This article was originally published on Quadrant Groups website. Quadrant Group was acquired by Progeny in March 2017.

The combination of short-term market uncertainty, human nature and an immediately attractive sounding moniker for an investment is a marketing mans dream. The investment industry has been masterful at constructing and selling such products, not least absolute return products, which employ active management strategies that seek to deliver positive (absolute) returns in any market conditions i.e. up, down or sideways, with minimal losses.

By way of background, in June 2016 net inflow into these funds was 221 million, whereas equity funds suffered withdrawals of around 2.8 billion in the month. In eight out of the twelve months to July 2016, the sector had the highest monthly net retail inflows1, in response to the poor start to the year by equity markets and Brexit worries.

The Investment Association (IA), which represents the fund management industry in the UK, sets a three years horizon over which returns should be expected to always be positive in order to qualify for its absolute return badge. However, it is worth noting that the IA itself states that it:

Recognises that there is a wide expectation among consumers and advisers that funds in the Targeted Absolute Return sector will aim to produce positive returns after twelve month periods.

Yet the reality of being able to deliver on this promise is far from convincing: strategies are varied, complex and hard to compare; fees are high, relative to sensible alternatives; and correlations to underlying assets such as equities and bonds are higher than might be expected.

The Investment Association tracks the performance of funds within the sector by looking at monthly rolling 12-month performance windows over the past 36 months i.e. providing 24, 12-month periods that roll forward one month at a time2. Only four of 75 funds (~5%) with at least 36 months track record had no losses in any twelve month period in the three years to June 2016. At the other end of the spectrum, 15 funds had losses in more than half of the 12-month windows.

Given this outcome, it is perhaps not surprising that the FCA the UK industrys regulator has recently confirmed that it will include absolute return funds in its wider review of the asset management industry and the value that it delivers to consumers.

Over five years to June 2016, the sector average returned 2.4% annualised, compared to 2.1% for short-dated global bonds (hedged to GBP) and almost 11% for developed market equities3. A simple 60/40 balance between global equities and bonds delivered around 7%. While the top 5 funds delivered an average return of 10%, the worst five funds lost money over this period. The sector as a whole has hardly covered itself in glory.

A recent piece of research on absolute return funds in the US4reveals that most active managers add nothing to performance over and above the known market risk premia returns. The research also showed that equity-related strategies exhibit significant exposure to the equity markets and bond strategies exhibit significant exposure to bond markets, despite the freedom and flexibility to mitigate such exposures. As such, losses should be expected from these portfolios when markets get tough. Fees were high, too, with expense ratios ranging from 1% to 2% depending on the strategy.

As ever, the siren songs of the investment industry can draw the naÃve onto the rocks. There is little evidence at the sector level that suggests that absolute return funds really do add something different to traditional portfolios. With exposure to market risks and thus potential losses high fees, and esoteric and complex strategies, most longer-term investors are better off sticking with their traditional, systematically managed portfolios. Short-term market losses are part and parcel of investing and are not uncommon. Those with the fortitude to stay invested and stay the course should be well rewarded. Patience, discipline and fortitude are the values that lead to success in this game. Absolutely!

[2]Investment Association Targeted Absolute Return sector monitoring information, month end: June 2016

[3] Global equities MSCI World Index (net div.); Global short-dated bonds Citigroup World Government Bond index (1 to 5 years) hedged GBP; Global balanced 60/40 60% global equities, 40% Global bonds less 0.25% estimated OCF.

[4] Klement, J., (2016), The Cross-Section of Liquid Absolute Return Funds,The Journal of Index Investing, Winter 2015, Vol. 6, No. 3: pp. 21-32.

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