How targeted absolute return strategies work

Let’s start with an in-depth look at absolute return funds. The concept is straightforward: deliver a positive return even as the stock market declines.  While they may share the same broad objective, these funds will be managed differently in terms of their specific targets and approach.

Although some investors focus on a single asset class, such as absolute return fixed income, portfolios in this area span a range of approaches, including fixed income, equity and multi-asset strategies. Their fund managers also use a variety of techniques to achieve positive returns. These include long/short strategies, hedging, and the use of derivatives.

A long position is when shares in a company are bought with the expectation that they’ll rise in value over time. However, shorting is when you profit from an asset’s decline in value. This can be achieved in different ways. One technique is to borrow the asset for a fee, then sell it with the intention of repurchasing it for less than the selling price, before returning it to the original owner.

Potential benefits

The best absolute return funds offer lower volatility relative to equity markets, as well as portfolio diversification. The extra tools at their disposal give managers greater potential to smooth returns than those running traditional equity portfolios. Their benchmark-free, target-based approach also enables them to better tackle sideways-trading or volatile markets. Of course, there is a significant caveat: an absolute return fund’s performance largely depends on its manager’s skills and the risk controls in place.

Key risks & limitations

The first thing to know is that an absolute return fund’s performance isn’t guaranteed. Its aim may be to deliver a positive return in any environment, but this is just an objective. No two absolute funds are identical. There will be differences in philosophy, asset mix, and investment process, which can affect returns.

The strategies employed, such as the use of derivatives, hedging and leverage, can also be complicated, while having the potential to intensify losses if the wrong calls are made. More generally, there’s a risk that some funds may lag strong bull markets, while it’s also worth checking the costs, as they’re usually higher than traditional long-only funds.

Targeted vs total/relative return

It’s essential to understand the differences between targeted absolute return funds and relative-return funds. Although relative return funds aim to outperform a benchmark, this may still result in a negative return if the market is in free fall. Absolute return funds aim to deliver positive returns regardless of whether the stock market is rising or falling. They should also have lower volatility over the long term.

How to evaluate a targeted absolute return fund

They may be in the same IA Targeted Absolute Return sector, but the funds tend to be run very differently in terms of their goals and day-to-day management. Some absolute return funds aim to achieve positive returns over 12 months, while others may focus on rolling three-year periods. This makes it impossible to accurately compare like-with-like. Prospective investors must understand how individual funds operate, what they invest in, and the risks involved.

For example, it’s worth examining their hit rate. This is the percentage of rolling periods in which they’ve met or exceeded their target and highlights their consistency – or otherwise. You should also review the fund’s worst 12-month and three-year periods, as well as how quickly it has recovered from losses. The volatility and risk taken to achieve the returns must also be considered.

Here is our checklist to help you identify the best absolute return funds:

• Be clear on the objective: Over what period is your fund aiming to deliver positive returns?
• Analyse past performance: Have they consistently outperformed in previous rolling periods?
• Understand the risk taken: Look at what they invest in and the strategies used to generate returns.
• Examine the correlation: What is the correlation of the absolute return fund with equities and bonds?
• Know the costs involved: Check you understand how much you’ll be charged for holding this investment.

Where they tend to work (and where not)

The best absolute return funds tend to be helpful in volatile conditions, as a benefit is the potential to reduce portfolio swings. This makes them ideal candidates for today. Political instability, an uncertain economic outlook, unpredictable trade policies, and increased volatility are driving demand for strategies that provide stability. However, they may lag strong, one-directional bull markets. Their behaviour during bear markets, meanwhile, will depend on their strategy and asset allocation.

Portfolio role & position sizing

UK absolute return funds are best used as satellite diversifiers alongside broader, core equity holdings, such as a global income portfolio. Although the allocation to this area will depend on an investor’s goals and risk tolerance, a rough range is 5-15%. However, it’s crucial to constantly rebalance your overall portfolio to reflect absolute return funds’ performances over various rolling periods.

How to invest in the UK

You should clear outstanding debts – particularly those built up on credit cards – before investing, as the interest charged is likely to be higher than the potential returns. It’s also worth keeping an emergency fund set aside in an easy-access account. A cash Individual Savings Account, for example, is the perfect vehicle.

Once these are in place, you can turn your attention to your investment portfolio and determine how much to allocate to absolute return funds. Remember to review the fund’s factsheet, its objective, rolling timeframe, risk and volatility, asset allocation correlations, and the various fees involved.

Once you’ve chosen the best absolute return funds for your needs, the next task is deciding the most suitable investment vehicles. It’s usually best to hold funds in either an Individual Savings Account (ISA) or a Self-Invested Personal Pension (SIPP), depending on your circumstances, as there are tax advantages.

Our process and how we select funds

Research is crucial to finding the best absolute return funds, and FundCalibre’s knowledgeable team can help you reach a conclusion. It analyses more than 3,000 funds and trusts, narrowing the list to 200 preferred portfolios worth considering.

The most trusted are given a prestigious ‘Elite Rating’. Typically, this is awarded to no more than 10% of funds in any sector. The rationale is: the fund is good enough, or it’s not. Fund managers must have at least three years of track record to be considered for inclusion, and risk-adjusted performance is measured using our AlphaQuest quantitative screening tool.

FAQs about TARFs