Issue: December 2012 / February 2013
Absolute-return products designed to deliver growth
Loftie Botha, portfolio manager at Momentum Asset Management, explains what they’re about.
By definition, absolute return products refer to funds that typically have dual investment objectives: a growth target, such as inflation plus x%, over a rolling three-year period, as well as a risk target, for example, of a low probability of delivering negative returns over any rolling 12-month period. Inflation-linked growth objectives offer two material advantages over relative return objectives in that they are easy to use in strategic planning and useful for monitoring how funds perform against an investor’s ultimate investment objective of inflation-beating growth.
“It is also possible to select an absolute return product that is tailored to target the amount of growth and corresponding level of risk that is required to meet individual investor needs,” says Loftie Botha, portfolio manager at Momentum Asset Management.
Typically, in the traditional/relative approach to investing, after studying the long-term growth history of various asset classes, a static strategic benchmark is determined.The next step is to task a relative return manager with beating this strategic benchmark.Considera scenariowhere the relative return fund manager outperforms the index-based strategic benchmark, despite it being sharply down. Here the fund managermay arguethat,whilst the benchmark dropped by 10%, the fund was “only” down by 8%andthus performed well.However, the client’s growth objectives have clearly not been met.While long-term performance figures frommore volatile balanced productsmay be excellent, a client who entered ata performancepeakor exited at a performance trough would not experience the product’s published long-term growth benefits. It is often better to forego highupsidepotential in exchange for the more subdued, but less volatile, growth that absolute return products offer.
Absolute return managers tend to use a wider variety of strategies than the tactical asset allocation and security selection focus of their relativereturn peers. The main strategies employed are strategic asset allocation, tactical asset allocation, downside protection and security selection.
The chart below illustrates the benefit of a strategic asset allocation analysis that is focused on achieving the growth and protection objectives of a CPI + 5% absolute return fund. For each asset class, the green bars show the probability of achieving the growth objective over the specified 36-month time frame. The red bars illustrate the risk associated with these assets by showing how much they contracted from peak to trough (also known as maximum drawdown) over the Global Financial Crisis (GFC).
For example, equities have a more than 60% probability of meeting the growth objective over the time frame. However, the corresponding downward pointing bar illustrates that equity investors would have lost around 35% from peak to trough during the above-mentioned period, a sharp reminder that high growthoften goes hand in hand with high risk. Blending the asset classes to form a properly constructedabsolute return portfolio (illustrated by the first green and red bar combination), however, shows the benefits of strategic asset allocation. Whilst the absolute return portfolio and equity both havea more than 60% probability of beating the growth target, the absolute return portfolio would have only experienced a drawdown of 7% over the GFC.
As the investment landscape becomes more uncertain, the benefits of investing in absolute return funds, where both the growth and capital protection objectives of the client and asset manager are aligned, are compelling.