15
June
2010
The investment fund of the moment is absolute return. Naturally, the idea of an investment which offers investors the prospects of gaining when markets rise, but avoiding the nasty losses when markets decline is attractive.
Financial advisers are also getting behind these funds and recommending them to their clients.
We therefore ask the following question: do absolute return funds belong in my portfolio?
The advantage of having a clear investment philosophy is that we are able to establish if any proposed investment idea stands up to rigorous scrutiny.
What is the expected return of an absolute return fund?
Returns are being driven by risk exposure, most absolute return funds employ some form of hedging strategy to mitigate downside risk. This has to limit exposure to risk and therefore has to limit the investor's potential returns. Absolute return funds therefore have to offer investors a lower expected return than a "market portfolio" before costs and must, must, must offer a lower expected return after costs.
Can it be measured?
Not really. The risk exposure of any absolute fund at any given time is going to be constantly changing based on the fund managers bets on the market. It is therefore not possible for an investor or their adviser to assess the expected return of a fund. Our question is therefore how can one employ an absolute return fund in an investor's portfolio? Since we have no idea of the expected returns, how can we recommend a fund?
Volatility and risk - Can it be measured?
The relative movement in the price of a fund can be measured from month to month, and there is an expectation that the volatility will be less than a "market" portfolio. However, most funds do not have very long track records and therefore it is not possible to draw meaningful statistical inferences.
However, we can measure the relative risk of a given fund compared to various asset classes in order to gauge relative risk.
The following chart illustrates the relative risk and return trade off for the Standard Life Global Absolute Return fund compared to Bonds and Equities since the launch of the Euro version of the fund in September 2008.
Please click on the image for a larger view
Source: MoneyMate/DFA
Clearly, the fund has a risk return trade off approximately the same as an investment in long-term government bonds.
We would therefore expect in a rising market for the fund to underperform a market portfolio. The following chart compares the GoldCore portfolios to the Standard Life GARs fund from March 2009 to May 2010.
Please click on the image for a larger view
As expected, the GARS fund has a low risk/low expected return profile about the same as the GoldCore 35% Risk portfolio.
Where does the return come from?
In a GARs fund the returns are not being driven by exposure to priced economic risk factors (Beta) but rather by supposed Fund Manager skill (Alpha). Since virtually all academic studies support the view that fund manager alpha is not persistant, there is no reason to believe that any fund selected at random based on it's recent track record will continue to perform consistently well in the future.
The verdict for absolute return funds
The investment product market is driven by what sells. We saw Tech funds being launched in the late 1990s, Property syndicates in late 2006, 2007 and we now see cash deposits and absolute return funds as the flavour of the month.
Investors who "chase" the latest hot fad more often than not end up buying high and selling low. It doesn't have to be that way. Investors who understand that risk and expected return are related and that proper diversification of a portfolio can limit risk to match their willingness to bear investment risk can have a successful investment experience without having to guess which star fund manager might outperform the market, whilst paying high fees for the privilige of finding out that, on average, most fail to do so.
For more information on investing in alternatives see the resources section here
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