Why choose an absolute return strategy

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While absolute return strategies seek to even out investment peaks and troughs by targeting consistently positive performance, can they deliver investor needs in the longer term? Here we consider the range of assets available within absolute return investing and some of their key strengths.

We live in strange times. Now more than ever it is clear that investing in financial assets, and particularly shares, can leave investors’ money vulnerable to the market setbacks that accompany the inevitable dips in the economic cycle.

Rates of economic growth never plot a straight line and informed investors realise that “bust” can follow “boom” as relentlessly as night follows day. And anyone telling you that “it’s different this time” is likely to be guilty of extreme wishful thinking. Many of us will remember, for instance, how the “brave new world” of the technology revolution at the turn of the millennium came tumbling down around our ears.

Softening the impact of those damaging market routs is probably the most effective way of preserving capital and building higher investment returns over the long term. Otherwise, the maths can be sobering. Say, for example, you invest £10,000 and the market subsequently falls by 50 per cent. To make up your losses, the market would then have to grow by 100 per cent.

The traditional ‘shock absorber’ solution is the balanced portfolio. It aims to spread risk as widely as possible by investing in a mix of assets: shares to generate attractive returns in the good times and government bonds to act as a buffer in the bad. This can work well when government bonds perform as you’d expect by rising in times of uncertainty. But what if they don’t?

The last decade or so has seen a new trend as government bonds and shares have performed more closely in line with each other. This closer correlation has partly been a consequence of quantitative easing and the unprecedented response of the world’s major central banks in their bid to shore up the global economy in the wake of 2008 global financial crisis.

With interest rates having been slashed to rock-bottom and with literally trillions of dollars being recycled into the financial system, bond prices have been inflated to such a degree that their status as an investment ‘safe-haven’ has almost been brought into disrepute.

Another important side-effect of sustained central bank support has been stubbornly low inflation. This came as an unwelcome surprise to the decision-makers and, as a result, economic growth outside some of the more dynamic emerging countries such as India has slowed to a relative crawl. What we see now, therefore, is an extended cycle of unspectacular growth, which is unlikely to change any time soon given the degree to which markets have become hooked on the ‘medicine’ of central bank intervention.

The danger for investors is that this environment offers limited upside potential for shares but considerable downside potential for overvalued bonds. So how can investors respond?

One option is the absolute return approach. Instead of riding out the economic cycle, an absolute return strategy seeks to even out its peaks and troughs by targeting consistently positive performance. If it works as designed, it might not capture all the upside when assets are rallying but it should reduce the destructive impact of market sell-offs on what investors get back in the long run.

The key to achieving this objective is flexibility. Unlike the classic balanced portfolio, which typically has fixed allocations to different types of assets, an absolute return strategy is free to go “off piste”, dynamically seeking out the investment ideas best suited to the prevailing economic conditions.

In practical terms these ideas will often be crystallised into two distinct groupings of assets: one that seeks to protect capital and one that seeks to generate capital growth. While this may echo the traditional balanced portfolio approach, there is a key difference in that the assets within these respective “pots” are not prescriptive. There is no reason, for instance, that government bonds couldn’t be used as growth generators if the fund manager saw a compelling reason to do so.

The array of assets available to absolute return strategies offers the fund manager a wide range of options. Whereas a traditional balanced portfolio usually restricts itself to bonds, shares, cash and perhaps some commercial property, absolute return funds dip into an eclectic tool-box that could extend to strategies taking views on currencies, commodities, gold and even alternative themes such as infrastructure and renewable energy. It also important to note that the fund manager also has the freedom to invest in derivative strategies that stand to benefit explicitly when conventional assets are falling in value.

The focus on a positive return, come what may, has meant that absolute return strategies have broken away from the straitjacket of prescribed asset allocations. Instead, many have targeted a fixed rate of annual growth above what investors would expect to receive risk-free.

These targets may in some cases represent an aspiration rather than a reality. However, it cannot be denied that some have been conspicuously successful at navigating their investors through a most turbulent decade in terms of markets, politics and economics. For investors wishing to either reduce the overall risk of their investments or build a solid core position within a broader portfolio, an absolute return fund merits strong consideration.

The value of investments can fall. Investors may not get back the amount invested.

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