Portfolio Adviser • Portfolio Adviser February 2019 v2 • Sector Report

For many, the experience of absolute return to date has not been particularly great. UK investors are increasingly looking beyond traditional asset classes – a trend likely to become more pronounced in the current economic environment.

The IA Targeted Return sector, home to the majority of retail absolute return funds, is frequently ranked as the best-selling fund sector by the Investment Association.

It has grown to accommodate more than 90 funds, managing over £80bn of assets. But this sector has serious limitations and fund selectors would be wise to approach it with caution.

Eighty per cent of the monies invested in the sector is managed by 10 funds. Of that 10, just five funds account for nearly 70% of the total assets under management. That’s a heavy skew and tells you that investor experience has been, and is likely to be, limited to a handful of funds.

Two of the top five funds follow a variant of the same strategy. They are run by managers who previously worked together on the same team and then set up their own offerings, attracting similar levels of inflows.

There is nothing wrong with that except for the fact there are a multitude of strategies within the absolute return sector, and it would be wrong to make an appraisal – or limit your exposure – to only one of them.

From an asset allocation perspective, the most attractive feature of absolute return funds is the potential to behave differently to both equity and bond markets. They can provide an important additional layer of diversification to a portfolio.

The expectation is that this feature will offer some shelter when markets take a turn for the worse. An absolute return fund is usually purchased to offset risk exposures elsewhere. You don’t want this segment of your portfolio to be delivering equity- like returns for equity-like risk. That can be found within a portfolio’s equity component.

All funds in the sector share a similar objective: to deliver a positive return in all market conditions. There are many different approaches to achieving that aim, which can present a few issues when selecting a fund.

Looking at top-quartile returns as an initial screening method will not be helpful in identifying manager skill unless you factor in the strategy they are adopting and the environment we are in.

Taking a three-year period, for example, would exclude the one-third of funds that don’t have a three-year track record. It would also exclude a number of important strategies, bond and market-neutral strategies to name but two.

Even factoring in more useful quantitative screening metrics that assess risk-adjusted return will likely prove too poor a filter.

Certain markets reward different strategies, with the most recent winners enjoying an environment where risk (equities) has been rewarded and macro themes have dominated.

The absolute return sector requires a little bit more work than other markets in identifying the types of strategy, the specific objectives, and the skills and abilities of the practitioners.

Ultimately, given the range, you will likely need to put together a number of different funds to reach the required level of diversification.

It is worth remembering that absolute return funds can act as an alternative to more traditional asset classes but not all alternatives are absolute return funds. The latter should form part, but not all, of a wider alternatives allocation.

It is now generally accepted that alternatives should form an established part of a diversified portfolio. How successful investors and advisers have been in executing absolute return allocations, and how well they have been served by the industry, is less certain.

The solution is to ignore the absolute return label and focus on what the fund actually does. Make sure it has a meaningful allocation to assets with low correlation to equities and bonds. As concerns grow around near-term prospects for both equities and bonds, the need to get this part of your portfolio right is increasingly important.