Absolute return funds seek clarity
Absolute return funds are being launched thick and fast, with every sign of more to come.
What triggered this mini-boom was the introduction of Ucits III in 2004, making it possible for funds marketed onshore to invest in a wider range of financial instruments, including derivatives, and to take short positions – all with the aim of achieving positive returns, regardless of what markets were doing.
Already these funds are worth tens of billions of euros overall.
The greatest demand comes from continental Europe – particularly Germany and Switzerland – both from retail and from institutional clients. It is not surprising that these markets have taken to this type of product, as they have long had expertise in fixed income portfolio management, and the use of derivatives.
However, UK investment houses have been slower to launch absolute return products than their continental counterparts.
Absolute return funds can of course be appropriate for investors who are clear about their own objectives and how a fund can achieve them. The funds generally have low volatility, but the drawback is that they will not participate in market upturns to the same extent as the mainstream funds.
However, what has not helped to sell these products in the UK has
been their less-than-sparkling performance within the sector as a whole. Many absolute return funds have missed their target returns altogether, over their brief lifespan.
This widespread underperformance from funds which investors have put money into precisely to avoid losing it, highlights the questions which are holding the sector back.
These are: Do these funds do what they say on the tin? And equally important: Do investors understand what the tin actually says about risk and returns?
Standard & Poor’s (S&P) new classification and assessment system for
absolute return funds is aimed at tackling these problems. One of the aims is to help investors identify whether a fund is well-managed, and whether it will achieve its target return.
The starting-point of the process is the definition of an absolute return fund.
“There is confusion in the market over what absolute return funds are, and they are often likened to (or confused with) target funds, total return funds and hedge funds,” says Kate Hollis, Standard & Poor’s fund services associate director. “To add to the confusion, the words ‘total return’ or ‘target fund’ may be used in a fund’s title, and it may still be a genuine absolute return fund. But absolute return funds have different return expectations and return profiles from these other funds.”
The situation is made worse by the fact that absolute return funds – which span many different investment processes – mingle in the market with existing long-only funds with absolute return objectives, and some types of hedge fund.
Already, S&P lists over 350 European-domiciled self-styled “absolute return” funds on its database.
“Our classification of these funds according to our definition will help investors distinguish between them,” says Hollis.
S&P believes it is the first to set down criteria on what is an absolute return fund.
This in turn means trying to differentiate between funds which (hopefully) do not lose money in falling markets, and those that will try and make money in rising or falling markets.
S&P does not classify a fund as an absolute return fund just because that is its objective, or what it is called.
Instead, absolute return funds are defined as those which use cash as their benchmark and which are able to short the markets. They aim to provide cash plus returns of at least Libor + 100 basis points before fees, irrespective of the market.
Genuine absolute return funds are likely to have low volatility, and provide more consistent returns reflecting their objective. They will have no directional bias (ie, they will not provide returns that are reflective of the direction of the market).
The funds are probably multi-asset class, and probably use derivatives as an integral part of the investment process. They are also unlikely to fit naturally into any other Standard & Poor’s fund services peer group.
A further characteristic of an absolute return fund is that the manager’s neutral position (what he holds when he has no particular market view) is cash or near-cash, and his bearish position is short, when permitted by the regulators.
This means that the new classification does not include long-only funds with an absolute return objective. This is because these funds can only hold near-cash in falling markets, so they cannot achieve substantial returns over money market rates. By contrast, absolute return funds can go short, and they have the ability to profit from falling markets.
Having enabled investors to determine whether a particular fund is a genuine absolute return fund, the spotlight then falls on the level of risk.
“The different risks involved across products, and among absolute return funds themselves, are particularly difficult for investors to spot and quantify,” says Hollis.
The fund rating process for absolute return funds is even more demanding than the process applied to conventional funds, as a fund’s performance is not judged merely against its peer group.
Instead, the initial analysis is based on the fund’s own objectives – or any other objectives which S&P deems appropriate for the way in which the fund is managed.
“Funds with a three-year track record should, as a minimum, have come close to achieving their objectives and be capable of achieving them in a reasonable market,” says Hollis. “Ratings will probably only be considered for young funds, or those just launched, if they are managed by a house with a proven ability to deliver alpha from the investment process used in the fund.”
The rating system also introduces a new supplementary N rating, which reflects Standard & Poor’s view on a fund’s potential capital stability. This will be shown alongside the established A, AA and AAA ratings.
“We believe investors in absolute return funds will be concerned by the possibility of capital losses,” says Hollis. “Since these funds have different objectives, processes and investment universes, we felt it would be helpful to give some indication of the relative degree of short-term capital stability which they are likely to exhibit in normal markets – hence the creation of the N-rating.”
The preliminary fund questionnaire requests details such as long and short duration and equity beta exposure.
“If the managers are not able to provide sufficient detail, their risk control and therefore their funds are probably not suitable for rating in this asset class,” says Hollis.
And during the fund manager’s interview, S&P pays particular attention to the investment process, investment universe and risk controls, to determine if they are suitable for the objective.
The result is that investors are presented with fund rating reports covering the major risks inherent in a fund’s investment process. As part of this, the top 10 holdings table familiar from conventional fund reports will disappear, to be replaced by three separate tables. These will monitor:
❒ Sensitivity to moves in interest rates, including geographical breakdown;
❒ Sensitivity to moves in equity markets, including geographical breakdown;
❒ Breakdown by credit rating.
This portfolio information will include the effects of derivatives. S&P still requires full portfolio disclosure before the rating interview, and says it will incorporate any unusually large or risky positions into the portfolio commentary, which is part of all fund rating reports available.
Under current regulatory reporting guidelines, funds are required to provide details of all holdings, including short and derivative positions. But they are not required to do so in a format which helps the investor form a clear view on the net investment positions of the fund.
“For instance, Ucits III funds cannot short securities, so they must achieve net short positions by using derivatives,” says Hollis. “But these are often disclosed in different places in the annual report, and investors may not be familiar with their characteristics. They may or may not be disclosed in monthly factsheets. So we want our new reports to provide increased transparency and intelligence on the funds’ overall investment risks.”
And she says: “If this is successful, it could lead to fewer managers bringing out funds with inappropriate targets, or funds which cannot be run efficiently. That will help fund managers, and of course it will help the investor, increasing confidence.”
At present, 12 funds classified as absolute return funds are going through the rating process. The
rating and research reports on these will be published in July by S&P. S&P is also assessing the sector qualification of a further 86 portfolios which have been placed in a Ucits III category.