No certainty with absolute return funds

Responding to my recent post about buying government bonds for diversification, a reader asked if I’d considered using absolute return funds or hedge funds instead.

I have, but only superficially; I’m far from an expert in either kind of fund, but I don’t particularly like what’s on offer, especially as a replacement for bonds.

In this post I’ll consider absolute return funds. Hedge funds we’ll look at some other day, perhaps when I’ve grown less jealous of the anti-hero hedge fund manager John Veals in Sebastian Faulks’ new novel A Week In December, who seems to have a whale of a time throughout the book.

For now here’s an overview of absolute return funds, what they’re meant to do, and why they’re not a substitute for government bonds.

Absolute return funds in a nutshell

Absolute return funds can simultaneously go both long AND short equities or other assets, with the aim of providing a positive return, regardless of whether the stock market goes up or down.

I consider them a sub-class of hedge fund, although the legal definition may be slightly different.

The basic principle of how absolute return funds work is:

• If the fund manager is feeling bullish on the market, he might have say 70% of the fund’s money in shares, and 30% in short positions that will gain if the market falls.

• Alternatively, if he’s bearish these figures could be reversed, so he will gain more from the market falling. He is hedged with his long positions, should he get it wrong.

In reality, the fund’s exact holdings will often be more diverse and complex, and they can use other hedging techniques, too, such as derivatives.

Absolutely fabulous, in theory

The net result of the long/short strategy is meant to be a positive return, regardless of the market’s direction.

Of course, this only works when the fund manager predicts the direction of the market correctly and so gets his long/short allocation right.

Because this is very difficult, some absolute return funds only aim for a positive return over rolling three year periods. This way, even if the manager gets it wrong for a while, the returns are smoothed, and his long/short hedge strategy should prevent the damage being too burdensome in any one year.

The targets can be more complicated. S0me funds might look to beat the returns on “cash + x%” every year, where x varies depending on the testosterone levels of the manager.

Presumably such funds will need to hold a lot of cash or fixed interest to be truly confident of doing this in terrible years – or maybe they simply close the fund if and when they fail. (Cynical? Moi?)

Why might you invest in an absolute return fund?

Absolute return funds are theoretically most useful when the market is falling, since few investors go short shares or the market, and are thus very exposed when a bear market strikes.

In contrast, absolute return funds will generally under-perform in rising markets due to their hedges working against their gains.

A manager who is exceptionally skilled or lucky at picking both long positions and goes short assets that decline even as the market rises may beat a rising market, but I’d put the chances of a regular repeat performance at zero.

But that’s not really a criticism – these funds are not meant to beat the index in both good and bad years. They are ‘simply’ meant to provide a positive return for risk averse investors.

How did they perform in 2008?

Many absolute return funds are pretty new (we’ll see why below) so there’s not a lot of data on their returns.

But according to a report on 2008 by Chelsea Financial Services (quoted here in The Guardian):

Only five of the 19 funds with a one-year track record made positive returns last year. While most lost less than 10%, so beating the rest of the market by a considerable stretch, that still does not meet most investors’ perception of an absolute return fund.

No indeed.

It’s a similar story according to this article on The Motley Fool UK. It uses data from Trustnet to find the average absolute fund lagged the UK stock market index until 2008, then smashed the market with a -1.8% return that year, versus -29.8% for UK shares.

Again it’s not the ‘absolute return’ we’re promised – although I doubt many absolute fund holders would complain if you compare it to the FTSE!

Obviously some absolute return funds did a lot better than average – SVM’s Saltire fund apparently grew by nearly 20% in 2008 – but then we’re down to the old problem of selecting the winners in advance. Very hard, or arguably impossible, so you have to consider the whole class I say.

One absolute certainty – high charges

Like all financial types who get a whiff of the cookie jar, absolute return fund managers aren’t shy of charging high fees.

These fees differ from fund to fund, but 2% a year plus performance fees are pretty standard.

The managers sometimes have some hurdle (say the return from Government bonds, or a flat 5%) that they have to meet before the performance fees are payable. As ever, check the small print.

The main point is that these funds are expensive to hold versus the 0.5% annual charge of a typical UK index tracking fund. And it’s even cheaper to hold government bonds once you’ve paid your dealing fees – it’s free!

A 1.5% a year difference might not sound like much, but if the tracker and the absolute return fund both returned an average of 10% a year before fees on an initial £100,000, then after 20 years:

• The absolute return fund, after 2% fees, would be worth: £466,096

• Subtracting another 2% to reflect performance fees leaves: £320,714

• In contrast, the tracker’s 10% a year minus fees gives: £614,161

An absolute fund manager would argue that the absolute return fund holder has suffered less volatility and has fewer grey hairs as a result, which was presumably what they wanted.

And that’s true, though as we’ve seen these funds still decline in steep bear markets.

But the potential differences in outcomes does outline highlight how expensive such protection from volatility is.

Remember, too, I’m assuming both trackers and funds even out to each return 10% a year.

In reality, I’d bet folding money that the tracker would win even before charges over two decades, assuming reinvested dividends.

Funds or government bonds?

Let’s return to the original question – could you hold these funds to reduce volatility as opposed to government bonds?

The return from government bonds in 2008, according to the Barclays Equity Gilt Study, was:

• 11.79% for UK gilts

• 24.6% for US treasuries

Compared to the deep bear market for equities in both the US and the UK, that’s a stunning result – definitely what I’d call an absolute return!

It’s also rather better than the -1.8% return from the average absolute return fund, although there’s no guarantee bonds will do this well in all bear markets.

Absolute return funds may hold bonds, of course. And to be fair, even a simple portfolio split 50/50 between equities and gilts would still have seen an overall loss in 2008, despite it’s relatively huge government bond weighting.

However charges would be a lot less, as we’ve seen (0.5% for the equities and zip for the gilts), and you’d still see a lot of growth in the good years. The whole point of such asset allocation is to create sort-of-absolute returns, after all.

In conclusion, I don’t see any merit in holding say 20% of my wealth in absolute return funds, versus government bonds. It would probably reduce volatility, but not by much given I’d still have 80% in straight shares – and it would definitely see more of my money going into fund managers’ pockets.

Absolute return funds may make more sense if you put virtually all your money into them (spreading it between several such funds). This way your allocation to the funds is big enough for their return to dominate your performance.

As we’ve seen already, though, you pay a high price for handing over responsibility and avoiding volatility, through both fees and mediocre performance in the good years.

I’d rather wait for a good price for government bonds, and split my money between equities, bonds, and cash as I see fit myself.