The quest for absolute returns...

Despite what some providers would like you to believe, there is nothing mystical or even that new about the concept of 'absolute' return funds - they have been around in one form or another since the advent of pooled funds.

In recent years, absolute return funds have been presented as some kind of new concept in the fundmanagement industry, but in essence, the idea behind such funds lies at the core of what all fund managers should be attempting to do for their clients: to strive to deliver a positive real (inflation adjusted) total return over a reasonable timescale. If a return is not an absolute one, it is ultimately of little use. Investment managers ultimately exist to make the nation's savings grow in real terms.

That said, this decade has seen a rash of absolute return funds launched and this is indeed, in the short term at least, a novelty for much of the industry, as well as investors and intermediaries. Until recently, there has been little demand for funds targeting absolute returns for much of the last few decades, and this has been a function of the investment climate that prevailed for much of that period. This environment led to the mindset of investors, and the architecture which supports them, being focused on 'relative' performance.

The rise of the 'relative' return....

You cannot spend, eat or retire on relative returns. This may sound like common sense, yet the great bulk of investment managers still have their performance assessed in relative terms.

The cult of relative performance is, of course, a 'bull market' phenomenon. Key is the belief that the market's trend is inexorably upwards, as it generally was for the period between 1980 and the turn of the millennium. This was a golden period; sure, equities had their ups and downs but broadly the trend was for falling inflation and interest rates, rising asset prices and a series of relatively mild economic cycles by historic standards. The result was an unprecedented era of strong returns (UK equities returned 20% per annum over the period in aggregate) which became the basis for investors expectations for the future.

Measuring relative returns then, is entirely rational if one believes that the major risk that an investor takes is being 'out of the market', as was the prevailing belief for much of the 1980s, 1990s and at least some of the current decade. It is a fairly simple way of judging who is doing well, and there is no doubt that in periods of falling markets everyone will want to be with a manager who loses them less, particularly if in the long run 'the market' will take care of the absolute return. Indeed in times of supernormal market returns, it is actually more difficult to tell whether the absolute return investor is doing a good job or getting a free ride from a bull market.

Of course it was not just investors' experiences in the equity market that built expectations of substantial investment returns. What might seem a challenging return for the long-term professional investor, of say cash plus 4% or RPI plus 5%, has seemed downright mediocre when compared with most individuals' experience of investing in residential property.

The availability of so much underpriced credit over the last two decades and the tax breaks available to households has conditioned expectations about return that are entirely unrealistic in the longer term. In the UK, particularly, there is a national obsession about property in all its forms that was neatly exploited by banks' headlong dash to grow their mortgage and commercial real-estate loan books. You simply cannot compare the returns on a leveraged investment (particularly if they are tax-free returns) with other types of investment when asset prices are rising. It is only when asset prices start to fall, and/or credit dries up, that the risk in leveraged investing becomes apparent.

Hedge funds led the return to an absolute world

Of course one cannot mention leveraged investing and absolute returns in the same sentence without addressing the subject of hedge funds. In the early days, these vehicles used varying levels of borrowing to multiply the results of good judgement or unsystematic anomalies into returns which appeared to be unrelated to the direction of asset markets generally.

This apparent lack of correlation and resilience (plus the lure of oversized returns) convinced increasing numbers of investors to pay previously unprecedented fee levels to get access to this new 'alternative' asset class. The asset management industry was, unsurprisingly, keen to meet the demand and launched them in droves. A decade or so on, and investors are learning about the risks of leveraged investing once more, and that the average hedge fund, just like the average traditional manager, is highly unlikely to produce above average returns.

A more systematic answer?

Investor and intermediary disillusionment with the average investment manager's inability to divine the future in a predictable enough manner so as to consistently outperform has fuelled the search for more systematic, quantitative approaches that remove the influence of pesky humans.

Passive approaches, which can be accessed for lower fees, were popular in the bull market, but obviously do not allow investors to sidestep 'market risk'. Other quantitative approaches are available and may well be successful individually, but in aggregate (and therefore for the average investor) they tend to be based on historic patterns, relationships or metrics and thus can stop working abruptly if the investment environment changes.

While the future mirrors the past, as tends to be the case in 'trending' environments (such as the period between 1980 and the turn of the century described above) it is more likely that systematic, quant-based approaches to absolute return will gain momentum and pick up adherents and imitators.

A well-publicised example of this phenomenon can be found in the 'diversified' style of investing practised by the giant endowment funds run by the elite US colleges Yale and Harvard. These funds garnered strong returns for many years, attracting significant praise from all quarters and powerful academic support. Not surprisingly, they also spawned an industry of imitators spreading the compelling gospel that a low-risk stream of 'equity-like' returns could be had by the average investor in perpetuity by diversifying amongst a range of traditional and 'alternative assets' using some kind of optimisation model.

The events of 2007/8 have come as a stark reminder that one of the few things that rise in a bear market is correlation; most asset prices fell and diversification did not produce the benefits that were expected by the models. That is not to say, of course, that diversifying is not broadly a prudent thing for an investor to do in the long run, the key, of course, is the price at which any asset is purchased. However, diversifying per se, particularly based on some 'optimised' model of the past, does not provide, however, a systematic answer to the conundrum of how to provide a long term real return.

Despite what much of the fund industry would have us believe, there is no 'secret recipe', no 'new and improved' formula and, importantly, no systematic quantitative model that delivers superior real returns to the average investor. Why? One simple answer is change: the one thing that we can be absolutely sure of in an uncertain world is that the world is constantly changing. Models that depend on the past as a guide to the future only work when things do not change much. When they do, the models tend to malfunction, or at worst, fall over, which the financial industry has recently found out, to its, and everyone else's cost.

Absolute winners

The winners in the absolute-return space are likely to have the same attributes as successful players in any other branch of investment: good ideas and a strong process within which these ideas can be turned into repeatable performance. In the long run, decent absolute returns are more likely to be reliably produced by managers who can access a wider range of assets rather than a single asset class approach.

In the more volatile world in which we now live there is simply no substitute for an active, flexible investment approach that weighs up each type of asset and every investment idea for the right characteristics; those that can allow it to produce positive returns in the investment climate prevailing at the time. This is very different from relatively passive diversification; at times it may be right to be running a fairly narrow portfolio, for example, which is focused on capital preservation rather than overtly seeking returns.

The key role for absolute strategies, then, is as funds for 'all seasons'. This makes them eminently suitable for the wealth management and defined contribution (DC) pension markets as core or default strategies - in the DC space particularly, where the aim is simply to build a pot of money over time with limited risk, giving the fund manager the discipline of an upward-only benchmark. This conditions a much more symmetrical mindset, in terms of making and losing money, which is likely to be closer to the risk appetite of the underlying client.

Those absolute strategies which can genuinely add value should also be able to challenge hedge funds, and particularly funds of hedge funds, in attracting investors who desire simpler, more transparent and lower cost solutions. In the institutional market place, absolute-return strategies that target RPI or cash-plus returns can be a useful tool for the trustees of defined benefit plans in a number of ways. Cash plus 4%, for example, if achieved over the longer term, should satisfy most liabilities.

For schemes where advisers see the asset allocation as crucial, a flexible absolute-oriented strategy can provide a useful 'swing' asset class, sitting between riskier strategies, such as global equity, and the liability matching assets.

Absolute peace of mind

Absolute strategies do, indeed, have a place in client portfolios, particularly in the world we now find ourselves in: one of lower returns, higher volatility and more potential divergence between various asset market returns.

Having decided what kind of approach to absolute return investing is appropriate - and there are a substantial range to choose from, such as TAA-type strategies, diversified growth, absolute bond approaches, equity market-neutral funds, or a combination of all of these etc - recommending a particular absolute return fund to clients turns on an adviser's understanding of the investment culture that underpins each fund manager and the process they have in place to ensure that their best ideas are smoothly and consistently implemented.

The final hurdle is persuading clients that an absolute return of, for example, cash plus 4%, is compelling. This is, however, becoming easier as the market and economic backdrops have weakened and is likely to become even more so in the years ahead. Perhaps what investors need to hear is not that a decent absolute return fund delivered (say) 5% in 2008, but that it outperformed the average UK All Companies fund by 37% (in relative terms)?

Iain Stewart is manager of the Newton Absolute Intrepid fund