Could performance from Targeted Absolute Return funds improve?

Targeted Absolute Return funds can help diversify a portfolio, but recent returns from the sector have been lacklustre.

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  1. Rob Morgan

 

One of the best-selling fund sectors in 2016 was IA* Targeted Absolute Return. This is a collection of funds that aim to make positive, albeit usually modest, returns regardless of stock market conditions. They tend to suit investors wishing to adopt a more cautious stance, or those wishing to diversify their portfolios away from assets totally reliant on market performance. However, there is no guarantee these funds will meet their aims and their value can fall as well as rise.

With low interest rates and returns from other asset classes seemingly constrained by a low growth and low inflation environment, many investors have turned to Targeted Absolute Return funds to offer a source of return less predicated on the direction of markets. In addition, ahead of key political events last year, many investors saw reason to dial back risk in their portfolios.

Disappointing short-term performance

As it transpired, caution wasn’t really warranted in 2016. Equity markets continued their upward trajectory despite a fast-changing political scene, and against this backdrop returns from the IA Targeted Return sector were pedestrian. The average fund in the sector gained just 1.1% and investors could be forgiven for feeling somewhat underwhelmed.

Yet you wouldn’t cancel your fire insurance because you haven’t had a fire. Targeted Absolute Return funds could form a valuable component of a diverse portfolio, and come into their own during more troubled times. By protecting capital when asset prices are falling they can help improve overall portfolio performance by reducing volatility. Indeed there are reasons to suppose that returns from the sector might improve going forward.

It is vital, however, to choose any fund carefully to ensure it meets your needs. The sector offers an eclectic mix of strategies and levels of risk, indeed the range of returns in the sector over 2016 varied from +10.8% to -25.6%. Each fund needs to be considered on its own merits and making direct comparisons with others or the peer group as a whole may not be particularly useful.

How do Targeted Absolute Return funds work?

Fund in this sector use sophisticated investment techniques such as short selling (to profit when prices fall). A number of funds in the sector focus on a certain asset class (for example UK equities) and blend traditional “long” positions with “shorts” that benefit from falling prices. The balance between the two determines whether the fund is “net long” or “net short” – or roughly neutral – and the overall exposure to ‘market risk’.

This can vary over time depending on the manager’s outlook, and can certainly differ a lot between funds. Some remain broadly balanced or generally slightly net long, whereas others are prepared to be far more aggressive and take on more market risk.

Other funds blend a variety of trades or strategies together to try and produce a positive return in a wide variety of scenarios. Here the emphasis is more on the ability of the managers to read the economic picture, as well as construct positions that work effectively as a portfolio in terms of diversification and minimising risk.

When assessing Targeted Absolute Return Funds it is important to remember that no matter how good a fund manager’s process is it won’t work all the time. If investment selection is poor, or the manager’s approach is at odds with prevailing trends or sentiment, then investors could experience negative returns. Year-in year-out positive returns from a single absolute fund is therefore not necessarily realistic, and in order to avoid overreliance on a single fund it is best to blend a number together within a portfolio.

The outlook for Targeted Absolute Return funds

There were some important reasons why many Targeted Absolute Return funds struggled in 2016. Some funds whose tactical asset allocation was aligned a specific set of circumstances playing out (for instance the EU referendum or US election results) came unstuck, while for others hedging out foreign currency exposure amidst a weakening pound was costly.

Yet perhaps the biggest issue has been a high level of correlation between asset classes and stock returns within sectors. Put simply, if stocks are moving up and down together in tandem, with little emphasis on company specifics, then it is harder for stock pickers to generate returns, especially if they run a ‘market neutral’ strategy.

This phenomenon of low cross-asset and intra stock/sector dispersion has been attributed to the effects of central bank policies. The creation of additional money through quantitative easing is thought to have led to a ‘rising tide’ of appreciation across many asset classes. If, as is widely expected, we see central bank influence on markets starting to wane then there may be greater dispersion of returns at an asset class and individual stock level going forward. That could provide greater opportunity to managers of Targeted Absolute Return funds to improve performance. For our investment ideas in the sector please refer to our Foundation Fundlist.

*Investment Association

This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in collectives should only be made after reading the Key Investor Information Document, Supplemental Information Document and/or Prospectus. Past performance is not a guide to the future. If you are unsure of the suitability of your investment please seek professional advice. 

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