In his most famous speech, John F Kennedy committed the US to land on the moon within the decade “not because it is easy, but because it is hard”. Had he been the chief investment officer of a fund management company, he might have instead opted for “positive returns in any market conditions”.
Turns out getting to the moon and back in something with the computational capacity of a toaster[1] is easier.
This has been the downfall of the IA Targeted Absolute Return sector.
Promising the Moon
Its commitment “positive returns in any market conditions” is ambitious. So ambitious that whomever drafted the sector definition added “returns are not guaranteed”, and that funds “may aim to achieve a return that is more demanding than a ‘greater than zero after fees objective’” in a period no longer than three years.
So, you may make more than nothing over the three-year period. But no guarantee.
Individual funds have beefed up the vaguer performance targets of the sector. One sector leviathan aimed to “exceed the return of six-month GBP LIBOR plus 5% per annum, evaluated over rolling three-year periods (before charges)”; another targeted “a gross return of 5% per annum above UK three-month LIBOR and aims to achieve this with less than half the volatility of global equities… over the same rolling three-year period”; while yet another aimed for “an average annual return of 5% above that of the Bank of England base rate, before the deduction of charges, over a rolling three-year period,” again, with less than half the volatility of global equities.
Five percent above six- or three-month LIBOR, less charges, is where the funds that have dominated the sector tend to be pitched. There is a variety of total expense ratios across the sector, ranging from more than 2% to a few basis points (bps), but the average is 1.3%. Three-month LIBOR is 13 bps at the moment; six-month is 16 bps. Let’s not quibble, and even out to an annualised 4% to be hitting performance targets.
Turning Tide
That promise initially held good, and assets flooded in. From 2013 to 2017, the sector beat all others in net flows. But then the tide turned: the sector has seen net redemptions every quarter but one (Q2 2018) since Q3 2017. From then to the second quarter of this year, it shed £41.7bn. About £45bn remains. One fund alone has suffered £24bn of net outflows over the period. Quarterly figures suggest much of this money circulated around the sector before heading out the door, but negative flows have been unremitting.
Such redemptions indicate the inability of the sector to live up to investors’ expectations. Which begs the question, were those targets viable?
The three-, five- and 10-year annualised average returns for Target Return are 2.6%, 2.5%, and 3%, respectively—somewhat less than the headline figures that attracted investors. Also, as the chart indicates, they have generally done better from the IA’s more “conventional” mixed investment sectors.
Chart 1: IA Targeted Absolute Return v Mixed Investment Annualised Returns, 2001 to 2020 (%)
Source: Refinitiv Lipper
Many Paths, Same Moon
One of the characteristics of this sector is its complexity. We need 23 Lipper classifications to cover the 124 funds within the sector, from long-short equity over a variety of regions to global bonds, which themselves have diverse return characteristics. Alternative Long/Short Equity Global within Target Absolute Return have averaged -9.9%, -6.6% and -1.5% over three, five, and 10 years, respectively. The funds grouped within Alternative Long/Short Equity Europe, however, returned 5.74%, 4.5% and 5.2% for the same periods.
Diversity isn’t necessarily a bad thing. It’s fine to have outcome-orientated sectors, allowing fund managers to figure out how they get there: as the Japanese Zen monk and poet Ikkyu wrote, “Many paths lead from the foot of the mountain, but at the peak we all gaze at the single bright moon”. Ultimately, however—to paraphrase a more recent ditty—while some investors did get a glimpse of the whole of the moon, others felt they’d just been shown a rain-dirty valley, took their cash and left.
Complexity of a product is sometimes used by pundits as a reason not to invest. However, I don’t understand the principle of the jet engine with any clarity, but I still get on the airplane. Or did, back when flying was a less hassle-laden process.
If a jet engine proves to be reliable technology, you’re not going to want to grill the chief engineer at Rolls Royce before trusting yourself to one of their creations. But if things continually go awry—even if it’s just ending up in Kathmandu when you booked a flight to Copenhagen—you’re going to think hard before going through the departure gate.
As the waiter famously asked George Best, where did it all go wrong? Perhaps, when all’s said and done, the sector could never live up to its promises. I’m always a little suspicious of financial engineering that promises that the (albeit moderately) good times will trundle on—and on. They seldom do.
This article was originally published in Portfolio Adviser.
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The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.
[1] My thanks to Hermes fund manager Chi Chan for this valuable insight
