Do Absolute Return Funds Live Up To Their Names?

An absolute return fund is a principal rather than a style. Funds that adopt such an approach seek to make positive returns regardless of market movements. The term ‘absolute’ is used to distinguish the difference between the relative returns approach used by most funds, which aim to outperform peers and/or the market as measured by a benchmark, such as the Hang Seng index. Since the market sell-off in 2008, these funds have become very popular as investors seek out funds that can protect them when markets are negative.

How does it work?

Absolute return funds aim to deliver positive returns in any market conditions by taking tactical market positions. There is a large range of investment strategies when it comes to absolute return funds: some hold equities, some hold cash and bonds, and many employ strategies that differ from traditional funds, such as derivatives, shorting, leverage and other alternative investments to pursue their goals.

Funds that target an absolute return have a number of distinguishing characteristics. Tactically shifting between equities and cash and fixed interest is a common trait as many of these funds seek to dial up the risk when they believe the environment is attractive for equities or shift into fixed income and cash when they believe equity markets will decline. Being nimble is the key.

Short selling is also common practice for some absolute return funds. Here, fund managers sell securities short that they believe will fall in price over time. Short selling allows managers to make money even in down markets. These funds generally produce high portfolio turnover, as managers actively buy and sell securities in an effort to profit from short-term investment opportunities.

The Problem with Absolute Return Funds

Do a quick search on the Morningstar database and you will find 23 funds with "absolute" or “tactical” in their names available for sale in Asia, in which 6 of these were launched in the last couple of years. However, this number is inexact due to the broad nature of the strategy. In addition, there are some cases in which absolute return techniques are employed but are not considered as absolute return funds, such as the ISF Asian Total Return from Schroders. Fund manager Robin Parbrook says that this is because it is impossible to meet Schroders’ standard definition of these funds, i.e. making no material losses over rolling 12-month periods, due to Asian market’s volatile nature. At Morningstar, we share this view that absolute return funds often fail to deliver on their promises.

The clear appeal of absolute return funds is its promise to make money even when markets go down, and so it is no wonder that these funds have enjoyed a burst of popularity since the financial crisis in 2008. However, track records show that absolute return funds have mostly failed to provide much protection in volatile markets; absolute return fund have generally produced returns in-line with the underlying markets. This was most evident during the market downturns in 2008 and 2011, when the average performance of the 23 funds was -19.50% and -4.50% respectively.

To illustrate our point you only need to look at performance in 2011: only 6 out of the 23 funds delivered positive annual returns for the year. One of the worst performers was Hwang Absolute Return, which made a loss of -17.96 percent. The fund has produced negative returns almost every year since inception in 2007, 2009 was the only time this fund finished a year in positive territory with a tail wind of a strong stock market rally. Some managers may argue that investors should focus on track records over a longer time horizon, and indeed the statistics have shown that most funds have generated positive returns over a 3-year period. But this is misleading, as the success was mostly attributable to the strong economy in 2009 – while investors are really looking for positive returns when the markets are falling.

On the other hand, not all hope is lost. The euro-denominated MFS Meridian Absolute Return fund managed to deliver positive returns consistently over the past five years, while charging reasonable management fees.  This fund differentiated itself in years past by heavily investing in fixed income and taking smaller positions in equities.

Given the broad spectrum of investment strategies that absolute return funds employ, it is difficult to determine the number of true absolute return funds in Asia and their value as an asset class – as with any class of funds, each offering should be judged based on its individual merit. This being said, one thing is almost a certainty: many absolute return funds do not live up to their names, and investors who are lured by the perception of that these funds will deliver positive performance under all market conditions are likely to be disappointed.