Since March 2020, investors have been exposed to volatile market conditions, with markets falling heavily at the height of the Covid-19 pandemic, only to be followed by a rapid recovery, and then weaker market conditions again this year, due to higher inflation and the conflict in Ukraine. Whilst volatile conditions lead to opportunities, there are a range of funds that aim to generate profit irrespective of whether markets are positive or weak.
These funds are known as Absolute Return funds, and as the name suggests, they aim to generate positive returns in all market conditions, by adopting a different strategy than is used in more traditional investment funds that tend to invest in a single type of asset (e.g. Equities or Corporate Bonds) or a mix of asset classes.
Absolute Return funds often use “long” and “short” strategies, and are designed to make money from shares in companies that go down as well as up, thus aiming to deliver a positive return for investors regardless of whether the market is rising or falling. They also aim to achieve returns that are smoother, reducing some of the volatility that has been so apparent for investors over recent years. This is also reflected in the choice of benchmark, or performance measure, used by Absolute Return funds, which is more often a return based on cash, or inflation, plus a percentage margin, rather than broader market movements.
A combination of strategies
The primary feature of Absolute Return funds is that the fund manager is not usually constrained by investing the fund in a rigid asset allocation, and has the flexibility to choose where the fund is invested across a range of different asset classes and strategies. In many Absolute Return funds, the manager will look to employ strategies that hold both “long” and “short” positions.
“Long” strategies are traditional investments into assets that the fund manager believes will rise in value over time and involves buying and holding the shares of companies or other assets. A “short” position can be adopted on any investment that the manager believes will fare less well, or fall in value. These positions make use of derivatives, which are complex financial instruments that typically allow the manager to sell shares they do not own, with the aim of buying them back at a lower price to make a profit.
In addition to these strategies, Absolute Return funds also invest in other assets depending on market conditions. Some use cash and short dated loans/bonds as a way of protecting the portfolio in more difficult market conditions, and use alternative assets and commodities as hedging tools.
What is the attraction?
Looking at historic returns from the sector, it is clear that a well managed Absolute Return fund can limit volatility and risk, whilst achieving good returns over the medium to longer term. The fact that the fund manager is not limited by strict guidelines can help tailor the portfolio to match the underlying and expected conditions more closely than when the fund manager is constrained by the fund guidelines. This flexibility can also mean that a strong performing Absolute Return fund can aim to deliver returns when other asset classes struggle.
And the drawbacks?
This type of investment is more heavily dependent on the skill set of the manager or management team than perhaps any other type of investment. As the investment strategies used often involve derivatives, these can amplify performance in both directions, and lead to greater losses if the wrong asset is held at the wrong time.
In addition, Absolute Return funds tend to be expensive in terms of their annual charges, and some funds charge a performance fee, which is charged in addition to the standard fund charge when certain performance targets are reached.
In addition to the added complexity of Absolute Return funds, in certain circumstances, positions taken within an Absolute Return fund can be less easily realisable than mainstream assets, which could lead to delays or difficulties if investors wish to sell or encash their investment.
Does flexibility translate into returns?
Absolute Return funds started becoming more popular immediately after the financial crisis of 2008, and by 2015, they represented the most popular type of fund by volume of sales. However, this popularity has waned over recent years, with outflows of £3bn from the sector seen during 2021.
Performance across the sector has been mixed. A number of funds have shown consistently strong performance over a range of different market conditions, and merit consideration. In a diverse sector, however, there have been a number of funds that have performed less well, with a wide divergence of returns seen over the medium term.
Given this variance in performance, increased due diligence is required when considering Absolute Return funds, and careful analysis of the strategy, track record of performance of the management team, and risks, is key to making the right selection within the sector. At FAS, we maintain a limited exposure within our portfolios to a small, select group of Absolute Return funds that we feel have good prospects for outperformance over the medium to longer term. However, we use these funds where appropriate as part of a much wider, diversified portfolio of assets.
If you would like to discuss Absolute Return funds or would like to review your portfolio strategy with one of our experienced advisers, please get in touch here.
The value of investments and the income they produce can fall as well as rise. You may get back less than you invested. Past performance is not a reliable indicator of future performance. Investing in stocks and shares should be regarded as a long term investment and should fit in with your overall attitude to risk and your financial circumstance.