Absolute return funds have tended to disappoint in recent years but there are still a number of attractive strategies that could live up expectations, according Waverton’s Luke Hyde-Smith. 
For a time, absolute return funds were some of the most heavily-bought products in the UK market as investors looked for strategies that were uncorrelated to traditional asset classes and could generate a positive return in any market environment.
However, the modest returns were disappointing when compared with the soaring markets of the post-financial crisis bull run and many went on to post negative returns – albeit smaller ones – during sell-offs.
Performance of absolute return funds vs FTSE All Share over 10yrs
Source: FE Analytics
Luke Hyde-Smith, head of third-party fund selection at Waverton Investment Management, said a combination of factors have led to the underperformance of some absolute return funds in recent years.
Hyde-Smith argued that some have “over-promised and under-delivered”: “Many funds in the absolute return sector set overly ambitious performance objectives which have proved extremely difficult to meet. Some have been running with very low levels of risk in order to protect investor capital but have failed to generate sufficient return.”
In addition, the assets under management of some absolute return funds rose sharply during those years of high inflows, which the manager argued can restrict their ability to generate alpha.
Another factor is that some of the sector’s popular funds have undergone changes to their team and company structure, which can impact their processes.
Meanwhile, central bank policy over recent years has affected the macro environment and asset class pricing, adding to absolute return funds’ challenges in generating alpha. “One example of this is the unstable correlation between gilts and the FTSE, which historically has displayed a consistently negative correlation for many years,” he added.
Some investors may have been further disappointed by absolute return funds’ performance in the opening quarter of 2020, when markets dropped as the coronavirus pandemic forced the global economy into lockdown.
Hyde-Smith cited the Kepler Absolute Hedge report, which shows that all UCITS III absolute return sectors delivered negative returns in 2020’s opening quarter. The worst sector was multi-asset, where the average strategy was down 9.6 per cent, while the best was managed futures’ fall of just 0.1 per cent.
However, as the chart below highlights, there was wide divergence in performance across absolute returns sectors which the manager said shows “selection matters in this space”.
Absolute return funds’ return dispersion in Q1 2020
Source: Kepler Absolute Hedge Q1 2020
Hyde-Smith is co-manager of the Waverton Absolute Return fund, which is a fund-of-funds product that builds its portfolio from other absolute return strategies. Over 2020 to date, it has made a loss of 0.81 per cent, compared with a 2.72 per cent fall from the average member of the IA Targeted Absolute Return sector.
When looking for suitable absolute return funds, the manager seeks out strategies that aim to deliver positive returns on a 12-month rolling basis, display low volatility and have a low correlation to the broad equity market.
“We seek to identify absolute return funds aiming to generate a positive return in the majority of market environments and protect the portfolio in periods of market stress. We seek genuinely active, differentiated funds and listed investment companies, managed by experienced managers with a sound investment philosophy,” he explained.
“We seek to invest with the highest quality investment managers selected from across the marketplace, whom we believe have a robust and repeatable process, together with a clear alignment of interests between the manager and investors, warranting the long-term capital of our clients.
“We tend to avoid funds with a large AUM focused approach, over-engineered investment approaches and instability in the team or corporate structure.”
Hyde-Smith also highlighted three funds that display ““attractive volatility dampening characteristics” – all of which posted positive returns in March and April 2020.
BMO Real Estate Equity Market Neutral
His first pick is the Alban Lhonneur and Marcus Phayre-Mudge’s €294m BMO Real Estate Equity Market Neutral fund. This strategy was launched in 2012 as the UCITS version of the Thames River Longstone hedge fund.
“Taken back under the management of Marcus and Alban in October 2013, the strategy has delivered to date on the low risk, uncorrelated, market neutral investment objective,” Hyde-Smith said.
“Both Marcus and Alban are experienced investors within the property equity sector and have established an enviable track record in the full range of strategies they manage. This fund provides a low beta means to access the opportunity set, with no yield and is therefore ideally suited to lower risk investment strategies and the absolute return strategy.”
Performance of funds over 2020
Source: FE Analytics
DCI Market Neutral Credit
This $128m credit market neutral strategy aims for zero credit beta with the goal of low drawdowns and volatility, with its portfolio comprising long/short individual CDS credit positions.
“The firm positions the long book in lower default-probability names with the exposure to the most positive mispriced/alpha names and higher default-probability names on the short side with exposure to the most negative mispricing/alpha exposures,” the Waverton manager explained.
“High quality credit approach, with robust market leading credit analysis which had delivered alpha on both the long-only product and the long/short credit market natural fund.”
Montlake Crabel Gemini
Hyde-Smith’s third pick is the $491m Montlake Crabel Gemini fund. It is run by managed futures trading firm Crabel, which has delivered 25 years of successful uncorrelated returns through a quantitative short-term trading approach.
“The fund exploits pricing inefficiency driven by the absence of large bank prop desks post the global financial crisis and large passive institutional investor flow. Uniquely within the quantitative ‘CTA’ space the fund benefits from ‘volatility break out’ or ‘trend reversal’ just when many strategies will suffer,” he added.
“Highly diversified, the strategy seeks to maximise returns for a 10 per cent per annum long-term volatility and is just as focused on downside risk as upside participation. Long-term strategy returns across the Crabel funds have been impressive and the UCITS has delivered impressive returns since launch.”