I remember coming out of the 2008 financial crisis and thinking that the investment world had changed forever and we need to be aware of the change that was coming if it hadn’t already arrived. The big change was dictated by the behaviour of central banks, with interest rates cut to all-time lows and the starting of an experiment called quantitative easing.
The thinking amongst investors at the time was that bonds, especially government bonds, were now a ‘dead’ asset class as interest rates were too low to provide income or diversification benefits and that we had to prepare for inflation due to the scale of money ‘printed’ by central banks. What was the solution to this ‘new world’?
It was an asset class that up to that point was a ‘scary’ sector called hedge funds however with some clever marketing it was rebranded as ‘absolute return’ for retail investors. It was the holy grail for investors as it provided positive real returns with low volatility and no correlation to equity or the now ‘dangerous’ bond market. Swap bonds for absolute return. Perfect.
I’ve spent a lot of the last ten years or so reviewing and analysing these ‘solutions’. They are effectively regulated hedge funds, that try and balance out (hedge) risks to provide smoother returns. They are often complex and it can be difficult to judge the true levels of risk and potential return. We have just completed a call with the management team of the one asset we do own for clients in this area. I reviewed the performance of this asset against eleven other, very well known, high profile funds in the ‘absolute return’ sector. The twelve funds between them have over £35bn of assets.
How many generated a double digit return for clients over the past five years (a 2% per annum simple return)?
Seven of them hadn’t managed total returns of 5% over that five year period. The Investment Association Targeted Absolute Return sector has generated returns of 1.15% over the last five years and 2.19% over the last ten years (both per annum, up to the end of August). The reasons for the underwhelming performance are numerous; one of them in my opinion is that they don’t take enough risk. How about those ‘dangerous’ bonds that we’d been warned about? It doesn’t matter if you look at sterling corporate or government bonds, you’ve been very well rewarded for owning these over the last five and ten years. So what about the next ten years? Should we acknowledge the mistake and sell absolute return and buy government bonds?
I wish it were that simple. If investors were worried about the potential of bonds to provide income and diversification following the 2008 crisis, they are doubly worried now. The problem we have now is that from a pure mathematics perspective, it’s very difficult for government bonds to offer similar levels of return to that of the last ten or twenty years.
However, in our opinion, they do still offer diversification benefits, as in times of stress interest rate expectations usually fall (unless the stress is caused by rising interest rates). The other benefit of government bonds is that I know how they will behave from a risk and return perspective depending on market conditions. Therefore we do still own some government bonds, however you have to make sure you understand your positioning and how it fits into your portfolio construction.
I have no idea how absolute return will perform in any market condition and the sector might not add to diversification benefits or provide improved returns. I do think investors have and continue to place too much faith in the supposed holy grail of the ‘solution’ that is absolute return.
There isn’t a single solution for clients requiring positive real returns with low volatility and no correlation to equity or bond markets. It requires investors to understand how different assets behave with each other in portfolio construction. Equity and bonds still work as do other assets such as infrastructure and gold. There are 143 funds in the ‘Cautious’ investment association sector, which have between 20-60% invested in equity markets. Of these 143 funds, only two have performed worse than the IA Absolute Return average over the last five years.
Sometimes the best solutions are the simplest.
Thanks for reading and