June, 2012 Print
Matthew Craig, LAPF Investments.
The case for an absolute return investing could be said to rest on the quote: “You cannot eat a relative return.” In other words, if a pension fund invests in a fund which is managed relative to a benchmark, then if the benchmark falls by 10%, it is highly likely that the fund will also fall in value. An asset manager can claim that a return of -9% is better than the benchmark fall of -10%, but this will not help pay pensions. In contrast, an absolute return fund aims to make a positive return regardless of market conditions. So if the market falls by 10%, an absolute return fund that delivers a return of 5% will help pay pensions. Absolute return investing can be applied to a wide range of asset classes, as it is essentially an investment style, but it is normally associated with those assets grouped in the alternative assets box, particularly hedge funds. However, it is also used for multi-asset funds and, increasingly, fixed income. Certain other real assets, such as infrastructure, can also be managed to deliver absolute returns.
There are number of reasons why asset owners, such as local authority pension funds, are now thinking about absolute return investing. One is a sense of disillusionment among investors with various aspects of conventional investing. For instance, many pension funds are heavily weighted to equities, which have failed to deliver good results whether managed actively or passively against market benchmarks. John Jones, who is interim finance director at the London Borough of Hounslow said: “Equity risk premium seems to have disappeared recently; equity returns are not as strong as they might have been and there has been a lot of volatility. A lot of local authority investors and others have become disillusioned with active management in the equity space.”
One response to poor relative returns from equities is to allocate assets which are managed on an absolute return basis. A recent survey by consultants Greenwich Associates of alternative asset allocations at local authority funds, found that the average allocation to alternatives was up from a negligible level in 2006 to 7% in 2012. As an example of these changes, a source close to the London Borough of Ealing Pension Fund said it is planning a major review of its strategic asset allocation, as it currently still has 70% of its assets in equities. “It is going to increase its property allocation to 10% out of equities and is considering more use of alternatives, such as an opportunities bucket, possibly infrastructure and possibly hedge funds,” the source commented.
Infrastructure is an example of an alternative asset that can be managed on an absolute return basis; Pension Protection Fund chief executive officer Alan Rubenstein, and National Association of Pension Funds chief executive, Joanne Segars, are currently seeking pension funds to invest in an infrastructure platform that aims to achieve a return of inflation, as measured by the RPI index, plus 4-5%. In virtually all circumstances this approach, if successful, will give an absolute return to investors, enabling them to pay pensions or close a funding gap. Some local authority funds have indicated that they are interested in this project, while others feel that they already have sufficient infrastructure investments. On infrastructure as an asset class, Jones said: “Politicians are promoting it, which makes everyone a bit wary – there is a danger that pension funds will be seen as a funding source to solve a problem. Joanne Segars said that this is not the case and infrastructure is quite attractive providing there is a proper investment approach. It is more difficult if infrastructure is more like private equity.”
At asset managers, absolute return funds have been designed to meet investor concerns about relative return investing, by giving investors a better chance of positive returns in flat or falling markets. To do this, specialised absolute return funds usually invest across a range of asset classes, such as equities, bonds, property and cash, in order to diversify and reduce risks and benefit from any positive market movements. Absolute return managers are also likely use futures and options to protect against market falls, or to enable them to move quickly in or out of an asset class they expect to rise or fall in value. Standard Life has offered its global absolute return strategies fund (GARS) to UK institutions since 2006 and it aims to produce equitylike returns at a lower risk level, with an investment objective of cash plus 5% over rolling three-year periods. Diversified growth funds are another popular trend among fund managers and similar to absolute return funds, in that they also use a range of assets and tools such as derivatives to deliver a real return to investors regardless of market conditions.
Another twist on the absolute return investing theme is for bond, or fixed income, funds to use an absolute return approach. This is partly in response to the current abnormal conditions in the bond markets, as a result of very weak growth in Western economies and policies such as quantitative easing which have pushed bond yields down to record low levels. Jones said that the yield on a recent German bund issue was so low that with inflation, investors are effectively paying the German government to hold their money. He added: “On the liability side of the equation, interest rates are 0.5%, bond yields are very low and that makes the valuation of liabilities worse. People are in a tight spot and are responding to that with more diversification in order to achieve returns.”
M&G is one fund manager which said it sees absolute returns as an important part of the mix for pension funds, particularly for pension funds which have a growth bucket. In fixed income investing, M&G said that absolute return funds are normally “cash plus” strategies that help investors meet interest rate risk. It added that opportunities for absolute returns in the credit market usually came from two methods. One is to produce a return of cash, as measured by Libor, plus 2% from a portfolio of investment-grade credit, asset-backed securities, high yield bonds, loans, infrastructure debt and government bonds. The second method is to invest in European loans, which are normally the preserve of banks or boutiques. Loans can give a return linked to interest rates, and a higher level of security than enjoyed by bond holders in the event of a default. At present, returns of cash plus 4% are feasible, M&G said.
Kames Capital, formerly the asset management arm of Dutch insurer AEGON, has also entered the absolute return bond fund market, and it aims to provide a positive total return to investors over a rolling three- to fiveyear period, regardless of market conditions. It will invest in global debt in any currency, from AAA government bonds, through to high yield and emerging market bonds. Kames Capital said it would also use derivatives to run long-short strategies, for example by using short positions through selling futures or buying put options.
Inflation is a particular concern for fixed income investors and a reason for considering an absolute return approach to fixed income investing. If inflation should take off, a portfolio of conventional bonds, managed against a bond index, would slump in value. Tim Haywood, co-fund manager for the JB Absolute Return Bond Fund commented on current conditions: “With the exception of Japan, inflation and inflation expectations have been ‘sticky’, not declining as much as some central bankers hoped. This combination of low bond yields and stubborn inflation creates unappealing prospective real yields.”
Absolute return fixed income strategies may also appeal to investors looking to get “more bang for their buck” from their assets. PIMCO is one of the world’s largest fixed income managers, and portfolio manager Mark Kiesel said of its credit absolute return strategy: “The strategy offers long and short exposure across multiple global credit sectors in order to target absolute returns. It is designed for investors who want exposure to credit with greater flexibility and a traditional benchmark-constrained approach.” Another asset class where absolute return investing makes sense is hedge funds. Up to 2008, many hedge funds claimed to be able to produce positive returns in all conditions, but when all asset classes fell in value in the latter part of 2008, this included many hedge funds. It must be said that other hedge funds did spectacularly well, if for example they had shorted subprime property. Investors looking to get an absolute return from hedge funds need to invest in a range of different hedge fund strategies and to ensure that their chosen managers have the skills and strategies necessary to produce returns when markets become choppy. Pension funds could also consider real assets, such as shipping, timber, or aircraft leasing, or new asset classes such as insurancelinked securities, in order to find returns when listed markets are struggling. This could then help to give an absolute return focus to their portfolios.
In conclusion, investors should think of absolute return investing as an overall strategy. Some funds carry an absolute return label and may help investors avoid losses when bond or equity markets stumble. But equally, by investing in assets which aim to produce real returns, such as infrastructure, investors can try to ensure that their investment portfolios produce absolute returns.