The growth of "absolute return" funds over the past few years can in part be put down to their optimistic title as well as some fortunate timing with unsettled equity markets. However, despite this popularity many are confused and there does not even seem to be a clearly agreed definition of them.
My interpretation is that the basis for such a structure is to try and take people away from their slavish addiction to benchmarks and to replace it with another potentially more logical measure – "cash return plus a bit". Or, to put it another way, can the manager beat a cash account with a decent margin above it.
In order to achieve this, the manager can now start to apply newly available tools not previously permitted under Undertakings for Collective Investment in Transferable Securities (UCITS – the name given by the EU to pan-European investment funds) rules.
Normally most managed funds managers can only generate positive returns when markets and their values are rising – which is obviously somewhat difficult at present.
However, with the ability to take both short and long positions this provides a great opportunity to take advantage of moving markets in either direction. These structures were previously only really recognised in the world of hedge fund managers and their very high net worth investors.
The new rules permit extensive use of financial derivatives including, swaps, options and futures; it thus opens the door for bullish managers to enter an area of far greater complexity as well as opportunity.
However, may I also caution how many managers have struggled to reach their intended goals with simple long-only structures. Consequently, what evidence do we have that any of them have the ability to do any better with even more toys to play with?
Just having access to more toys has never been a key reason for longer term investment success. Perhaps this is a timely moment to remind ourselves of the old benefits and disciplines of asset allocation and its impact on returns over a longer term.
Asset allocation should not be ignored and the UCITS iii directive has provided a further liberalisation by allowing these new funds to extend the reach in terms of inclusion of other asset classes, with commodities being a prime example given their prominence over the past few years.
Effectively, what the loosening of the UCITS iii rules has done has been to liberate the fund managers and in theory provide them with the ability to outperform the traditional long-only managers.
It is important to point out that UCITS iii is not a "carte blanche" for managers to turn into free ranging hedge managers. The regulations quite rightly highlight the vital risk management procedures that should be employed by absolute return managers.
My concern is that certain managers charged with absolute return mandates may have the willingness and enthusiasm, but will they really have had the experience, understanding and appreciation of these investment tools and techniques, and most importantly of all the management of the risk involved?
Investing is the easy bit – managing the risk to the downside is far more complicated. Of course, not all absolute return funds have to be high risk. In fact many can be regarded as having a very defensive measure. It really depends just how much over return they feel they can truly expect to give over and above their cash return target.
The obvious ability to take advantage of market movements both up and down must have its attractions, but investors may be quite cynical over managers to call markets in such volatile times. After all was it not "time in the market" rather than "timing the market" that was always so crucial?
Just because our language can imply that an absolute return is a positive return, perhaps we should also remind ourselves that some absolute return funds have returned absolutely nothing.