Targeted Return funds: fact and fallacy
Investors have entrusted most of their savings to asset allocation funds (money market funds excluded), according to the Association for Savings & Investment SA’s (ASISA) fourth quarter 2009 statistics. This sector has the bulk of assets under management (R174,2 billion as at 31 December 2009) and experienced the largest net inflow of R9,1 billion over the December quarter.
Within the asset allocation fund sector, Targeted Absolute and Real Return funds is the second largest subsector by both assets under management and number of accounts. However, according to Dr Prieur du Plessis, Plexus group chairman, these funds are probably the most misunderstood by the investing public.
“The fact is that the investment mandates, performance objectives and investment strategies of funds in this sector differ vastly. If prospective investors do not understand exactly what the fund managers are trying to achieve and how they try to attain their objective, the investor may well end up being disappointed,” says Du Plessis.
“The different investment mandates and performance objectives also result in the portfolio compositions of funds in this sector varying considerably,” he adds. “Some funds invest only in fixed-interest securities (enhanced income funds); some have more balanced portfolios with low equity exposure, while others have relatively high exposure to equities.”
According to Du Plessis, the common denominator categorising targeted return funds is the objective to achieve positive returns over a specified period irrespective of market conditions, while limiting the risk of capital loss as far as possible. “These funds use different investment strategies to achieve this, such as the use of derivative instruments, highly active asset allocation, stringent risk-control measures and share-selection criteria, and exposure to inflation-linked bonds.”
Targeted return funds have absolute benchmarks – namely a benchmark linked to cash or the inflation rate – as opposed to relative benchmarks such as an equity or bond market index. “The benchmarks – or performance objectives – vary considerably: targets range from a modest inflation plus 1% per annum to inflation plus 7% per annum. Investors should thus not compare the performances of these funds with one another without taking into account the funds’ risk characteristics,” warns Du Plessis.
He says investors need to understand that the higher the benchmark or performance objective, the more risk the manager must accept to achieve the objective. “A high performance objective can be achieved only by having relatively high exposure to equities. This ultimately results in higher volatility in returns and a higher probability of capital losses when markets are buffeted by financial instability.”
A study of the returns achieved by the funds in this subsector over the past year ended 31 January 2010 reveals a variance in return from 41% to a paltry 3% – a difference of 38% between the best and worst performers. Even over a longer period of three years, the returns varied from 20,1% to negative 1,8%, an astounding difference of almost 22%.
“The most important consideration for choosing a targeted return fund is its risk-adjusted returns,” says Du Plessis. “A fund that achieves a real return (i.e. after inflation) of 3% per annum with a volatility (or standard deviation) of 10% is a better risk-adjusted performer than a fund that achieves a real return of 4% per annum but with a volatility of 15%.”
Du Plessis advises investors who intend investing in targeted return funds to first determine their investment objectives and then compare the risk-adjusted performance of funds with corresponding objectives. They should also understand the investment strategies of the various funds they are considering, and know how strictly the funds comply with their mandates. Investors who cannot afford or tolerate any significant loss of capital should analyse a fund’s drawdown history, especially during times of financial and economic crisis.
Lastly, investors should accept that is no guarantee that a targeted return fund will achieve its objective all the time. “This is especially true when we experience rare occurrences such as the 2007/2008 credit crisis, which affected virtually all asset classes negatively,” says Du Plessis. “To make matters worse, South African targeted return funds have at the same time been competing against a stubbornly high inflation rate, which makes it extremely difficult for managers to achieve their objectives.”
According to Du Plessis, targeted return funds nevertheless deliver some of the best risk-adjusted returns in the industry and therefore deserve a place in a well-balanced investment portfolio. “Make sure your financial adviser has the necessary expertise and tools at his disposal to make the right choice for you,” says Du Plessis.
