Testing times ahead for Absolute Return Funds

Investment returns are uncertain, even those that are ostensibly guaranteed.

And that, says Stephen Roberts, joint MD of Taquanta Asset Managers and head of the group’s Quants asset management operation, is what proponents of Absolute Return Funds (ARFs) may have to grapple with for the first time since these funds were first introduced to the market.

“It’s not surprising that ARFs have become increasingly popular in recent years. Who wouldn’t want to invest in an instrument that promises never to deliver anything less than a positive return?” he asks.

“However, in order to achieve this, the fund has to outperform CPI on a sustained, and sustainable basis, regardless of market conditions. Investors need to remember that not all ARFs are same – while they all seemingly chase the same targets, they use different routes, and asset classes, to get there.”

According to Roberts, investors need to ask themselves is whether their ARF is likely to remain absolute in the face of a sustained market downturn.

He points out that many ARFs are heavily invested in equities. In a bull market, being invested in equities can be regarded as a good strategy as it allows these funds to deliver far more than absolute returns. However, the current bull run could be drawing to a close.

Research shows that over the long term, one can expect the stock market to deliver returns of about 7% above inflation. Over the last three years it has delivered in South Africa about 25% above inflation. It’s therefore reasonable to assume that given the increase in the number of storm clouds on the horizon – the fuel price, rising inflation, the electricity crisis and political uncertainty – a sustained downturn is possible.

“This will provide a real test for ARF and will go a long way towards sorting the truly successful ARFs from the wannabes,” he adds.

At the end of the last bear market in April 2003, 25% of the “absolute return” funds in a major South African institutional survey had achieved negative returns over 12 months. All bar one had substantially underperformed their benchmarks by on average 12%. Those with three year track records had underperformed their benchmarks on average by 3% p.a.

The clearest sign of looming trouble for ARFs occurred in January when the equity market fell some 15% and almost every ARF turned in negative returns.

Things improved in February before dropping back in March – an indication that current market volatility is likely to continue.

Roberts believes that ARF investors who truly want the security and certainty inherent in the very concept of an ARF, need to ensure that their ARF incorporates a large proportion of assets that will give positive returns in all markets.

“Taquanta’s low risk ARF in the institutional surveys – which has never given a negative monthly return - utilises a combination of enhanced cash and other low volatility instruments. This significantly reduces the risk attached to the investment. Certainly, our returns over the past few years have been lower than those achieved by ARFs that have invested heavily in equities – but then their risk profile has been higher. .

“With rising risk of a period of sustained negative returns, the ARF sector could turn up some seriously disappointed investors,” he concludes.