Liquid alternatives, fundamental analysis of companies and responsible investing are three characteristics that differentiate between the worst and the best absolute return funds, according to Latitude Investment Management’s Freddie Lait.
Lait, manager of the offshore Latitude Horizon fund, said that given the lack of excitement over traditional asset classes, such as equities and bonds, investors will increasingly need to look into non-traditional assets to generate returns.
“Because of the bull market that we’ve had for the last 10 or 20 years, expected returns are very low,” said Lait.
“The average return from bonds we are going to make over the next 10 years is 2 per cent and from equities is 5 per cent.
“Both are very much lower than we’ve been used to and that’s before inflation, so if you want to stand out and generate some excess returns for your clients you have to look into non-traditional asset classes.”
Performance of indices over 20yrs
Source: FE Analytics
According to Lait, there has been a big shift in asset allocation by investors globally over the past 10 years, with allocation to alternatives growing from 15 per cent to around 25 per cent today.
However, he noted that in order to achieve the highest possible returns, there are some key boxes that strategies with absolute return frameworks should tick.
Absolute return investing aims to deliver a positive return regardless of markets conditions, he said. Even when markets are falling sharply, absolute return funds can deliver positive gains
To do so, these vehicles tend to use a range of non-traditional investment strategies, which can include short-selling, leverage or alternative investments such as options, derivatives or commodities.
Many well-known absolute return mandates – such as the giant Standard Life Global Absolute Return Strategies fund – tend to use a combination of traditional assets, advanced derivative techniques, pair trading and short positions to minimise volatility for their clients.
In contrast, the manager of the Latitude Horizon fund focuses on avoiding short positions and derivatives, aiming instead for portfolio diversification, bottom-up stock selection and double-digit cash weightings.
According to Lait (pictured), when looking to invest into non-traditional asset classes, the first distinction investors should make is between liquid and illiquid alternatives.
“A lot of private equity is obviously illiquid and it deserves to be, because you are buying an asset or a company that you need to turn around for example and you need a duration of cashflow to keep that going,” he explained.
“Most hedge funds used to be illiquid and there are still a number of them which are very illiquid and don’t deserve to be – they buy liquid securities but lock up your capital and make your capital very hard to get to.” 
Lait added: “Illiquid are less attractive than liquid funds or similar things. If you have a daily or at least weekly liquidity fund, wealth managers won’t talk to you.
“A decade ago, wealth managers would buy quarterly redemption funds and similar strategies, but tolerance of illiquidity has now disappeared.”
One of the benefits of liquid strategies he noted was that they are more transparent than illiquid ones, have lower costs and are favoured by regulators.
In the liquid spectrum, investors can opt for quantitative strategies – such as CTAs (commodity trading advisors or managed futures), macro funds or some diversified growth funds among others –or fundamental funds, where a manager manually picks single stocks.
While the fundamental approach tends to be transparent, Lait noted those funds that pick companies by relying just on quantitative analysis are “a black box”, where investors might not know what they are buying.
“We pick single stocks. We look at the market, the macro environment and make manual assessments of that, so we are not trusting algorithms,” he said. “This is more resource-intensive but it generates better returns.
“At a time when people are turning towards ETFs [exchange-traded funds], CTAs or high-frequency traders, most of the market has moved away from human trades and much more towards these program trades.
“But the fundamental window has opened wider as a result, because all of the quant money is focusing on trying to count these free counts which drives stock volatility hugely and moves stock prices dramatically. This gives patient, long-term fundamental investors a huge advantage,” the manager highlighted.
He said the £62.5m Latitude Horizon fund is constructed with a fundamental approach to absolute return, with half of the portfolio invested in single stocks – including Tesco, Unilever, Google-parent Alphabet, Visa, Sony or Orange – that they tend to own for a decade on average.
“We take a very long-term view investing in great businesses that we believe have a great opportunity for the future,” said Lait.
“What we do when we are thinking five or 10 years ahead is focusing on the quality of the business, the quality of the governance, the stewardship within it, what the culture is like within the business, speaking to HR.
“On the other side we take macro positions by trying to reduce exposures to macro risks. We will never run short positions or option strategies: I’ve done both in my past career and I think they are very good ways to destroy clients’ capital. They are not welcome in this portfolio.”
A final differentiator between fundamental and quantitative absolute return funds or active funds versus passive strategies is the focus on responsible investing and environmental, social & governance (ESG).
“People who do shorting strategies are in and out very frequently so don’t tend to pay attention to ESG and I don’t believe in a quantitative scoring method that says ‘I can quantitatively tell if your business is more ESG-friendly’.
“We don’t believe the numbers are a good representation, you have to meet with managers, you have to assess what they are doing as a business and to try to have that mindset,” Lait said.
Performance of fund vs sector since launch
Source: FE Analytics
Since launch in 2016, DMS Latitude Horizon has delivered a 12.45 per cent total return compared with a 5.32 per cent gain for the average fund in the FO Mixed Asset Flexible sector. It has an ongoing charges figure (OCF) of 1.76 per cent.