Autumn 2012

ABSOLUTE RETURNS: Not quite what they were expecting?

Broken-eggSignificant performance variations among absolute return funds have startled investors. Muriel Oatham takes a look at a booming sector and finds massively differing investment strategies.

Poor performance in Asian equities and elsewhere has led to a boom in sales of absolute return funds, but many have failed to live up to their expectations.

Of the 24 funds with a twelve-month track record on Morningstar Asia’s database, just seven have generated positive returns. And in Britain, the sector even faces an investigation by the Financial Services Authority after half of all funds reported losses last year.

However, losses and bad publicity do not appear to deter investors.

“There is a clear trend towards absolute return in Asia,” says Sunny Ng, head of research at Morningstar Asia. “The poor performance of Asian equities over recent years has driven investors to seek funds offering more protection.”  

And the sector is growing rapidly as a result. “Half of the [absolute return] funds Morningstar Asia is tracking have launched within the last three years and seven in the last year,” says Ng.

Significant performance variations within the sector have startled investors.

“The last 18 months have been very choppy,” says Hugh Simon, chief executive officer at Hamon Asset Management. “Asian markets have not achieved the 5% to 8% growth rates that people expected. China is at five-year lows and India has been very difficult. Investors are getting frustrated and moving their money away.”

According to Morningstar Asia, performance of this group of funds labeled “absolute return” or “tactical” has been highly varied, ranging from positive returns of 5-6% to losses of between 20-25%.

These disparities are partly owing to differing investment approaches adopted in the absolute return sector. “This is not a homogenous group of strategies. Managers are running very different strategies within the absolute return space,” says Ng.  

“There are funds which call themselves absolute return which are really balanced funds, as they move around very little. Others are really long-only equity funds,” he says. “And there are funds running absolute return strategies, such as Schroders ISF Asian Total Return, that are not included as it does not fit its own in-house definition of absolute return.”

Providers have entered the Asian absolute return market from a variety of backgrounds. “We have seen global absolute return products increasing their marketing towards Asian investors. And we have seen many small and rapidly growing Hong Kong and Chinese hedge funds moving into the retail space,” says Ng.

The absolute return sector has evolved over the past couple of years. “Up to 2008, the long/short side was very popular: managers playing with long equities whilst shorting individual stocks or futures,” Simon says. “But the last three to five years have seen the development of more defensive strategies: absolute return funds which are long equities with bonds or cash.”

And it has been easier for providers to attract assets into the absolute return space than into hedge funds. Within this diverse sector, however, opinions differ over what the most successful investment strategies are.

Richard Cardiff, chief executive officer of Coupland Cardiff, attributes the underperformance of many funds to economic uncertainty in Europe. Stockpickers who resist getting drawn into the macroeconomic debate, he says, can still find stocks that will do well.

Dividend-based stocks, for example, have been highly sought-after. Cardiff says: “In Asia, the stocks that rose a lot accrued significant earnings upgrades, and similarly, those that fell saw significant downgrades. Last year, the market was very driven by earnings at stock level.”  

Yet Richard Batty, investment director, multi-asset investing at Standard Life Investments, says global absolute return strategies are macro-economic strategies.

In order to deliver this strategy, he says, the ability to take a long-term view is critical. In contrast to many other absolute return funds, which have annual targets, the Standard Life Global Absolute Return fund aims to generate annual returns but is run on a three-year basis.  

“This is an under-researched and under-invested view. Many absolute return managers try to trade the noise, taking a six-month view or even shorter. The information gap over the three year time horizon gives us an advantage,” he adds.

Batty uses selected Asian positions within the global fund. Currently, about 15% of the fund is invested in Asia, across five individual exposures.

The largest of these is a variance position on Asian stock indices. “Volatility is a classic asset,” he says. “We think the more cyclical indices in Japan, China and Hong Kong – the Nikkei, HSCI and Hang Seng – will see higher volatility than the more defensive S&P 500 and FTSE. So we think they are priced too low in Asia and we are expecting that volatility gap to widen.”

Batty says Asian currencies are too expensive, which is why he holds positions against the yen and the Australian dollar.

While investment strategies differ, experts agree that the Asian market has characteristics that make it less suited to absolute returns than Europe or America.

“It is definitely more difficult to run an absolute return strategy in Asia,” says Ng. “Liquidity is poor, so even if you are running a long portfolio it can be difficult to adjust cash levels. And markets quickly dry up if there is a sell-off.”

Shorting individual stocks in Asia creates a challenge for fund managers, mainly because poor investments rally when markets recover, resulting in a negative reputation from shorting a stock that falls for a short time but then rallies.

Ng says managers face higher costs in Asia than developed markets. Shorting, for example, is a lot more expensive. While managers can get an investment bank to structure an over-the-counter derivative, this is costly.

A lazy view
The volatility of Asian markets makes them harder to predict, too. “Markets are very policy-driven,” Ng says. “For example, if China decides a new housing policy if affects the market, but that is hard to anticipate. Macro-economic funds might take advantage of this but others will struggle.”

Cardiff, however, says to single out the Asian market as uniquely difficult is a somewhat “lazy view”. He adds: “Asia lends itself perfectly to equity long/short strategies. It is not as well analysed as the US. That creates an information gap for good analysts and fund managers to exploit.”

Ng says even though absolute return funds have underperformed against a benchmark, they have still outperformed equities in general. “There is still demand for absolute return strategies from investors looking to allocate away from strictly equities,” he says, explaining that launches are, therefore, likely to continue.

The sustained growth of multi-strategy Asian hedge funds is expected to stimulate the market. “The availability of underlying instruments such as futures, currencies and derivatives, the tools you need to run a good absolute return strategy is increasing,” he says.

With markets becoming more sophisticated, the sector is likely to evolve further, which will add pressure on asset managers.

“Absolute return is not a uniform sector,” Batty says. “You cannot simply be a value specialist or a growth manager or a stock-picker. You need to generate ideas and keep evaluating them.”

©2012 funds global

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