The asset management industry is being flooded with so-called absolute return type investments, and their benefits against any disadvantages are not always explained.
Comments Bernard Fick, Head of Alexander Forbes Asset Consultants, Absolute return strategies do provide a welcome change from the traditional peer group approach to benchmarking and performance measurement. As such they can assist pension fund trustees when designing a mandate to suit their funds specific liability profile and investment objectives.
However, while these portfolios may target absolute returns, they do not offer absolute guarantees of performance.
Most major asset management houses offer these products, and they have received a lot of exposure in the press.
An absolute return strategy involves targeting a return objective that is neither related to general investment market returns (for example the FTSE/JSE All Share Index), nor to a peer group (such as the median of the Alexander Forbes Large Manager Watch survey), he explains.
Instead, the targets are fixed in absolute terms. An example would be setting a return target of, say 10% per annum, regardless of any peer group or benchmark.
In the South African context, the objective of such a strategy is typically to achieve a return that is specified in relation to inflation. This seemingly fits in well with investment objectives of trustees of retirement funds, as most of the liabilities of these funds are directly related to inflation: either salary or price inflation, depending on the benefits offered by the fund.
In the absence of a complete asset-liability modelling study, an absolute return strategy may therefore provide some comfort to a board of trustees in that the objective of the portfolio is consistent with some of the major factors that affect the funds liabilities, comments Mr Fick.
However, potential investors should be aware that only a few of these portfolios have achieved their performance targets over recent periods, he warns. The absolute return strategies followed by local managers differ substantially from one another, with a range of targets on offer from as low as inflation to as high as inflation plus 8% p.a.
Two different definitions of inflation are also used, being Headline CPI and CPIX.
Most of the local absolute return portfolios typically invest in the full range of traditional asset classes, which include equities, bonds, cash, and offshore assets. Many portfolios utilise hedge funds for a portion of their offshore assets. The higher the target, the greater the portfolios exposure to equities, which at the same time increases the volatility of returns.
Consequently, these portfolios will attempt to limit the risk of negative returns. Investing mainly in equities with a clear value bias usually does this. The use of derivative instruments also plays an integral part in reducing risk.
As a result of these strategies, absolute return type products are often perceived to be a low risk investment, he says, but in reality there are a number of definite risks involved with these products:
• If the real return target level is set too high, it could result in the manager taking on excessive risk in an attempt to achieve the target;
• Most absolute return portfolios include inflation-linked bonds as a key component. However, as the demand for inflation linked bonds has far exceeded the supply, these are fairly expensive;
• Absolute return portfolios generally maintain a lower exposure to equities compared to traditional balanced portfolios. This underweight exposure could result in absolute return portfolios underperforming if equities outperform;
• Key individuals often form an integral part of the absolute return process, and this adds in a key man risk.
When evaluating absolute return portfolios, investors cannot merely accept that the manager will achieve the return objective. Investors should understand how the portfolio is being managed, and what risks are being taken to achieve the targeted return, says Mr Fick.
Copyright © Insurance Times and Investments® Vol:16.6
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