Absolute Return Funds: A rare balance of growth and risk
Numbers don’t lie. An article published on citywire.co.za last week noted that in recent times the ‘Absolute Return’ funds available to South African institutional investors have largely failed to achieve their CPI-related performance targets.
This is a legitimate observation (returns matter), but we’d like to highlight a few more nuances in Absolute Return fund performance: market context, risk management in volatile markets, and the selection of an appropriate benchmark.
The reason this category of funds was launched was to meet a specific need: to protect the real value of investors’ capital against inflation and short-term drawdowns. Many investors are both averse to drawdowns and aware of the corrosive effect of inflation on the purchasing power of their savings. The prospect of a portfolio that grows faster than inflation over the medium to long term, with relatively little risk of drawdowns, is therefore highly attractive to investors, particularly those at a certain stage of life.
The article quotes the Alexander Forbes survey dated 31 March 2023 which shows that none of the six funds targeting an annualised return of CPI +6% achieved it over the past five years. We are not making excuses for the industry, but when an entire category fails to hit a target, it is fair to wonder whether the target was achievable in the first place. Most, if not all, Absolute Return funds fall under Regulation 28, so there are restrictions on the asset classes they can allocate to. If their permitted asset classes are not producing enough positive return, even the most brilliant asset allocator will struggle to deliver a given level of absolute return. Also, achieving absolute returns is significantly easier if a fund is allowed to short assets in falling markets and use leverage to amplify high-conviction positions. The six funds that failed to meet that CPI +6% target are unable to do either.
We agree it is fair that managers who promise to outperform an index benchmark should be judged on their ability to do so, since it is always possible to beat an index. But during certain market conditions, it may be impossible to achieve a ‘CPI plus’ benchmark. An Absolute Return portfolio manager chasing a ‘CPI plus’ target using asset classes which follow a random walk is, in a sense, like a sailor committing to an arrival time without knowing what the wind will do. This reality does not compromise the value of Absolute Return as an investment mandate, but rather provides a proper context for investors to assess the category’s performance. Absolute Return managers who are pursuing the same return target should certainly be judged against one another. It makes less sense to judge them simply on whether they hit their target without considering the returns available from their underlying asset classes during that time.
This obviously raises the question whether the higher ‘CPI plus’ targets are appropriate in a world of higher inflation and lower asset returns (this is definitely a point worth exploring in another article). CPI +6% certainly feels like a mountain to climb when South African equities, the ‘growth’ driver of any multi-asset portfolio, have only beaten inflation by 6.5% over the very long term, global equities by 5.5% and EM equities by 6% annualised. STANLIB’s Multi-Strategy team has long been of the view that forward-looking returns are likely to be lower. As the following chart indicates, five-year trailing returns generated by the dominant multi-asset strategies in South Africa have collapsed over the last 15 years. We think that the classic ‘60/40’ balanced fund will only deliver an annualised return of circa 8% over the next 10 years.
Returns structurally lower?
Source: Morningstar, STANLIB Multi-Strategy, data as at 28 February 2023, South African ASISISA Classification
Capital markets theory states that if two assets achieve an identical return, the one that achieves those returns with fewer and smaller drawdowns (or lower volatility) is the more valuable. Even if Absolute Return funds have missed their ‘CPI plus’ return targets, some of them have still grown their investors’ capital with lower volatility than any of the underlying asset classes.
To illustrate what Absolute Return funds can achieve, we consider STANLIB’s Absolute Plus Fund, a long-only, Reg 28 strategy with a track record of almost eight years under the current portfolio managers. Over five years, the fund underperformed its CPI +5% target by six basis points (gross of fees and based on the Alex Forbes survey). But consider its return against the relevant underlying asset classes in the same period: the fund delivered an annualised gross return of 9.4% against SA Bonds (i.e. the FTSE/JSE All Bond Index) with an annualised return of 6.9%, SA Equity (JSE FTSE All-Share Index) 10.4%, Global Bonds (Bloomberg Global Aggregate) 6.2% and Global Equity (MSCI World) 17.4% in rands.
As discussed above, an investment’s value can only be properly understood if its performance is seen in the context of the volatility that it experienced. Seen in this light, the quality of the STANLIB Absolute Plus fund’s return is notable: its annualised volatility of 6.5% was one of the lowest in its sector (as was its maximum drawdown). To put this in context, SA Bonds experienced an annualised volatility of 8% over the same period, SA Equity 16.8%, Global Bonds 15.1% and Global Equity 16.5%. Basically, the STANLIB Absolute Plus fund delivered a return close to that of SA Equity with less volatility than bonds. This performance is even more significant considering the fund is committed to avoiding a drawdown over any 12-month period, and capital protection comes with a cost, whether cash or opportunity.
Looking over a longer time horizon, since the current portfolio management team took over in July 2015, the STANLIB Absolute Plus fund has missed its CPI +5% target but matched the return of the SA Equity market and beaten the median return of each of the three classes of Multi-Asset (Low, Medium and High Equity). The fund has an annualised return of 8.6% with volatility of 5.8% while SA Equity returned 8.7% with almost three times as much volatility (15.1%) and SA Bonds returned 8%, also with a higher volatility of 8%. The fund may have missed its target, but it cannot be argued that it has not created objective value for its investors.
Portfolio Theory states that in efficient markets greater returns can only be achieved by taking greater risks, so any fund which can generate equity-type returns with the volatility of fixed income must be a valuable component of an investor’s portfolio. This rare balance of growth and risk delivers value to investors who understand the corrosive effect of drawdowns and allows them to take more risk elsewhere in their portfolios, putting more cash to work in longer term strategies, like pure equities or illiquid assets, without compromising liquidity or returns. In the language of Portfolio Theory, they can shift their efficient frontier up and to the left.
In STANLIB’s Multi Strategy Investment Team we believe that Absolute Return portfolios can solve a specific problem and will continue to offer them to clients who appreciate the strong risk-adjusted returns that it provides.