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The Absolute Return asset class is an increasingly large and varied universe of investment solutions.  Rather than being categorised by a specific index, or range of investments that a fund invests into, (such as UK Equity), they form an asset class by their outcome objective. Often this means they aim to deliver a specified return, within a set volatility over a rolling period an absolute return target.

The way the fund aims to achieve that return varies greatly across the space. It can target a specific asset class, like an absolute return convertible bond fund, or it can be a multi asset fund. The fund can be long only, or be full of complex derivatives.

Ultimately this leads to plethora of options and the subsequent range of returns and volatilities associated. As such the IA Targeted Return sector has a very different profile to many funds classified into the absolute return space.

Even so, the sector can be simplified into one overarching philosophy that risk and return are inextricably linked. If you take on more risk, then you should expect a larger return over the cycle but with a higher potential downside.

It is only in ourdrawdown solution, Guardianthat absolute return funds feature because the downside protection is so important. Traditional accumulation solutions can achieve optimum risk adjusted returns through vanilla equity and bond allocations. In decumulation however, when regular withdrawals are occurring, the sequence of returns becomes disproportionally more important. Consequently, in decumulation investors require a portfolio that better protects value in times of market stress. Easy you may say, just reduce the volatility, however, in retirement, where investors need to maximise the withdrawal amount from the portfolio, they will need growth as well as downside protection to help replenish the capital being drawn.

The solution that Guardian targets is reduced downside risk for every unit of volatility. One way we achieve this is through the added diversification and capital protection offered from absolute return. The lack of correlation with traditional asset classes can mean absolute return funds protect portfolios when bonds and or equities are struggling.

Over the past 5 years you could be excused for wondering what the benefit of absolute return funds was. Significant positive returns from both bonds and equities negated the need for insurance offered by the sector. The below graphic highlights how the IA Targeted Return sector under-performed both Equities and Gilts thus inclusion in portfolios would have simply dampened returns.

The market backdrop pictured is from an unusual point in history with huge liquidity provided to the market, artificially fueling asset class returns. The source of portfolio protection that absolute return can provide is not valued when the central banks provide the protection themselves. The environment today is however changing. There are concerns that if the US Federal Reserve increases rates too sharply concurrent to the unwinding of Quantitative Easing, both Equities and Bonds could fall simultaneously. Traditional bond and equity portfolios would offer limited protection in this scenario, and this is most costly for investors in decumulation where portfolio declines are realised. The addition of absolute return could offer vital protection.

Absolute return funds offer us uncorrelated returns. They sell themselves on their ability when added to a portfolio of Equities and Bonds, to improve sharp ratios. Consequently, the industry is suggesting that their addition within a basic portfolio will increase the return per unit of risk. The below graphic comes as you may expect, from the literature of a hedge fund. It shows the distribution of returns for a portfolio of 50% stocks and bonds, compared to a portfolio of 30% stocks, 30% bonds and 40% Hedge Funds (absolute return funds). This offers evidence that adding absolute return funds to a portfolio trims the extreme outliers of negative (and positive) returns, precisely what is desired in decumulation strategies.

So I ask again, what is the downside? Given the extended period of low volatility seen in markets, there are few funds in the sector that have been truly tested in times of prolonged market stress.  During the financial crisis, supposedly uncorrelated asset classes reverted to much higher correlation. When risk was dramatically taken off the table, the driver of that risk became irrelevant, and all risky assets moved in unison. Consequently, while todays absolute return funds have extensive risk controls with forward looking scenario tests, it remains unknown as to how they will react in the next big sell off.

Absolute return funds provide an opportunity for a positive return uncorrelated to traditional asset classes. In an environment of easy money they improved sharp ratios but have often dampened returns in the process. Strategic asset allocation should however look through discrete periods and aim to optimise portfolios across the cycle. In solutions where downside protection is paramount, the value of an uncorrelated insurance policy increases. It is true that a large proportion of the industry is untested to sustained market stress, but rather than negate the importance of the sector, it places more importance on the range of funds employed. With a huge variety of underlying strategies that span the risk spectrum, the importance of tailoring your exposure through your choice of funds has never been more important.

The above article is intended to be a topical commentary and should not be construed as financial advice from either the author or Parmenion Capital Partners LLP. If a client wishes to obtain financial advice as to whether an investment is suitable for their needs, they should consult an authorised Financial Adviser. Past performance is not an indicator of future returns.

Any news and/or views expressed within this document are intended as general information only and should not be viewed as a form of personal recommendation. All investment carries risk and it is important you understand this. If you are in any doubt about whether an investment is suitable for you, please contact your financial adviser.

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