Making sense of playing defensive

This article first appeared in Money Marketing on 22 June 2022

“We’re up to our necks in it!” – that was the polite response when I asked for a market outlook from a fund manager I spoke to earlier this month.

Although blunt, you can hardly argue the point as a persistent pandemic, endlessly elevated energy prices and the outbreak of war really have shaken markets.

At the start of the year, I said we’d do well to get mid-single digit returns in 2022, many would snap your hand off for that now.

Take the first quarter of the year as an example of the challenges facing investors. I recently read the best-case scenario for a stock and bonds investor was a loss of 4.5 per cent from high yield bonds*. Every asset class fell, there was nowhere to hide – questions about asset correlation and the death of the 60/40 portfolio are running rife once again.

LF Ruffer Diversified Return co-manager Duncan MacInnes says there have been only five occasions since 1980 where every asset class fell over a quarter, the last of which was back in 1990 – adding that the only real place to hide was conventional assets in commodities*.

Looking at the returns of all Investment Association sectors so far this year confirms the uncertainty, with only a handful registering any sort of positive return. However, it was the performance of the Targeted Absolute Return sector which caught my eye.

A negligible loss of 0.1 per cent on average is nothing to write home about – but it does appear they are delivering on their promise in uncertain times (global equities are down 8 per cent year to date)**, in fact the average targeted absolute return fund is in positive territory over 12 months (1.1 per cent)***.

I’ve talked before about the different types of vehicles in the sector – long-only, long-short, UK centric, global and fixed interest funds just some of the beasts sitting there, it makes no sense at all. Performance has not been what investors expected. The dispersion of returns has also been a significant issue – take 2021 for example, the difference between the best and worst performer is over 50 per cent, with the best performer returning 34 per cent in a calendar year**** – a fair bit of risk needed to be taken to get that in my view.

But sentiment carries a lot of weight for investors and, despite better returns in uncertain times, they’ve not forgiven the sector for its failure to protect investor assets in the past. In fact, retail investors pulled some £900m from the sector in the first four months of this year^.

Much of the poor sentiment is warranted. I’ve been to a few presentations of absolute returns where I simply did not understand the complexities of the strategy (I was by no means alone). Many simply grew significantly in size but failed when things turned against them.

In some defence of the sector, QE has made it harder for companies to fail as borrowing costs have fallen through the floor and have helped lift many equity markets. This means absolute return managers, looking to short losers and buy winners, have been fighting against a rising tide.

Ultimately, the track record of the sector has been so questionable that I feel a couple of additional changes need to be made to change investor perception. First, it could do with stripping down to remove some of the overly complicated and aggressive strategies that still sit among the 100 or so constituents within it – I’m thinking specifically of the quasi hedge-funds, the aggressive long/short vehicles and some funds which just simply invest in the punchier part of the market.

The industry must also help investors understand that attempting to deliver positive returns in all market conditions is doomed to fail – you must accept some risk.

It’s here where Artemis Target Return Bond manager Stephen Snowden’s decision to emphasise the ‘target return’ rather than ‘absolute return’ label comes to mind, because it helps investors understand there are limitations attached. He cites two within his own fund – the first is that bonds are expensive to short (meaning you pay out an income rather than receive one) and that they tend to do best in volatile markets (something we have not seen too much of since the Global Financial Crisis until recently).

Perhaps the best way to think of them is like a soldier with an extra coat of armour – the good ones can withstand more but are by no means immune to damage during battle.

If we are entering a new cycle where political, economic, and inflationary turmoil are rife, we are going to have to start looking more closely for solutions designed for market volatility. There are plenty of good funds in the targeted absolute return sector that are straightforward and do exactly what they say on the tin.

Alongside LF Ruffer Diversified Return, I’d also look at the likes of Blackrock European Absolute Alpha, which has a huge resource behind it and the scope of the European market to find both buy and sell ideas, Sanlam Enterprise, or Janus Henderson Absolute Return.

There are also several attractive targeted absolute return funds in the bond market, including the Artemis fund mentioned earlier. Another consideration is the TwentyFour Absolute Return Credit fund, managed by Chris Bowie, which invests predominantly in investment grade bonds that are due to mature shortly.

*Source: Ruffer: Nowhere to Hide – May 2022
**Source: FE fundinfo, total returns in sterling, IA Targeted Absolute Return sector and the MSCI World, 31 December 2021 to 10 June 2022
***Source: FE fundinfo, total returns in sterling, 11 June 2021 to 11 June 2022
****Source: FE fundinfo, total returns in sterling, calendar year 2021
^Source: Investment Association
^^Source: Artemis – Off Target? The problem with ‘absolute return’ funds

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