Absolute return funds – the truth behind the spin

Averitable universe of investments in the retail arena has been built on a brilliantly simple idea: namely that absolute return funds can produce positive gains in all markets by controlling upside and downside risk using a speculative approach to the markets. Some managers do deliver on the goods, but by and large it’s just marketing spin built on a huge range of differing strategies featuring everything from good old fashioned value investing through to aggressive use of long/short equity portfolios.

You might have guessed from my tone that I have no truck with this nonsense. I don’t like the charges imposed by the fund managers and I’m also hugely suspicious of the innate complexity. If I struggle to know what goes on inside the engine room, what will the ordinary unadventurous investor make of the unexplained risks?

My sense is that most advisers and investors just look at the label on the tin – which says low risk, positive returns – and don’t ask too many more questions. But the idea of risk control and a subtle appreciation of the ebb and flow of liquid, volatile markets is nevertheless valuable. I’d also maintain that a lower risk strategy in mainstream equities can be delivered using a brilliantly simple idea called trend analysis.

I’ve written before about the idea of using moving averages – you don’t have to have a deep understanding of technical analysis to realise that markets tend to move over discernable periods of time in a trend-like fashion. A US analyst called Mebane Faber has been developing a range of simple portfolio ideas that suggest that, when a market moves below its 200-day moving average, investors should start to cut their risk exposure (move to cash) and then wait for a new upward trend to re-engage with the markets.

In the UK a new fund is about to launch that takes this simple idea and builds it into a fund called the IFSL Barclays FTSE 100 Trend Strategy. This OEIC tracks the performance of a total return version of the FTSE 100 (the total return bit means that the dividends are rolled up into the index returns) using a simple risk control mechanism. If the 20-day moving average is above the 250-day trend, the market is in an uptrend, and the fund is 100 per cent allocated to equities. If the 20-day trend is below the 250-day trend, the index is in a downtrend and the fund is in cash. Crucially a “trend” is only established if the up or down indicator remains constant for at least 10 days.

On a biweekly basis the portfolio’s FTSE 100 exposure is adjusted by looking at the volatility of daily returns, the idea being that the more the index moves above its short-term average, the more volatile the market. As volatility increases so does risk, and the managers pull back into cash.

A more elaborate version of the fund that has a Smart tracker feature that uses stop loss trading to control risk on especially volatile days is now being sold, but I’d stick to the main idea. The logic here is powerful, forcing the investor to look at risk through the prism of volatility and momentum. In simple terms, the markets behave rather like a herd – investors in aggregate react to short-term news announcements and adjust their sentiment accordingly. As more positive or negative news piles up, sentiment turns volatile, forcing big moves in either direction as either greed or fear takes hold. Trying to second-guess these moves is a mug’s game and forces you to use emotion as a basis for market timing. The Barclays Capital approach takes the emotion out of the picture and suggests that you simply follow the trend and then retreat into safety when the herd becomes skittish or over-exuberant. When a trend re-establishes itself, you move back into the game and ride the long-term equity risk premium.

What’s particularly attractive about this relatively simple fund for adventurous investors is that BarCap is doing all the hard work of scrutinising the trends for you, although obviously there’s a cost involved with a total expense ratio of about 0.5 per cent. I can’t say that strikes me as a screaming bargain, but it’s a huge improvement on the 2 per cent plus charged by absolute return funds.

Crucially, the idea behind this fund stands up to rigorous academic scrutiny based on long data series of returns. Even efficient markets theorists accept that momentum – the power of the herd moving relentlessly forward or backward – is a clearly established phenomenon that can be captured systematically. Be mechanical and consistent and constantly watch out for the possibility that the system might just stop working if everyone else jumps on the bandwagon.

With only one retail fund using these ideas, I don’t think we’re at saturation point yet, so this BarCap fund might be a great way of buying core UK exposure with an absolute returns skew. The fund’s developers reckon it’s worked in the past – their backtest shows clear outperformance since 2000 – but I’d be sceptical of any past returns data. Instead, I’d ask a simpler question – do you understand the strategy and the risks involved and is it delivered efficiently, mechanically and at low(ish) cost? If it ticks those boxes I’d suggest it’s worthy of further research.

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