Right on target?

High returns for low volatility should make absolute return funds an obvious candidate for defaults. Paul Farrow finds the jury is still out

Default funds have come in for a barrage of criticism for being laggards, but now those that offer the perceived safety of lifestyling are getting it in the neck too, for protecting people from the stock market at the wrong time. Supporters of absolute return funds on the other hand say they can give pension investors the exposure to equities they need throughout their core accumulation years.

“Absolute return funds have a crucial role to play as a default fund,” says Chris Nichols, investment director for strategic solutions, at Standard Life. He believes lifestyle funds let pension investors down at the very time they need exposure to riskier assets such as shares because they begin to ditch them in favour of bonds.

“It is about getting the bigger return for the bigger risk buck and for members of DC schemes making sure their retirement wealth is intrinsically linked to what happens in the markets in the last five years. The only option to date is to either be in a bond/equity fund for the life of the pension or to do lifestyle,” he says.

He calculates that people who move to a 60:40 equities and bonds split five years from retirement will be 10 per cent worse off than they need to be when they pick up their golden watch and 20 per cent if they move wholesale into bonds.

“The problem is not in the first few years when you only have a small amount in your pension. The problem with lifestyling is that you are moving out of the very assets you need exposure to at this crucial stage but you can’t successfully because of the volatility,” he says. “That’s why absolute return funds have a crucial role to play as a default fund. Equities outperform inflation and we can tap into equity performance with a third of the traditional level of volatility – meaning volatility levels normally associated with bonds.”

Providers such as JPMorgan that are developing products specifically with the DC and GPP markets in mind claim that they have the answer to volatility.

“It is vital that the asset management sector finds a core investment option that is more closely aligned with the needs and expectations of members than traditional ‘relative return’ investment options that have been inherited from the defined benefit market,” says Peter Ball, head of UK institutional business at JPMorgan Asset Management. “We believe that total return funds offer a far better match with member expectations and requirements than traditional DC default/core options such as global equity and balanced funds. Total return funds offer the potential for consistent returns and they actively look to limit downside risk.”

Absolute (or total) returns funds come in different guises and are frequently associated with hedge funds. Managed funds can be given the absolute return tag too, as can some equity only funds with a more focused remit.

But the absolute returns funds Nichols and Ball refer to typically set their own targets, such as to a percentage over cash – this could be anything from 2 percentage points to four. They use cash as their benchmark and aim to outperform standard measures such as Libor by at least 100 basis points before fees, whatever the market conditions. However, several experts wonder whether target return funds aiming to deliver 2.5 per cent above Libor are too conservative and that you have to take more of a punt if you are to deliver equity type returns.

One of the drivers of this new breed of funds -that have already taken off in Europe – are the UCITs III rules which has opened up the investment landscape for fund managers. Funds can now invest in instruments such as derivatives or contracts for difference in a bid to reduce risk and deliver a set return.

Importantly, they also give funds an opportunity to make money when stock markets are falling. Indeed, the advocates of absolute return funds believe they answer the classic conflict of pension member’s key needs. Namely, members want to achieve good returns but they do not want to experience any material fall in their account value.

For most private investors risk is what providers describe as highly ‘symmetrical’- high reward requires high risk, while low risk only generates low reward. And the problem for many investors is that they are uncomfortable with the volatility of equities.

“Extreme market volatility may deter DC scheme members from contributing altogether. What DC members are asking for is ‘asymmetric’ risk – low risk with higher reward. Until recently there were no mainstream DC products that could provide this,” says Ball. “However, we believe this demand for asymmetric risk can now be successfully accommodated through a new generation of funds known as total return funds.”

The propaganda sounds appealing but do absolute return funds deliver and are trustees buying the spiel of providers? The cynics suggest that some providers are actually doing nothing new and are merely rebranding old mixed managed funds, or balanced funds that now purport to be absolute return.

“Some of the funds are not designed to create a risk profile but have been adapted for marketing reasons,” says Crispin Lace, investment director at Watson Wyatt.

But several providers have been attempting to woo private investors in the retail space already with the launch of absolute/total/target returns but the problem so far is that performance is also sketchy. In the summer, Standard & Poor’s Funds Services published damning figures that showed the funds included in S&P’s sector fell short of their return targets after fees, and most failed to match the performance of cash.

With many funds based on fixed-income strategies, the poor performance was been partly blamed on the bond markets, which have suffered a dismal time over the past couple of years thanks to narrowing of spreads.

To be fair S&P added that a few absolute return funds were on course to achieve their targets by year-end and that many were outperforming cash at the time they published the report. It’s true that a few have started to deliver what they say on the tin. A look at the performance tables shows several have delivered more than a 5 per cent return over the past 12 months, but equally many are in negative territory. Indeed only 10 out of 35 onshore and offshore funds listed by Morningstar returned more than 5.75 per cent (the current level of base rate) over the past year. This performance may make them suitable for someone with five years to retirement, but what about those with 30 years to go?

“The fixed income funds generally struggled: Credit Suisse Target Return is one that comes to mind, targeting Baring Directional Bond is another. Both failed to hit their libor + targets,” says Robert Harley, research analyst, Bestinvest. “But the Blackrock UK Absolute Alpha, essentially a UCITs III equity long/short fund, continues to meet performance expectations from an absolute and risk, return point of view.”

The BlackRock Absolute Return fund has returned a healthy 12.88 per cent for example and Aviva Morley has returned 9.3 per cent. UBS has eight funds – mainly Luxembourg-based yet only one has delivered a positive return (4.64 per cent over that period). Its UK Absolute Return Bond is down 0.8 per cent. SWIP has three funds the best of which has returned 5.8 per cent, the other two less than 1 per cent.

Providers are extremely defensive when it comes to commenting on the performance figures. They argue it is early days and that only over a sustained period or a market cycle can the funds be properly judged. They may have a point.

“All investments have ups and downs or periods of better and worse performance – including absolute return funds. They are not a panacea but with the right manager and product these funds offer the potential of achieving positive returns in all market conditions,” says Dermot Keegan, managing director, institutional at Old Mutual Asset Managers.

But performance is not the only stumbling block to absolute return funds. The concept of absolute return funds seems ideal and may also seem simple, but the strategies behind them are far from straightforward. The funds are all structured slightly differently and can be complex. This could present a problem to trustees, employers, advisers and employees.

Take the reaction from IFAs when DWS launched its Ratebuster fund in 2004. Here was a fund offering a potential return of 3 to 4 per cent above base rate. It was promoted as an alternative to a buildings societies savings account and to attempt to generate the return (it failed after a year and was closed when Aberdeen swooped on the company) DWS used a swap arrangement, an integrated alpha platform and currency and duration strategies. One IFA remarked at the time: “I am not sure how I am going to explain that to the client. It’s a Pandora’s box, a bloody nightmare.”

Bestinvest’s Harley agrees that the biggest challenge for absolute return fund providers is “educating the market; ensuring that they realistically manage return expectations and pricing the product properly”, while Paul Gibney, investment partner at Lane Clark Peacock admits that the level of sophistication could be too high for some members.

“But perhaps they could be used as part of a solution and perhaps employees don’t need to understand the inner workings of the fund – just the concept,” says Gibney.

Naturally Nichols is more bullish, insisting that insurers have been running funds with an absolute return philosophy embracing liability management for years. He does admit, however, that communication of the funds is critical to their success – and that they maybe difficult for employees to grasp.

“We have every confidence this will be proven over the long-term – we have been doing it for many years. They have derived from DB thinking – the liability side and its exposure to inflation and interest rates – and the asset side about generating better diversity,” he says.

The take up is also slow at this juncture – Standard Life, for example, has just two DC schemes that have embraced absolute return funds – because “they are untried and untested” according to Lace, who argues that multi asset funds, many of which are absolute return funds in all but name, could steal their thunder.

Traditional cautious managed funds invest in a mix of British equities (up to a maximum of 60 per cent), bonds and cash. But again Ucits III has altered the landscape and given fund groups greater flexibility in terms of asset choice. Funds can now invest in physical property, funds of hedge funds and private equity. All the big fund management groups including Fidelity, Schroders and M&G have adapted their offering as a result.

Lace is not alone in his thoughts and while absolute return funds appear to offer pension investors the perfect scenario, a fund that delivers an equity type return without the risk, they need to prove themselves. It could be a few years before they begin to show up as default funds on company schemes.