfolio
Absolute return is a valuable investment tool. But it should not be viewed as a replacement for
relative return investing. Rather, our research shows that it is a valuable component that can be
used to enhance a portfolio’s risk-reward profile.
Performance analysis reveals that certain groups of attributes can be assigned to absolute return
and relative return funds. Namely:
Absolute return funds display a narrow range of returns in all market conditions; a higher likelihood
of delivering positive outperformance when market returns are negative and a tendency to
underperform when markets are rising strongly.
Conversely, relative return funds display a broader range of returns (which widen when market
returns are also extreme); a greater likelihood to deliver negative returns when market returns are
negative and the potential to deliver very strong positive returns when markets are rising strongly.
Given these attributes, there are market environments when it may benefit an investor to
favour absolute return strategies over relative return strategies and vice versa. Absolute return
funds are likely to offer the best return when the market environment is negative or volatile on
a sustained basis. Relative return funds offer superior return potential when markets are
experiencing a strong growth phase.
Our analysis shows that portfolios that are able to have exposure to both relative return and
absolute return funds are likely to have a more attractive risk-return profile than portfolios that
are restricted to one type of strategy. But in addition, actively rotating a portfolio’s allocation
towards either absolute return or relative return, depending on the market environment, can
significantly enhance returns and reduce losses.
This suggests that the decision to skew a portfolio towards either a relative return or absolute
return bias could be treated as an additional source of investment return alongside other traditional
investment decisions, such as market and asset allocation.
5. Evaluating absolute return strategies
Absolute return funds are a highly valuable tool for investors and their wider availability should be
welcomed. However, investors need to be sure that funds are appropriate to their needs and also
that a fund manager has the appropriate mix of skills and experience to deliver absolute return
funds while also meeting the requirements of the regulated funds market.
To this end, we have outlined a list of areas that we believe need to be assessed as part of any
due diligence process – and for which managers should readily supply information. These include:
the experience of the manager in managing absolute return strategies (specifically aspects such
as short-selling and managing leverage); the manager’s experience in meeting the requirements
of the regulated fund market; the target return and the timeframe to deliver this return; where
and why the fund allocates its risk budget; volatility parameters; suitability of underlying
investments; market correlations; liquidity and a fund’s charging structure.
Conclusion
Absolute return funds still only account for a tiny fraction of the European regulated funds
market but the sector is evolving. The sector is now seeing heightened interest in the wake of
the credit crisis as investors look for new ways to manage risks against a background of low
interest rates – and more managers migrate from the unregulated to the regulated market.
The key concern now is whether investor demand can be matched by appropriate strategies run
by managers with the necessary dual experience in running absolute return mandates and
meeting the requirements of the regulated fund market. Until performance track records are
long enough to identify those ‘high-value’ managers who are proven to have the appropriate
combined skills-set, deep due diligence of absolute return funds remains essential.
3
4
Going mainstream – how absolute return is moving into the regulated market
‘Absolute return is
therefore highly
consistent with most
investors’ primary
reason for taking on
investment risk –
namely to achieve a
return above that
available on ‘risk-free’
cash deposits.’
Part One:
Defining our terms: what we mean by ‘absolute return’
Absolute return investing refers to the discipline of targeting a positive investment return
over a given period of time, irrespective of market conditions. Often it involves seeking
to outperform a named cash or inflation benchmark.
This is distinct from relative return investing, where the target is to outperform a market, index
or benchmark portfolio whose value can fall as well as rise. Under a relative return mandate, a
fund can deliver a negative return and still achieve its outperformance target so long as it falls
less than the benchmark in question. Absolute return funds have only delivered on their remit if
they produce a positive return in line with or in excess of their benchmark.
The key attributes of any absolute return strategy are:
 Aims for consistently positive returns over a given time period
 Low or zero correlation with market movements
 High alpha content – with returns generated by investor skill
Absolute return is therefore highly consistent with most investors’ primary reason for
taking on investment risk – namely to achieve a return above that available on ‘risk-free’
cash deposits.
Methods of achieving absolute return
Investment professionals have explored a range of strategies to achieve a persistently positive
return regardless of the market environment. The majority of these take both long and short
positions on stocks/asset classes/markets. Some strategies may be long-only (but may not
necessarily classify themselves as absolute return, as a result). Some of the most common
strategies are as follows:
i. Portable alpha (long-short)
This involves building an actively-managed relative return portfolio, aiming to outperform a given
index or market. Using an index swap, the performance of the index (‘beta’) is hedged, leaving
only the excess return (‘alpha’) generated by the portfolio manager. This can then be added
onto the beta of another lower-risk or uncorrelated asset class which is provided using a lowcost derivative such as an index future.
Diagram 1: Using portable alpha to generate absolute returns
Alpha
Excess
return
(manager
return)
Beta risk is
stripped
out using
derivatives
Beta
Risk-free
return
(market
return)
Alpha
engine
Risk-free
return
Eg:
Govt bonds
Libor
+
Risk-free
return
=
Absolute
return
Going mainstream – how absolute return is moving into the regulated market
ii. Pairs trading/market neutral (long-short)
This involves a portfolio manager taking simultaneous positions in two different but comparable
securities, eg, the shares of two companies in the same sector. A long position is taken in the
security expected to perform best out of the two, while a short position is taken in the expected
underperformer. Pairs trading reduces the importance of predicting which direction the shares
will move in. So long as the manager is correct in how the two will perform relative to one
another, a positive return will be achieved – see Diagram 2.
Diagram 2: Scenarios in which a pairs trade will achieve a positive return
Pairs trade:
Long position on Share A (outperformer)
Short position on Share B (underperformer)
A positive return will be achieved in all of the following events:
Profit
Profit
A
A
B
B
A
B
Profit
iii. Cash enhancement (long-short)
This involves two elements. The first is a portfolio of investments, typically short-dated bonds,
designed to generate a return roughly in line with cash deposits. This portfolio is then used as
collateral for derivative trades using long and short positions to reflect the manager’s views on
markets, asset classes and individual stocks or shares. Provided these positions are correct, the
profits from the derivative strategies can be used to augment the return on the low-risk bond
portfolio, thereby delivering a low-risk cash-plus return – see Diagram 3.
Diagram 3: Cash enhancement strategy
Low-risk
bond
portfolio
Used as
collateral for
+
Cash-like
return
Derivative
trades
Alpha
generation
=
Alpha
Cash
return
5
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Going mainstream – how absolute return is moving into the regulated market
iv. Multi-asset (long only)
This is a long-only strategy that has the flexibility to move across different asset classes, markets
and strategies, depending on which is expected to deliver a positive return. The portfolio’s default
position is 100% cash. Only if the manager has a view that a particular market or asset class will
deliver a positive return will s/he deviate from this. While the manager won’t use derivatives to
create short positions, derivatives may be used to achieve tactical exposure to an asset class
swiftly and efficiently. Maximum exposure to higher-risk asset classes will often be restricted.
These multi-asset strategies are sometimes referred to as ‘total return’ to differentiate them
from funds that can take short positions.
Diagram 4: Multi-asset long-only strategy
Maximum
50% of
portfolio
Real Assets etc
Convertibles
Maximum
100% of
portfolio
Equities
Bonds
Cash
Falling stock markets
Rising stock markets
Benefits and drawbacks of absolute return investing
The strategies above will each have their advantages and disadvantages but the key benefits
and drawbacks of an absolute return approach can be summarised as follows:
Benefits
i. Increases the opportunity set
By taking both long and short positions, a manager can make money in both rising and falling
markets. A long-only manager can only make money from their non-cash positions when markets
are rising. A long/short manager can therefore make profits from two set of convictions: which
securities, sectors or markets s/he believes are going to rise and which s/he believes are going
to fall.
ii. Reduces reliance on market returns
An absolute return approach that strips out beta-driven returns reduces an investor’s reliance on
the direction of markets to make profits. Returns tend to have far lower correlation with market
movements than is the case with relative return strategies, so market risk is reduced.
iii. Reduces volatility and improves cash preservation
Tactics such as taking symmetrical long and short positions across stocks and/or holding high
cash exposures are designed to minimise volatility. Many strategies make cash preservation a
stated goal.
Drawbacks
i. Increases opportunity for miscalling market/stock/asset movements
A long-short strategy doubles the opportunity set to generate returns but it also doubles the risk
of miscalling a position. Moreover, losses on a long position are limited to the current value of
the security. Losses on a mis-called short position are potentially unlimited as there is no limit
on how far a security could rise in value.
Going mainstream – how absolute return is moving into the regulated market
ii. Likely to lag strongly rising markets
In their bid to generate consistently positive returns and minimise volatility, absolute return
funds are likely to underperform in strongly rising markets and therefore will not be suitable
where an investor is seeking to maximise return.
iii. Greater reliance on manager skill
Where a fund employs a strategy that looks to neutralise market movements (beta) it becomes
reliant on manager skill (alpha) to generate return. Selection of an experienced and proven
manager becomes vital.
In short
Absolute return investing is a distinct investment discipline from traditional relative return
investing. It can use a variety of approaches to achieve its target positive returns, typically using
long and short positions, high cash exposures and flexibility in terms of asset allocation. In the
next section we will assess how investors have responded to the opportunity to access
absolute return approaches through regulated markets.
Part Two:
The rise of regulated absolute return funds in Europe
The concept of absolute return investing has been around since the creation of the first
hedge funds in the late-1940s, which were designed to reduce risk by neutralising market
movements.
Over the next 50 years, the expansion of absolute return investing took place in the unregulated
hedge fund sector and institutional investment market, while regulated products were restricted
to long-only strategies. However, the past decade has seen developments that have enabled
the absolute return concept to migrate from the unregulated to the regulated market.
UCITS III brings absolute return to the regulated market
Undertakings for Collective Investment in Transferable Securities (UCITS) are a set of European
directives designed to enable retail distribution of any compliant fund across the 30 countries of
the European Union, provided a fund is registered in at least one member state. As well as
enabling fund distribution across Europe, the UCITS ‘brand’ has also achieved recognition in
other markets including Asia and South America.
In the late-1990s, the UCITS requirements were revised to enable a broader range of strategies
to be marketed to investors, to reflect advances in financial markets. ‘UCITS III’ was designed
to enable more investors to benefit from risk management and return-generation techniques
previously only available via the unregulated hedge fund market.
From 2002, the UCITS III directive enabled European regulated funds to:
 Use derivatives (for example, futures, options and swaps and contracts for difference) to
generate investment returns, not simply for efficient portfolio management.
 Invest in diversified indices and their derivatives (including hedge fund indices).
 Retain unlimited cash positions and use money market instruments more extensively.
 Exercise greater flexibility to combine multiple asset classes in a single fund.
Unlike their unregulated hedge fund counterparts, UCITS III funds cannot short sell a stock, but
they can use derivatives to take ‘synthetic’ short positions.
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Going mainstream – how absolute return is moving into the regulated market
The UCITS regime also imposes strict requirements regarding risk management, investor access
and reporting in order to make funds transparent and accountable. These requirements include:
 Assessing and reporting Value at Risk (VaR)
 Periodic stress-testing simulations
 Maximum redemption period of 14 days2, with redemption at net asset value
 Indicative daily pricing
 Fund diversification through the 5/10/40 rule3
 Comprehensive reporting and a simplified prospectus
 Independent fund board
In other words, the UCITS III directive has enabled hedge fund techniques to be applied in a
highly regulated investment structure. Demand from investors was initially strong. By the end
of 2006, total net assets in UCITS III funds with a total/absolute return mandate exceeded
EUR80 billion – see Diagram 5. However, the sector saw a sharp outflow of funds during the
credit crisis – effectively halving funds under management to close to EUR40 billion. This
outflow has been partially reversed in 2008-2009. By the end of 2009, AUM in total
return/absolute return UCITS funds represented about 1% of total net assets in Europeandomiciled UCITS funds4.
Diagram 5: Total net assets in UCITS total return/absolute return strategies
90000
80000
70000
EUR mn
8
60000
50000
40000
30000
20000
10000
0
2002
2003
2004
2005
2006
2007
2008
2009
Source: Lipper FMI. As at 31 December 2009.
‘Newcits’ – hedge funds move to the regulated market
The strength of the UCITS brand has also attracted strong inflows from hedge fund investors.
Following high-profile hedge fund fraud such as the Madoff affair, more investors are now
seeking out the more rigorous standards on liquidity, reporting, risk management and custody
that the regulated market offers. To capture this migration, many hedge fund managers are now
choosing to launch UCITS III equivalents – dubbed ‘Newcits’– of their most popular strategies.
This migration largely accounts for the strong uptick in UCITS III inflows shown in Diagram 5
over 2008-2009. Given the size of the global hedge fund market (EUR1.28 trillion5) it could
continue to be responsible for huge inflows into the regulated absolute return market over the
medium term.
2
In practice most funds are providing weekly or daily liquidity.
This requires that no more than 10% of a UCITS fund’s net assets may be invested in transferable securities or money market
instruments issued by the same body, with a further aggregate limit of 40% of net assets on exposures of greater than 5% to
single issuers.
4
The European Fund and Asset Management Association estimates that EUR5.29 trillion of net assets was held in European
UCITS funds as at end-2009, with a further EUR1.74 trillion in non-UCITS funds.
5
Hedge Fund Research Group, total industry figure of US$1.67 trillion for Q1 2010.
3
Going mainstream – how absolute return is moving into the regulated market
A further push factor could be the EU’s proposed Alternative Investment Fund Managers
(AIFM) directive. This is looking to provide a regulatory framework for non-UCITS funds
including hedge funds, real estate and private equity funds. However, it may encourage more
alternative managers to adopt UCITS legislation rather than be caught by the untested
obligations of the AIFM directive.6
According to Hedge Fund Research, more than 200 hedge funds offerings were UCITS IIIcompliant products as at end-February 2010, with total assets under management in excess of
US$35 billion.
Country focus: the UK
Individual markets are creating their own sectors to classify regulated absolute return funds.
In the UK, the Investment Management Association (IMA) launched a sector specifically for
open-ended funds with an absolute return objective in April 2008. Classified as a specialist
sector, it covers funds managed with “the aim of delivering absolute (ie more than zero)
returns in any market conditions”. Funds in this sector would normally expect to deliver an
absolute return over a 12-month period.
Inflows into the sector have experienced strong momentum. During and in the wake of the
credit crisis, the sector has competed with corporate bonds and property as the best-selling
asset class, achieving the highest net sales of any IMA sector in Q2-Q3 2008 and September
and December 2009 – see Diagram 6 below.
The strong growth in net sales towards the end of 2009 is particularly interesting given that,
by this time, equity markets had mounted a sustained recovery. This contradicts the idea that
absolute return investing is only of interest to investors during periods of market downturn –
although it may reflect the attraction of absolute return strategies both during and after periods
of severe market volatility.
Diagram 6: Net sales in the IMA Absolute Return sector Apr 2008 – Dec 2009 versus
FTSE All-Share performance
3500.0
Institutional
Retail
FTSE All-Share
1,000
900
Best-selling IMA sector –
Sept and Dec 2009
3000.0
800
Net sales (£mns)
600
500
400
2000.0
Best-selling IMA sector –
Q2 and Q3 2008
FTSE All-Share
2500.0
700
300
1500.0
200
100
1000.0
0
-100
Apr-08
Jul-08
Oct-08
Jan-09
Apr-09
Jul-09
Oct-09
Source: IMA/Morningstar/FTSE.
6
UCITS compliance may also be more appealing than the AIFM directive as it automatically enables managers to distribute
funds to retail investors, whereas the AIFM only offers an automatic passport for distribution to professional investors.
9
10
Going mainstream – how absolute return is moving into the regulated market
‘the migration of hedge
fund strategies to the
regulated UCITS market
looks likely to continue
to drive investor
interest.’
Absolute return market by strategy
Data group Citywire has been one of the first analysts to assess the composition of the European
absolute-return UCITS market (and coined the term ‘newcits’). Analysing 276 UCITS-compliant
funds that use derivatives as a central part of their investment process, it has categorised funds
into 13 peer groups. Its analysis shows that long-short equity strategies account for the largest
single category (by number of funds), followed by credit-based strategies, multi-strategy funds,
then market neutral accounting for just under 10% of constituents. Traditionally illiquid hedgefund strategies such as event-driven investing account for the lowest number of constituents.
Diagram 7: Composition of the ‘newcits’ market (by % of constituents)
Currency
7%
Market Neutral
9%
Emerging Market Equity inc Asia
5%
Global Macro
5%
Managed Futures
5%
Volatility Trading
5%
Multi
Strategy
13%
Commodities
4%
Other
11%
Fund of Funds
4%
Event Driven
1%
Convertibles
1%
Credit
Strategies
16%
Long/Short Equity
25%
Data provided by Citywire using their Newcits categories.
Further information on Citywire’s Newcits database can be found on www.newcits.com
Source: Citywire – www.citywire.co.uk. As at 30 April 2010.
In short
The introduction of UCITS III regulation triggered very strong growth in the regulated absolute
return sector in Europe and in other markets. Although the sector suffered substantial outflows
during the credit crisis, the migration of hedge fund strategies to the regulated UCITS market
looks likely to continue to drive investor interest and continue to capture new asset inflows.
In the next section, we will assess a number of factors that may drive investor demand for
absolute return approaches in the next five to 10 years.
Going mainstream – how absolute return is moving into the regulated market
Part Three:
Factors set to drive absolute return demand
As we saw in the previous section of this report, the nascent regulated absolute return
sector has experienced strong inflows from investors attracted by the concept of funds
that aim to deliver consistently positive returns.
Even so, absolute return still only accounts for around 1% of UCITS-regulated assets. But in our
view, there are a number of factors now at play that could drive significant inflows into absolute
return approaches, causing these strategies to account for a much larger proportion of the
European regulated funds market in the next five to 10 years.
i. Low interest rates demand alternatives for low-risk investors
With cash yielding almost zero as interest rates languish at historic lows, risk-averse investors
need alternative means to preserve capital while achieving above-inflation returns.
Certainly, the growing sales in absolute return strategies have coincided with a sustained decline
in bank base rates. As long as central banks need to keep interest rates low in order to bolster
economic growth, investors will continue to look for low-risk alternatives to low-paying deposits.
Given concerns over traditional cash alternatives such as sovereign debt, absolute return strategies
are well placed to capture inflows from low-risk investors.
However, the fund industry needs to be careful that investors are not sold absolute return funds
as a direct substitute for zero-risk deposits. The additional risks involved and the basis for
performance must be clearly explained.
ii. Market volatility has increased
While the last 50 years have seen sustained stock market gains, data also suggests the periods
of growth are getting shorter and the fluctuations in markets are getting deeper. As Diagram 8
shows, rolling three-year volatility on the MSCI World Index of global equities has more than
doubled since 2007.
Diagram 8 – Rising volatility in equities
30%
450
25%
350
300
20%
250
15%
200
10%
150
100
5%
50
0
0%
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
MSCI AC World Index
Source: MSCI/Morningstar/Threadneedle. As at 31 March 2010.
Rolling 3 Year Volatility
Rolling 3-year volatility
MSCI AC World Index
400
11
12
Going mainstream – how absolute return is moving into the regulated market
Absolute return strategies may be more appealing in a more volatile market environment for
two reasons. First, many strategies specifically aim to reduce the impact of market volatility.
Second, by taking both long and short positions, they can actively prosper from market volatility
and outperform their long-only counterparts. For both of these reasons, signs of sustained
market volatility should encourage inflows into absolute return strategies.
iii. Asset classes have become more correlated
Traditionally, investors have looked to reduce risk by diversifying across different geographic
markets and asset classes. But this tactic has become steadily less effective as markets and
investments experience greater performance correlation.
The growing convergence between geographic markets as economies become more interdependent has been well documented. However, there are also indications that correlation
between asset classes has increased – particularly during periods of deep market stress –
further limiting investor options for managing risk.
Diagram 9 shows the historic correlations between traditionally ‘uncorrelated’ asset classes –
global equities, global bonds and commodities – since the start of 2001. The closer the line is to
zero, the lower the correlation between the two assets. Since 2005 we see that correlations
have increased. Global equities and commodities have seen their correlation increase positively
(which means they move in the same direction). Global bonds have seen a sharp increase in
negative, or inverse, correlation with both equities and commodities, which means a fall in one
is likely to be matched by a rise in another, and vice versa.
Diagram 9: Correlations between asset classes
0.8
0.6
0.4
0.2
0
-0.2
-0.4
-0.6
-0.8
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
Correlation between equities and bonds
Correlation between equities and commodities
Correlation between bonds and commodities
Source: MSCI/ JP Morgan Global Index Research/Goldman Sachs/Morningstar/Threadneedle. Based on the following indices:
Global equities – MSCI AC World Index, Global Bonds – JP Morgan GBI Global Traded Index; Commodities – Goldman Sachs
Commodities Index. As at 31 March 2010.
Of course this sharp increase in correlations may be an anomaly created by recent extreme
market conditions and we will have to see if asset behaviour reverts to its long-term historic
patterns. But if asset class correlations remain significant, absolute return strategies may
increasingly be viewed as a valuable source of ‘decorrelation’ in a portfolio as they are
specifically structured to have low market beta.
Levels of correlation between absolute return strategies and market performance will vary
enormously and each strategy needs to be assessed individually. But to take one example,
our data shows that the Threadneedle Absolute Return Bond Fund has low correlation with
equities, commodities and most types of bond, with the exception of UK government bonds
where correlation is 0.57 – see Diagram 10.
Absolute return strategies that demonstrate sustained low correlation with major asset classes
may become highly valued as core portfolio holdings.
Going mainstream – how absolute return is moving into the regulated market
Diagram 10: Correlation between absolute return and other asset classes
Absolute
UK
UK
Return Bond Government Corporate
Fund
Bonds
Debt
Absolute Return Bond Fund
UK Government Bonds
UK
Commodities
High Yield
Debt
Global
Equities
–
0.57
0.03
-0.30
0.14
-0.32
0.57
–
0.43
-0.28
-0.07
-0.11
UK Corporate Debt
0.03
0.43
–
0.57
-0.19
0.50
UK High Yield Debt
-0.30
-0.28
0.57
–
-0.20
0.64
Commodities
0.14
-0.07
-0.19
-0.20
–
0.01
Global Equities
-0.32
-0.11
0.50
0.64
0.01
–
Source: Merrill Lynch/ MSCI/ Goldman Sachs/ Bloomberg/ Thomson Financial Datastream/ Threadneedle. Based on the following
indices: Global equities – MSCI AC World Index; UK Government Bonds – Merrill Lynch UK Gilts Index; UK Corporate Bonds –
Merrill Lynch Sterling Corporates Index; UK High Yield – Merrill Lynch Sterling High Yield Index; Commodities – Goldman Sachs
Commodities Index. Based on the period from the launch of the Threadneedle Absolute Return Bond Fund (November 2005)
to 26 February 2010.
iv. The burden of investment risk is shifting
Demand for absolute return may also be driven by a fundamental shift in who is assuming
investment risk.
In most countries, pensions account for the largest segment of invested assets. In the past, the
majority of employer pension schemes were managed on a defined-benefit (DB) basis where the
risk of funding for retirement was shouldered primarily by the scheme sponsor (eg, a company,
government, local authority). However, this had led to massive funding issues with both companies
and local governments contending with substantial deficits between what they are obligated to
pay members and the value of funds available.
As a result, a growing proportion of employers are turning to defined contribution (DC) schemes,
where the size of the pension fund at retirement is dependent on size of contribution and
performance of the pension funds selected by the employee. Diagram 11 shows the estimated
proportion of major company pension schemes across Europe that are now managed on a DB,
DC or ‘hybrid’ basis (eg on a DC basis with some form of benefit guarantee). This indicates that
defined benefit schemes now only account for more than half of corporate pension scheme
provision in two major European markets – the Netherlands and Belgium.
13
14
Going mainstream – how absolute return is moving into the regulated market
Diagram 11: Growth of DC pensions in Europe
Prevalence of scheme type among multinational and local leading companies (%)
0
40
20
60
80
100
Austria
Belgium
Denmark
Finland
France
Germany
Ireland
Italy
Luxembourg
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
UK
Defined benefit
Defined contribution
Hybrid
Source: Mercer – Introduction to Benefit Plans Around the World, September 2009.
Moving from a defined benefit to a defined contribution pension culture means that the burden
of investment risk is shifting from the employer/sponsor to the individual. It is therefore
essential that employees are offered a suitable choice of investments that can:
a) enable them to achieve meaningful levels of real growth to build a sufficient pension fund
b) protect their fund from market downturns – especially in the run-up to retirement, when they
have less time to recover from falls in fund value
c) actively benefit from periods of volatility
Designing default DC pension funds
It is especially important that the ‘default option’ (the investment option used if members do
not indicate an investment choice) has an appropriate risk-reward profile. Where a DC scheme
has a default option, it is estimated that a weighted average of 40% of members are automatically
defaulted into it.7 In some markets such as the UK, it is estimated that between 60% and 100%
of DC pension scheme members invest in the default option.8
7
Mercer 2009 Global DC Survey.
Default Options in Workplace Personal Pensions: Report of a qualitative study – PriceWaterhouseCoopers on behalf of the UK
Department of Work and Pensions, January 2010.
8
Going mainstream – how absolute return is moving into the regulated market
A common default option is a lifestyling, or ‘target date’, strategy. This may begin as 100%
invested in global equity, moving to a final allocation of bonds and cash, with the switch typically
starting five to 10 years before retirement. Typically, the equity element is passively invested,
meaning that investors are fully exposed to market declines. Should we experience a repeat of
the market decline witnessed in 2008, then a pension scheme member who is 100% invested in
a passively-managed global equity fund is likely to have seen their fund fall in value by a third.
Granted, a lifestyling option will only expose members to this level of equity risk 10 years or more
before their selected retirement date. However, this level of decline in pension assets across
40-100% of the working population may be viewed as unacceptable – politically and economically.
Absolute return funds could have a crucial role in helping to manage these investment risks for
millions of individuals. If included as part of a default option, an absolute return strategy could
potentially enable members to:
 achieve cash-plus returns at low levels of risk
 reduce their reliance on equity market performance
 generate investment returns even when markets are falling
For investors nearing retirement, absolute return funds can also offer a benefit over traditional
bond funds in that their performance won’t be tied to the same factors (ie bond yields) that will
ultimately determine the return that retirees achieve on their retirement annuity.
To date, interest among DC pension schemes in absolute return approaches has been low,
partially because so few funds have the three-year performance record generally required by
trustees and consultants. However, anecdotal data suggests that major employers are starting
to introduce absolute return strategies in their default DC fund design.
We accept that an investment strategy using derivatives to achieve investment return is likely
to be viewed with caution by both trustees and scheme members. However, as the effective
risk reduction attributes of absolute return strategies become better known and more funds
build a sufficient performance record, we anticipate these funds will play a growing role in DC
pension scheme design – and in any investment vehicle where preservation of investment
growth is key.
In short
Increased market volatility, reduced risk diversification opportunities and sustained low interest
rates could all potentially drive demand for absolute return approaches. Plus, as more individuals
are required to manage their own investment risks, the ability to achieve attractive returns
while limiting downside losses will be increasingly valuable.
In the next section we look at how these attributes of absolute return funds can be employed
most effectively within a portfolio.
‘as more individuals are
required to manage
their own investment
risks, the ability to
achieve attractive
returns while limiting
downside losses will be
increasingly valuable.’
15
16
Going mainstream – how absolute return is moving into the regulated market
Part Four:
Employing absolute return in a portfolio
As we have hoped to show throughout this paper, mainstream interest in absolute return
strategies is strong and there are many drivers that may cause this approach to become
more dominant.
However, we do not believe absolute return investing should be viewed as a replacement for
relative return investing. Rather, it is a valuable component that can be used to enhance a portfolio’s
risk-reward profile. In this section, we want to explore how absolute return strategies differ from
their relative return counterparts and consider what this tells us about the role that absolute return
might play within a portfolio.
i. Investment attributes of absolute return and relative return
Relative return and absolute return strategies both offer investors a valuable set of attributes –
each of which have their role to play within an investment portfolio.
To demonstrate this, we have compared two Threadneedle UK-registered OEIC funds that invest
in the same universe.
 Absolute return (AR) – Threadneedle Absolute Return Bond Fund is an absolute return
strategy investing in global bond markets. It employs a cash enhancement approach and can
use both long and short positions. Its benchmark is 3-month LIBOR.
 Relative return (RR) – Threadneedle Global Bond Fund is a long-only strategy investing
in global bond markets. (NB: Although its stated aim is as a total return fund, this fund’s longonly approach enables us to treat it as a relative return fund.) Its benchmark is the JPM
Global Bond Ex Japan Index.
Diagram 12 shows discrete quarterly returns for these two funds over the four most recent
calendar years. The JPM Global Bond ex Japan Index is included as proxy for the global bond
market (the fund data is therefore gross of fees and tax to enable like-for-like comparisons).
2006-2009 is the only four-year period for which data for both funds is available (Threadneedle
Absolute Return Bond Fund was launched in November 2005). The limitations of demonstrating
fund performance over one short period of time are acknowledged. There again, the extremes
experienced in fixed income markets over these four years makes them a very interesting
test period to assess how relative return and absolute return strategies behave in different
market conditions.
Going mainstream – how absolute return is moving into the regulated market
Diagram 12: Quarterly returns from absolute return and relative return bond strategies 2006-2009
40
30
ABSOLUTE RETURN – Threadneedle Absolute Return Bond Fund
RELATIVE RETURN – Threadneedle Global Bond Fund
MARKET RETURN – JPM Global (ex Japan) Bond Index
Return (%)
20
10
0
-10
-20
Q1 06
Q306
Q107
Q307
Q108
Q308
Q109
Q309
Note: All data is quoted in: GBP. Fund data is sourced from Morningstar. Index data provided by Thomson Reuters Datastream
and JPMorgan. Fund data is quoted on a Bid-Bid basis with Income re-invested at Bid. Fund data is gross of tax and total
expense ratios to facilitate comparison with indices.
Diagram 13 – Risk analysis of absolute return and relative return bond funds
Risk analysis over 3 years
Threadneedle Absolute Return Bond Fund Threadneedle Global Bond Fund
Absolute volatility
4.0%
15.0%
Sharpe Ratio*
1.34
0.72
Information Ratio
1.22
0.23
Note: we have shown risk measures over three years as this is conventional for these metrics *assumes 4% risk-free rate.
Source: Morningstar. As at 31 December 2009.
We can make a number of observations about the performance of the two funds over this period:
Absolute performance
 the absolute return (AR) strategy delivered the most consistent positive returns – delivering
positive performance in 14 out of 16 periods.
 the AR strategy achieved positive returns in five out of eight periods when market returns
were negative; the RR fund posted negative returns in all eight periods that market returns
were negative.
 The AR fund only outperformed a positive market return in two instances (Q406 and Q307) –
in both cases these immediately followed a negative market return.
Volatility
 the AR strategy experienced a narrower band of returns, with shallow gains and losses.
 the RR fund achieved a much wider range of returns (although the range reduces significantly
if we strip out the anomalous returns of Q408).
 Both funds have delivered positive risk-return results as measured by Sharpe and
Information Ratios. In both cases, the absolute return fund has delivered the higher return
per unit of risk taken.
Returns
 the RR fund achieved its strongest returns when bond market returns were also highly positive.
 the AR fund was most likely to lag both the market and the RR fund during periods of strong
bond market performance – however, these were also the periods when the AR fund delivered
its highest positive returns.
17
18
Going mainstream – how absolute return is moving into the regulated market
With the strong caveat that this data is quite limited and covers only a brief period of time, we
can assign certain groups of attributes to the absolute return and the relative return funds –
shown in Diagram 14 below:
Diagram 14: Key attributes of absolute v relative return funds
Absolute return fund
Relative return
Narrow range of returns in all market conditions
Broader range of returns – widening when market
returns are also extreme
Likely to deliver positive outperformance when market
returns are negative
Likely to deliver negative returns when market returns
are negative
Potential to outperform when markets are in initial
recovery – but not conclusive
Potential to outperform when markets are in initial
recovery – but not conclusive
Likely to underperform relative return funds when
markets are rising strongly
Potential to deliver very strong positive returns when
markets are rising strongly
ii. Allocating strategies by market environment
From these attributes, we can conclude that there are market environments when it may
benefit an investor to favour absolute return strategies over relative return strategies and vice
versa. We would summarise these periods as follows:
Diagram 15: Potential strategy weighting against market performance
Market
environment
Strongly
negative
Absolute Return OVERWEIGHT
Fund
Relative Return
Fund
UNDERWEIGHT
Medium
Initial
negative/volatile recovery
Medium
positive
Strongly
positive
OVERWEIGHT
EQUAL WEIGHT
UNDERWEIGHT
UNDERWEIGHT
UNDERWEIGHT
EQUAL WEIGHT
OVERWEIGHT
OVERWEIGHT
In summary, absolute return funds are likely to offer the best return when the market
environment is negative or volatile on a sustained basis. Relative return funds offer the strong
return opportunity when markets are experiencing a strong growth phase. Outperformance of
either type of fund is less apparent when markets are in the very early stages of recovery. That
said, the consistently lower volatility of absolute return funds may lead investors to favour them
in uncertain market conditions.
To test these conclusions, we wanted to see how rotating weightings to these two different
strategies would have affected returns over the four-year period. We also wanted to see if
actively allocating between the two strategies would be more effective than statically allocating
weightings to them. To do this, we tested six portfolios:
Portfolios 1 and 2 are 100% invested in the Absolute Return and the Relative Return strategies
respectively for the whole period.
Portfolio 3 is evenly weighted 50:50 across the Absolute Return and the Relative Return
strategies for the whole period.
Portfolio 4 is overweight Absolute Return, with the portfolio allocated 70% Absolute Return:
30% Relative Return for the whole period.
Portfolio 5 is overweight Relative Return, with the portfolio allocated 30% Absolute Return:
70% Relative Return for the whole period.
Portfolio 6 is rotated between the two funds in line with the market environment as shown in
Diagram 16:
Q106-Q207 – 100% Absolute Return
Q307-Q408 – 100% Relative Return
Q109-Q409 – 100% Absolute Return
Going mainstream – how absolute return is moving into the regulated market
Diagram 16: Fund rotation for Portfolio 6
40
ABSOLUTE RETURN – Threadneedle Absolute Return Bond Fund
RELATIVE RETURN – Threadneedle Global Bond Fund
MARKET RETURN – JPM Global (ex Japan) Bond Index
30
Return (%)
20
1
0
-10
100% Absolute Return
100% Relative Return
100% Absolute Return
-20
Q 06
Q1
Q 06
Q3
Q 07
Q1
Q 07
Q3
Q 08
Q1
Q 08
Q3
Q 09
Q1
Q 09
Q3
Source: Morningstar, Thomson Reuters Datastream and JPMorgan.
The performance results of the six portfolios are shown in Diagram 17 below. We can see that,
of the two ‘pure’ bond portfolios (see Portfolios 1 and 2), the relative return portfolio produced
the highest total return over the period but with almost four times the volatility of the absolute
return portfolio.
Combining the two strategies in different static combinations (Portfolios 3, 4 and 5) has helped
to improve return and reduced the worst quarterly loss. However the most dramatic results
have come from Portfolio 6, where allocation between the two portfolios has been actively
rotated. Here we see that the total return is almost double the return from any of the other five
portfolios while the worst quarterly loss is just -4.0%. Upside has been dramatically enhanced
while downside losses have been limited.
Diagram 17: Performance of test portfolios 2006-2009
Portfolio
Total return
Volatility
Quarterly Return
Best
Median
Worst
Portfolio 1
100% Absolute Return
Portfolio 2:
100% Relative Return
Portfolio 3:
50% Absolute Return
50% Relative Return
36.5%
7.4%
1.2%
-3.4%
5.7%
45.3%
37.4%
-0.6%
-10.5%
20.9%
42.5%
22.4%
0.3%
-3.9%
12.6%
Portfolio 4:
75% Absolute Return
25% Relative Return
40.5%
16.4%
0.7%
-3.6
Portfolio 5:
25% Absolute Return
75% Relative Return
44.0%
28.4%
0.0%
-6.6%
15.8%
Portfolio 6:
Rotated portfolio
– see Diagram 16
88.8%
37.4%
1.2%
-4.0%
18.3%
9.4%
Source: Morningstar.
Caveats to this data must be stressed:
- Performance is based on one specific period of time.
- Data is based on the performance of two specific funds and therefore may not be representative
of the behaviour of all relative return and absolute return strategies.
- This data only relates to global bonds – extrapolation for other asset classes needs to be treated
with caution.
19
20
Going mainstream – how absolute return is moving into the regulated market
‘The particular set of
attributes offered by
absolute return
strategies can play a
valuable role in a
portfolio and are
especially effective
when used in
combination with
relative return funds –
particularly if
allocations are actively
managed.’
- We have been able to determine the optimal rotation points for the two strategies in retrospect.
In real life, an investor is highly unlikely to anticipate inflexion points in the markets so accurately.
- Rotating between strategies can give rise to additional dealing costs or tax liabilities, which
have not been accounted for in our data.
Nonetheless we would suggest that our data tentatively indicates two points:
1. Portfolios that are able to have exposure to both relative return and absolute return funds are
likely to have a more attractive risk-return profile than portfolios that are restricted to one type
of strategy;
2. Actively rotating a portfolio’s allocation towards either absolute return or relative return,
depending on the market environment, can significantly enhance returns and reduce
downside losses.
iii. Defining a new source of return
Investing in absolute or relative return strategies is not an either/or decision. Our research
suggests that holding both relative and absolute return strategies can improve a portfolio’s riskreturn profile.
But, more than this, our research suggests each type of strategy can offer greater or lesser
attractions in different market environments. As such, actively managing allocations to relative
and absolute return strategies in response to the market environment can further enhance
portfolio performance.
This suggests that the decision to skew a portfolio towards either a relative return or absolute
return bias can be treated as an additional source of investment return alongside other
traditional investment decisions, such as to which asset classes and markets to allocate –
see Diagram 18 below.
In our exercise, we have shown the behaviour of absolute and relative return funds within the
global bond sector. But the decision to rotate between the two philosophies could equally be
made for other asset classes. In this way, investors or portfolio managers have another useful
lever by which to generate return and manage risk.
Diagram 18: Increasing the sources of return in a portfolio
Sources of return in a portfolio

Cash

Asset allocation


Bonds
Equities
Other
Market
Market
Market


Absolute/
Relative


Absolute/
Relative


Absolute/
Relative
In short
The particular set of attributes offered by absolute return strategies can play a valuable
role in a portfolio and are especially effective when used in combination with relative
return funds – particularly if allocations are actively managed.
In the last section of the report, we will consider how absolute return funds need to be
evaluated so that investors can identify appropriate and well-managed strategies.
Going mainstream – how absolute return is moving into the regulated market
Part Five:
Evaluating absolute return strategies
Absolute return funds are a highly valuable tool for investors and their wider availability
should be welcomed. Even so, it needs to be fully understood that investing to produce
a consistently positive return is a different discipline from investing to beat a market
benchmark and requires a different, less widely-available skill set.
Concerns over the availability of appropriate skills to manage absolute return strategies in the
regulated market have been voiced widely. In a recent review of the UK asset management
industry conducted by the Investment Management Association, a number of IMA member
firms interviewed voiced doubts about the ability of a large number of firms to achieve absolute
returns consistently. One respondent remarked:
“Even if 100% of the population decided that they wanted an absolute return product, it
should not be used as a substitute for relative return. The talent and capability is not there
to deliver it.”9
The absolute return sector has been one of the biggest-selling sectors since the credit crisis.
We believe there is a real risk that, as demand for absolute return funds continues, less able or
experienced asset managers may look to fill this demand.
In addition, there is still a strong tendency to treat the absolute return market as a homogenous
sector of low-risk strategies when, in fact, it contains a huge diversity of investment approaches
with a very wide range of risk profiles. So even where a manager is experienced, investors may
be tempted to invest in strategies that may not be appropriate in terms of their risk profile or
investment remit. In some cases, investors may be over-confident simply because a fund is
UCITS-compliant.
Conducting due diligence
For all the reasons above, we believe investors need to place substantial emphasis on due
diligence when selecting an absolute return fund and its manager.
To ensure that investors make appropriate choices, we believe management firms should make
information on all of the following aspects of their funds and processes readily available.
1. Management team’s experience
Managing an absolute return strategy is a different discipline from relative return investing.
The portfolio team and its associated analysts should have an established record in absolute
return investing – particularly where a strategy involves short-selling.
Given that track records in the regulated absolute return sector are still relatively short, a strong
performance record in the unregulated hedge-fund sector is currently a major bonus, although
we expect this will recede as the regulated absolute return sector builds a long-term
performance record.
It is also important to remember that the additional strictures imposed by UCITS III in terms of
liquidity, leverage and permissible investments mean that hedge fund managers who have been
successful in their offshore strategies may not necessarily achieve the same results in their
regulated fund versions.
Firms that possess extensive experience in both the unregulated and regulated fund markets
may be best positioned to deliver strong performance in the regulated absolute return sector.
9
Asset Management in the UK 2008 – Investment Management Association, published July 2009.
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Going mainstream – how absolute return is moving into the regulated market
2. Target return
An absolute return fund’s target return (be it an absolute figure or the excess over its benchmark)
can be a good initial indicator of a strategy’s risk profile. The higher the target return, the more
aggressive a strategy will need to be.
Obviously, an investor should also analyse a fund’s success in achieving its target return. Again,
given the immaturity of most regulated absolute return funds, most performance track records
are too short to indicate levels of performance consistency.
3. Timeframe to deliver the target return
Funds should indicate over what period they intend to deliver their target absolute return. In
many cases, the timeframe to deliver a positive return is 12 months but other funds may
annualise their performance over a period of three years. Investors need to consider if the
target return is consistently achievable in the expected timeframe. The shorter the timeframe,
the less risk a fund can afford to take.
4. Suitability of the fund’s benchmark
An absolute return fund will typically measure its performance against a ‘risk-free rate’ – such as
a cash benchmark, or against inflation. A benchmark is only relevant if it accurately reflects a fund’s
investable neutral position – ie how it would invest, and the return that would be achieved, if the
portfolio manager had no investment view. Otherwise, a benchmark is simply acting as an arbitrary
hurdle rate for the fund.
A cash benchmark indicates a target return above zero. Even so, investors should be aware that
if the interest rate on the cash benchmark drops sharply, so will the fund’s target return.
5. Suitability of underlying asset classes
As with any type of investment fund, the suitability of the underlying asset classes needs to be
assessed against an investor’s risk profile. While absolute return funds generally look to reduce
market volatility, an absolute return fund investing in emerging markets is still likely to be more
volatile than a fund that focuses on investment grade bonds.
6. Transparency of risk allocation
The portfolio manager should be able to indicate all sources of return in a fund. There should be
transparency as to how and where risk is being budgeted to achieve the target return – and the
reasoning behind each risk allocation.
7. Volatility parameters
Absolute return funds will often have a remit to deliver cash-plus returns with as little volatility
as possible. If so, they should impose limits on the maximum absolute volatility that returns
should experience and have a clear strategy to ensure that portfolio fluctuations remain within
these parameters. Investors should be able to assess to what extent a fund has remained within
these parameters and be able to access information about the maximum drawdown (the maximum
percentage loss from peak to trough) experienced by a fund over different time periods.
8. Correlation with markets
Where an absolute return fund aims to strip out market risk, its correlation with the markets in
which it invests should be low (ie close to zero). Persistently high correlation suggests returns
are dependent on capturing beta rather than manager skill.
9. Credit risk
Where an absolute return strategy invests extensively in cash instruments, the credit quality of
these instruments needs to be assessed carefully. Some funds may restrict themselves to
highly-rated treasury securities. Some credit instruments may involve high exposure to particular
sectors such as financials. An absolute return manager with high cash exposure should demonstrate
the skills and resources to monitor the credit risk of the cash instruments they hold.
Going mainstream – how absolute return is moving into the regulated market
10. Market leverage
UCITS funds are not permitted to borrow to finance investment positions. However, derivatives
can be used to gain market exposure for only a small initial outlay – which creates ‘market
leverage’. Like any kind of leverage this can amplify both gains and losses, so the fund’s policy
on maximum levels of leverage needs to be clear.
11. Access and liquidity
Authorised absolute return funds have to adhere to strict requirements regarding investor access
and liquidity. Even so, a fund should have a clear policy to manage redemptions and minimise
the need to sell investments or unwind positions involuntarily if there are high net outflows from
the fund. Liquidity should be assessed particularly carefully where a hedge fund manager has
only recently entered the authorised fund market for the first time and is less experienced in
working within the liquidity restrictions demanded by UCITS regulations.
12. Fees
Many absolute return funds solely levy conventional ad valorem annual management charges,
but some may also have a performance fee. This may be deducted as a percentage of any
outperformance in the net asset value above a stated hurdle rate. The hurdle rate, the basis for
the high water mark and the size of the performance fee all need to be assessed alongside all
other ongoing charges.
In short
Until there is sufficient mass to classify different absolute return strategies with greater granularity,
deep due diligence remains essential in order to differentiate between strategies, their
respective goals and risk profiles – as well as the experience and skills of each management
team. Investors also have to be mindful that track records in the sector are still very short and it
is difficult to assess managers on their past performance. In particular, it is still hard to see which
managers are achieving their target return consistently. This will become less of an issue over
time. However, while the majority of constituents have performance records of less than five
years, investors need to proceed cautiously when selecting funds. It is also important to remember
that track records in the unregulated fund market may not always be replicable in a regulated
fund which has additional liquidity, leverage and investment constraints.
‘deep due diligence
remains essential in
order to differentiate
between strategies’
23
24
Going mainstream – how absolute return is moving into the regulated market
Conclusion
Absolute return strategies have been available in the regulated European investment market for
less than a decade. They still account for only a small fraction of funds under management –
around EUR50 billion of a European UCITS market that is estimated to be worth EUR5,299 billion
according to the European Fund and Asset Management Association (EFAMA).
Yet the market is growing swiftly and interest in it has accelerated as investors seek new ways to
manage risk and combine the best elements of the hedge fund market and the regulated market.
Even during the period that it has taken to write this report, we have seen many new fund launches,
often from established and respected names in the hedge fund industry entering the regulated
fund market for the first time.
The role of absolute return
The attributes demonstrated by absolute return funds (low volatility, cash-plus returns, low market
correlation) enable them to play a unique role in a portfolio in terms of steadying performance
throughout the market cycle and enabling investors to achieve attractive returns in both up and
down markets. As more onus is placed on private individuals to shoulder investment risk, these
attributes should become increasingly prized.
But absolute return funds are not a cure-all. There are times when they will underperform other
funds. As such, absolute return strategies are most powerful as part of a diversified portfolio
that also includes traditional relative return strategies. Given the growing diversity of the absolute
return sector, it is now possible for investors to ‘match’ relative and absolute return approaches
across many different asset classes including equities, government bonds, credit and currency,
and across both developed and emerging markets.
It is often assumed that – given their typically low-risk profile – absolute return funds will generally
be treated as a “static” long-term portfolio holding. Certainly, they can play this role very well.
But we also envisage that many investors will look to use absolute return strategies in more
dynamic ways. As our analysis has shown, actively rotating between relative return and absolute
return strategies at different stages of the market cycle can have a dramatic and positive impact
on returns achieved and losses avoided. As such, the decision to allocate to absolute return or
relative return could be treated as an additional source of value-add in an investment strategy,
alongside other traditional asset allocation and market allocation decisions.
Winners in the sector
Our key concern for the sector is whether investor demand can be matched by manager skill.
It is understandable that fund managers may view absolute return as a means to stymie fund
outflows at times of market volatility or downturn. But absolute return investing is a specialist
skill that relative return managers cannot acquire overnight. The skills required can be found in
the unregulated hedge fund market but those managers, conversely, have to be able to adapt to
the great restrictions on permissible investments, leverage, liquidity and risk management that
the regulated fund market demands.
The absolute return managers that are likely to do best – and are likely to be seen of greatest value –
therefore, are those that both possess a long-term track record in the hedge fund market and
also deep experience of compliance in the regulated fund market. Managers possessing only
one of these sets of attributes are likely to struggle to meet investor (and regulator) expectations.
Going mainstream – how absolute return is moving into the regulated market
Diagram 19: Skills convergence of high-value absolute return managers
Hedge fund
experience
 Short-selling
 Leverage
 Derivative
management
UCITS experience
 Liquidity rules
 Investment &
leverage
restrictions
 Reporting
requirements
High-value
absolute return
managers
Equally, there is a concern that investors may be lulled by the presence of a regulated fund structure
to invest in quasi-hedge fund strategies that are not appropriate. Absolute return funds are often
bought as low-risk investments but this is not always the case. The risk-reward profiles of these
funds can vary hugely and investors must not assume that cash-plus returns mean cash-like
levels of risk.
For all these reasons, deep due diligence is essential. The promise of absolute returns is very
enticing – and will continue to attract strong inflows over the next five to 10 years. The biggest
challenge for investors now is determining which managers and which funds can consistently
deliver on that promise.
25
Important information
Please remember that past performance is not a guide to the future and the value of investments can fall as well as rise, and therefore an investor may not get back the
amount invested. Changes in exchange rates may also affect the value of investments. The research and analysis included in this document has been produced by
Threadneedle for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Information obtained
from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. Any opinions expressed are made as at the date of publication
but are subject to change without notice. Subscriptions to a fund may only be made on the basis of the current Prospectus or Simplified Prospectus and the latest annual
or interim reports, which can be obtained free of charge on request. The Absolute Return Bond Fund may hold up to 100% in cash or money market securities. Therefore,
investors should be aware that the Fund may not participate fully in a market rise. The Fund’s exposure involves short sales of securities and leverage which increases
the risk of the Fund. Short selling is designed to make a profit from falling prices. However, if the value of the underlying investment increases, the short position will
negatively affect the Fund’s value. Leverage amplifies the effect of changes in the price of an investment on the Fund’s value. As such, leverage can enhance returns to
shareholders but can also increase losses. For the avoidance of doubt, this Fund does not offer any form of guarantee with respect to investment performance, and no
form of capital protection will apply. The Global Bond Fund may deduct its annual management charge from capital rather than income. This may erode capital or
reduce the potential for capital growth over time. The interest rate on most government and corporate bonds will not increase in line with inflation. Thus, over time, the
real value of investors’ income could fall.
Issued by Threadneedle Asset Management Limited. Authorised and regulated by the FSA. Registered in England & Wales No 984167, 60 St Mary Axe, London EC3A
8JQ. Threadneedle is a brand name, and both the name and logo are trademarks or registered trademarks of the Threadneedle group of companies. threadneedle.co.uk
For investment professional use only
(not for onward distribution to, or to be
relied upon by, private investors).
06.10/ T2335_Valid to 12.10