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It would be easy to lose faith in absolute return after it suffered big outflows last year, but value can still be found

Money flooded out of hedge funds in Q4 2018 for the third consecutive quarter. Investors withdrew €20bn during that time frame, leading to total losses of €30bn in 2018, according to Hedge Fund Research, and marking the biggest quarterly outflow for the sector since Q3 2016.

Though the size of the sector remains substantial enough to influence the behaviour of markets, does this trend highlight a decrease in appetite from investors for absolute return?

When considering performance alone its easy to see why these products may have become less desirable. Absolute return strategies averaged a performance of -2.74% and failed to protect the downside during the sell-off at the end of 2018.

During the past three years, the sector has returned a mediocre 0.79%, while most of the long-only strategies especially equities produced double-digit returns.

But performance is not the be-all and end-all in portfolio construction. Absolute return can add value to a strategy by controlling risk and adding diversification.

With valuations on global bond and equity markets at historical highs, return expectations in the medium term for these traditional asset classes are now skewed to negative numbers. Therefore, investors might feel the need to diversify away from relative directional, long-only strategies and invest in absolute return.

Hedge fund strategies such as long/short equity funds can adjust their net and gross exposures to increase or decrease their sensitivity to equity markets.

The same applies for fixed-income arbitrage managers who have the flexibility to generate alpha from bond picking and relative value strategies but also by playing on sensitivity to interest rates (duration) and credit spreads.

Global macro strategies make several bets on directions of different asset classes or markets, expecting the combination of those different macro views to generate a performance independent of the direction of the main asset classes over time.

Absolute return also offers the benefit of understanding risk before investment (ex-ante risk). Most absolute return strategies integrate risk management in the investment process so that the portfolio manager can assess how much absolute risk as measured by volatility is in the portfolio.

Thanks to the portfolio construction process, an absolute return manager can adjust the volatility of the portfolio before implementing an investment decision. Long-only managers dont have this capacity as they can only control the beta, or sensitivity, to the benchmark.

During the Greek debt crisis of 2012, European equity managers were only able to limit the sensitivity of their portfolios relative to the FTSE World Europe by decreasing beta.

However, long-short European equity managers could move their net exposure to zero so that performance only depended on their stockpicking skills and relative value bets, rather than on the direction of the European equity markets.

What we see in chart 1, therefore, comes as no surprise. A more interesting observation is that the volatility of the absolute return sector has been significantly lower than that of mixed assets, even defensive mixed assets.

Funds that solely employ this strategy generally just take long-only positions in securities and asset classes.

However, this on its own is not enough to truly diversify risk and there are many multi-asset funds to be found in this sector that provide a good risk/return when markets are stable, but which are still exposed to the breakdown of correlations in extreme market conditions.

Unsurprisingly, the volatility of the mixed assets sector began picking up just as correlations between bonds and equities started to converge.

We saw this happen in the third quarter of 2018 in the same way it had occurred during the infamous taper tantrum of May 2013.

Absolute return also adds diversification benefits to a portfolio, in addition to its capacity to control risk. These funds have a lower sensitivity to traditional asset classes and can rely on different sources of returns to generate performance.

This feature is highlighted in chart 2, which tracks the R-squared of the absolute return market versus major stock indices.

Despite being slightly skewed towards global equities, on average 50% of returns from the absolute return sector are explained by the equity factor. This skew might also be due to the high number of long-short equity strategies within the sector.

It is evident that absolute return strategies should be considered by investors due to their capacity to control risk and add diversification.

Therefore, this asset class shares many features with cash. However, we believe that instead of sitting on cash, the robustness of their investment process should allow absolute return strategies to generate additional return while maintaining strong risk control.

Looking at the funds with a minimum three-year track record in the sector, 35.6% have generated a positive Sharpe ratio over the past three years. In other words, these funds have justified their extra risk relative to cash by generating excess return.

Looking at funds in the Europe including UK Equity sector and their information ratio relative to the FTSE World Europe Index over the same period, only 8.9% generated a positive information ratio.

This means less than 10% of active European equity funds can justify their excess active risk as measured by the tracking error to generate excess return relative to the FTSE World Europe Index.

The odds are on our side and we believe absolute return is still relevant.

Charles Younes is a research manager at FE Analytics

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