Issue: February/March 2006
Edutorials
RMB

Absolute Return Funds: What is all the hype about?

Perhaps one of the more frustrating parts of a trustee's job is being told how well their fund has performed when the returns are actually negative. How can a fund have performed well when value has been destroyed? Well, the answer is - it's all relative. A fund that has managed to produce returns which have outperformed the market, has done relatively well. Its returns relative to its benchmark (be it an Index, another fund or a combination of both) are favourable, despite the return being negative. It is the quest for an absolute rather than a relative return that has led to the rise in popularity of absolute return funds.

If one looks at global trends, pension funds have been steadily increasing their investment in absolute return funds since 1997. The pie charts below show the average allocations of global pension funds in 1997, and then in 2003. The biggest movement has been the increased allocation to "other" assets, which is mainly increased investment in absolute return funds.

But what exactly is an absolute return fund?

Often the term "absolute return funds" has been used interchangeably with real return funds and targeted return funds, when in fact they are quite different.

In its purest form, an absolute return fund targets a return above zero.

Real return funds target a given return above inflation, whilst targeted return funds aim to deliver a predetermined target. But common practice, both locally and internationally, is that the term "absolute return funds" refers collectively to real return funds, targeted return funds, and of course, the pure absolute return funds.

Absolute return funds can therefore be defined as any fund which seeks to generate positive returns, irrespective of market conditions. Their focus is to avoid the volatility generally associated with equity and/or bond market investing, whilst providing a degree of capital protection.

What sort of strategies does an absolute return fund use?

A hedge fund is a good example of a true absolute return fund as it aims to deliver positive returns in all market conditions. Hedge funds may use a wide range of strategies which are not available to conventional funds. Most notably these would include shorting (selling a share that the fund doesn't own with the expectation that it can be bought at a lower price in the future before the sale of the share has to be settled), and leverage.

Most of the absolute return funds that we are familiar with in South Africa typically use conventional strategies whilst still focusing on delivering a positive return, irrespective of market conditions. These strategies could include:

  • High exposure to the property sector which is traditionally more defensive
  • Low exposure to the equity sector which is traditionally more volatile
  • Extensive use of derivatives to protect both equity and bonds
  • Extensive use of inflation-linked bonds to provide for inflation
  • Aggressive asset allocation between the various asset classes to protect against downside risk. For example, a large portion of the fund may be switched to cash when falling equity/bond markets are forecast.

When should absolute return funds be used?

Like any product, absolute return funds should be used with the relevant needs of the investor in mind. They are typically appropriate when:

  • The liabilities of a pension fund require a reasonable predictability of returns
  • Capital loss needs to be minimised. (In this instance it is important to ensure that the product in question does provide the necessary downside protection)
  • The investment horizon is short-term. Absolute return products should generally not be used alone over a long time frame. This is because they are unlikely to provide enough money for retirement in the longer term as they may hold too little equities for real growth.

Asset Allocation of Institutional Investors


Pension Funds

1997

2003

Source: IMF Global Financial Stability Report, Sept '05

Factors fo assess when choosing an absolute return fund

The majority of South African absolute return funds have been launched during the last few years, when equity markets have been rising. Until we have experienced falling equity markets over a protracted period, it is difficult to measure the success of these products. A true absolute return fund should offer downside protection during falling markets, as opposed to a conventional balanced fund simply sold as an absolute return fund. But in the meanwhile, some of the factors to consider when choosing an absolute return fund are:

  • What strategies, if any, are in place for downside protection?
  • Over what time period is the absolute return to be delivered? (This should typically be one to three years)
  • How much exposure to a rising equity market does the fund have?

Used appropriately, absolute return funds can form an essential part of an investment portfolio, especially in uncertain markets. It is, however, very important to ensure that any absolute return fund chosen really does meet your risk profile and investment horizon. Understanding the various absolute return products available in the market, the objectives they seek to achieve, and the various strategies they employ, assists in ensuring that the appropriate product is chosen.

www.rmbam.co.za info@rmbam.co.za