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9 May 2016

Not all absolute return funds are created equal

Sam Liddle, Church House Investment Management

Absolute return funds have attracted some criticism in recent weeks. The biggest gripe has been that they haven’t protected capital during the first quarter sell-off in markets. While Church House believe that a few months is too short a time to judge any investment, the controversy raises some important points about the nature of absolute return funds and how risk is managed.

Start with cash

To our mind, says Sam, an absolute return fund should have a number of key characteristics. First, it should start with cash: every investment beyond cash should offer a compelling reward potential for an appropriate level of risk.

At the start of this year, we were finding relatively few opportunities that met those criteria and as such, were holding higher weights in cash and near-cash instruments. This proved serendipitous, but our positioning was not because we foresaw a crash, it was simply a reasoned reflection on current valuation levels.

How low can it go?

Absolute return also means ensuring that every investment is made with an awareness of the downside risk (how far it could fall in value) and contributes to the diversification of returns. Standard equity and bond funds can ride market highs and lows, and can claim to have done their job if they lose less than the market. This is not a claim that can reasonably be made with an absolute return fund.

This is important because of the impact significant drawdowns can have on long-term returns. The greater the amount lost, the higher the gain required to break even. While a 10% loss in any one year would require an 11% gain to break even, a 30% loss requires a rise of 43% to break even. In other words, even relatively short-term losses can have a lasting impact on long-term returns. Avoiding these losses is a vitally important feature of any fund that claims to be ‘absolute return’ in nature.

At Church House, we monitor a range of securities at all times, setting alerts when they reach a price we see as attractive, Sam explains. We look very specifically at each stock and we even have processes in place to make sure we are prevented from getting ‘carried away’ with a good idea.

These checks and balances help ensure that we are not as vulnerable to the behavioural traits that can dent returns. A genuinely ‘absolute return’ approach requires measures like these in place. It is important to understand the maximum downside of any position. In the recent market volatility, it is clear that a number of absolute return funds have not been run with these risk measures in place.

View Elite Rated absolute return funds

Using absolute return funds for pension pots

Absolute return funds potentially have an important role to play in decumulation portfolios as part of the new pension rules. A genuine absolute return fund should be able to deliver reliable returns, so that retirees can take regular withdrawals from the total return and still preserve, or even grow, their capital over time. However, they cannot fulfil this role if they are experiencing significant market directionality or drawdowns at any one time.

We believe some of the criticism directed at absolute return funds in recent months tars all funds with the same brush, Sam says. There are funds that protected capital during the recent market volatility, and even used the volatility to their advantage. Investors just have to pick with discernment.

Church House Tenax Absolute Return Strategies is Elite Rated by FundCalibre

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Sam's views are his own and do not constitute financial advice.

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