Delivering in bull and bear markets

Paul Burgin examines the Absolute Return sector, the second best-selling retail class of 2009. Managers are betting both ways on recovery as they wait for government action on interest rates, economic stimulus and sovereign debt.

This plays to the strengths of the Absolute Return sector which proved the second best-selling retail sector in 2009, maintaining its ranking behind Sterling Corporate Bond for the second year running. Net sales totalled £2.55bn.

The offshore Threadneedle Target Return fund accounted for almost £1bn of that new money. Meanwhile, the Absolute Return Bond, its onshore cousin, added another £400m to the total, according to Financial Express Analytics. Standard Life and Newton also attracted substantial sums.

Investors were tempted by the funds’ abilities to make money in rising and falling markets. By using long/short strategies in a range of asset classes, the average Absolute Return fund gained 8.74% in the year to end January. The Octopus Partner Absolute Return fund run by David Crawford was the best performer, returning 35.11% in the past year.

Just three out of 24 funds were in negative territory. The Thames River Absolute Income fund faltered last year, after three years of positive returns averaging about 5.5% per annum. In the past 12 months, it has dropped to last place, losing 10.91%.

Manager Michael Warren says call writing strategies struggled in sharply rising markets. Over six months the fund is down 4.81%, although Warren says the fund will meet its Libor +2% income and total return objectives this year.

Taking no chances

The Gartmore UK Absolute Return fund launched last April and has returned 8% since then. For 2010, its team is taking no chances on Britain’s economy. The fund has become steadily more cautious as the recovery gets under way – or not, as the case may be.

The balance between a number of long and short positions has been paired back. The fund was net +39% at the end of 2009 and is now down to net +10%. Growth positions have also been reduced over fears the British economic recovery could be knocked off course by volatility and contagion from sovereign debt problems in the EU.

“When volatility spikes we withdraw cash from the market, we need less capital at work,” says Luke Newman, co-manager of the fund.

Newman adds he is also waiting to see whether stimulus measures are the only reason behind the recent green shoots of recovery. He says: “We are at an important point in the cycle and need to see what tools central bankers are going to use. We also need to see how deft they are at removing the stimulus.”

Move to defensives

Since October of last year, the team has shifted away from recovery in the long part of the portfolio to defensive high-quality stocks. Newman believes the likes of Rolls Royce, Compass and Imperial Tobacco are set for a revaluation. “They have good franchises but the market is not differentiating between those companies with high profitability volatility and those where we know how they can grow their earnings,” he says.

Likewise, there has been little differentiation recently between UK-facing companies and those with exposure to overseas markets with greater recovery potential. The fund is now skewed towards London-listed stocks, that derive more earnings from foreign markets, in case the UK consumer and economy take another battering.

Opportunities on the short side tie in with both differentiation themes, focusing on those companies most likely to face cash constraints if the economy takes off or falters.

Newman says: “UK house builders, property stocks and industrials will be hit in recovery, as they need to borrow cash for new jobs and investment. Or they will be hit in a double dip by debt-servicing and balance sheet issues.”

Iain Stewart of the Newton Real Return multi asset fund is also waiting to see how governments react to economic conditions. He says: “As the saying goes, none of them would like to start from here. They know austerity is what they need for a couple of years but do not want to take the risk.”

The risk is deflation as stimulus is withdrawn and public-sector spending shrinks to bring down national debts. In the meantime, authorities run the risk of creating mini-inflationary bubbles as low interest rate policies distort markets, as can be seen in Hong Kong real estate and certain commodities. Stewart says: “You need to be aware of both the deflationary and inflationary risk, so you need a lot of hedges in place.”

Those hedges come with costs attached, but some are worth it. The fund’s euro/US dollar hedge has been used to offset volatility as the weak dollar has been correlated with equity price increases.

Inflation hedge

The fund has inflationary hedge positions in gold, agriculture and index-linked corporates in the UK and USA. Stewart’s currency hedging has also allowed him to take profits several times on gold, which is almost back to its peak in sterling terms.

Bond hedges are being used as a cushion against deflation. Apart from the likes of Norway, the fund has few direct government bond long positions. This could change as Stewart looks to boost weak fund performance year to date. “A move to sovereign-distressed debt could help.

We have already bought a bit of Greece and Lithuania. You have to be quite patient; sovereigns could yield a decent return in time,” he says.

The Henderson Credit Alpha fund is unique in the Absolute Return sector, concentrating only on long/short credit. The fund did well in the past year, rising by 28.51% as investor fixed income demand boosted beta.

With much of the low hanging fruit gone, this year was always going to be busier for the team. They knew 2010 would kick off with plenty of volatility but many of their expected themes played out in the first six weeks. However, there is still plenty to occupy their minds.

The fund was already shorting weakness in the Mediterranean region, with shorts on Spanish debt issued by Banco Sabadell and Banco Popular that finally came good.

Co-manager Thomas Ross says the team has avoided playing Greece directly, but nimble footwork allowed it to play on corporate debt issued by OTE, the Hellenic telecoms operator that counts Deutsche Telekom and the Greek Government as its biggest shareholders. Playing long risk OTE versus Deutsche allows the fund to profit if either party has to prop up the firm.

Other big themes have already been set up within the fund. They include a move into Tier 1 bank debt in the Benelux region. “The rationale was that changes in bank regulation will make these very expensive funding instruments,” Ross says. Banks are likely to exercise their buy-back rights at the first available call dates, or offer exchanges to different structures as British banks have done already.

At the same time, Ross and lead manager Stephen Thariyan have reduced exposure to senior financial debt. Ross expects markets will likely be unable or unwilling to meet the amount of funding banks will need.

While investor demand for corporate bonds was strong in 2009, the team have since sold down their sterling and euro holdings. They believe future demand is unlikely to match the current risk/reward payoff.

Percentage Growth Return over five years