Absolute return strategies also aim to reduce the volatility found in traditional assets like equities. As a result, many such strategies use alternative rather than traditional investment vehicles. This in turn adds diversity.
To give an idea of how quickly it is catching on, in 2004 all UK pension funds advised by Watson Wyatt Investment Consulting awarded double the number of alternative investment mandates (32) to fund managers than they did in 2003. This increased the assets allocated by the firm’s clients to alternative investment mandates by 40 per cent from the year before and amounted to approximately £1.75bn (€2.59bn); comprising £1bn to hedge funds, £400m to property and £350m to private equity. According to Watson Wyatt, between a third and a half of these alternative mandates were set up on an absolute return basis.
Return imperative
Nick Watts, European head of investment consulting at Watson Wyatt, says: “The imperative to generate returns to reduce deficits has strengthened, with the result that many funds have moved some of their assets away from benchmark-sensitive instruments to make meaningful allocations to absolute return products, notably to funds of hedge funds.”
Most fund managers agree that countries such as the UK have lagged behind America in their adoption of absolute return strategies but that demand is now increasing.
Tony Dalwood, head of public equities, SVG Capital, says: “There is a big demand for absolute return strategies and investors will increasingly move towards them. In America a good example is the Yale pension fund which is about 70 per cent invested in this type of strategies and has had fabulous returns for years. It has invested in areas like private equity, property, oil and gas. Demand has been led by retail and high-net-worth investors but the institutional market is catching up. In the UK demand has been led by consultants who are becoming more receptive."
The global picture is even rosier. Pension funds globally invested over $62bn (Í52.8bn) in alternative asset classes during 2004, comprising almost $30bn in property, $17bn in private equity and $16bn in fund of hedge funds (FoHFs), according to data from Watson Wyatt. This shows that, of all the alternative assets managed for pension funds globally, 49 per cent is in property, 38 per cent is in private equity and 13 per cent is in FoHFs.
Roger Urwin, global head of investment consulting at Watson Wyatt, said: “Pension funds continue to reduce their reliance on equities as they find suitable alternative sources of risk. The message of diversification is definitely getting through.”
The survey, which brought together the world’s largest alternative players in FoHFs, private equity fund of funds, property and commodities, identified net gains across these asset classes of $161bn during the year and brings the total of alternative assets to around $1000bn.
Growing demand
Demand for absolute return strategies is growing for a variety of reasons and through a variety of distribution channels. But most managers and consultants agree that low interest rates and prospects for low bond and equity returns mean investors are prepared to look at a wider range of investment alternatives.
Steve Goldman, a senior vice-president at fixed income manager, Pimco, says: “Pension funds’ interest is increasing, particularly as they identify new ways to decrease their asset-liability mismatch while leaving open opportunities for higher yielding asset classes. Foundation and endowment interest is also growing, as these strategies offer prospects for greater income returns than many traditional products.”
 Anthony Culligan, F&C Partners | Anthony Culligan, managing partner of F&C Partners, the fund of funds operation within F&C, explains: “Absolute return strategies look for a better risk return trade-off than in the long-only world. You might expect a return from equities of 8 per cent, which would be the typical projection that an insurance company or pension fund might make. With equities you would have to bear a volatility of about 15 per cent for that 8 per cent return. Then you also have periods of extended draw down. For instance, in 2001 and 2002 you had a 30 per cent draw down in that sort of asset.” |
No reductions
He says that absolute return strategies offer much less variation in your return. So if you were looking for an 8 per cent return, absolute return could typically achieve that with, say, half the volatility of equities. Also they have demonstrated much shallower and short-lived “draw down” periods. With an investment in a range of absolute return strategies, an institution might suffer reductions of 5-7 per cent in a disaster scenario. But that is nothing like the 15 or 30 per cent we have seen in long-only strategies.
Mr Culligan added that absolute return strategies have very little correlation with other strategies within a typical institution portfolio, so also bring diversification.
Today investors have a wide range of absolute return strategies to choose from, and the number continues growing. Mr Goldman says: “The search for alternatives means new absolute return strategies are coming to the market across a wide range of asset classes and products. In addition to hedge funds and other levered currency, fixed-income and equity products, structured debt, bank loans and collateralised debt obligation/collateralised loan obligation type structures also offer prospects for increasing returns.”
Mr Culligan, who operates a fund of funds, provides a good overview of the kinds of strategies available and what they do. He says: “Equity long/short strategies are common because it is a very liquid market. Then there are fixed-income based strategies which look at the relative value of various sections of the fixed-income marketplace, such as trading one part of the yield curve against another. Related to that are macro trading strategies which take a view on interest rates, currencies, commodities, in a George Soros style.
“We have a number of investments in event-focused funds. These look to capitalise on particular events, for example, changing corporate structures, mergers and acquisitions, buyouts and distressed investing.”
Mr Culligan explains he looks at funds that are invested in mortgages, particularly in the US because they can provide value in absolute and relative terms. There are also funds for investing in capital structure that look at the differences in value between different securities that a company may have issued, and which can be traded against debt or bank loans. Another option is to invest in systematic funds which are quantitative and might look for a value or momentum effect, or to use CTAs which are also momentum driven macro funds.
“Then there are a number of funds that are geographically focused. For example, in Japan there is a range of funds called active response which exploit the rising level of corporate governance in that country. There are multi-strategy funds which engage in two or three of those strategies or in the whole range and allocate between them. We invest in all these types of funds,” Mr Culligan adds.
But what is the best way to implement absolute return strategies? According to Alistair Lowe, director of global asset allocation at State Street Global Advisers, diversification is the key. “You don’t want to put all your money in a US market neutral strategy or even a global equity strategy. You get better risk-adjusted returns by mixing equity market neutral strategies with fixed income and absolute return strategies with currency.
“This is because there are times when different flavours work or don’t work. For example, most equity market neutral strategies had a horrible October. But some of the fixed income absolute return strategies did better.”
So why don’t investors put all of their money into absolute return strategies? Mr Culligan says: “There are capacity issues, so it is not the whole answer. An institution’s directors cannot put more than say 10 per cent of their assets in this area very easily. It would become difficult to place that sort of money. It is always going to be a significant but small part of an institutional portfolio.”
Accounting for risk
Also investors need to take into account the risks out there. “The biggest risks of absolute return products are managers that either don't understand the full range of risks they have taken within a strategy or lack risk controls,” Pimco’s Mr Goldman explains. “We have invested heavily in our fixed-income analytics and believe we understand the risks we are taking inside and out. We do not rely on outside vendors to provide risk analysis because their underlying assumptions can be hard to understand.”
Alexis de Mones, global product specialist for fixed income, ABN Amro Asset Management, says: “If you switch constantly from equity exposure to fixed income to convertibles to assets within your absolute return portfolio, it is harder to control the risk, because your asset allocation introduces a level of risk that is difficult to control. It is independent of the risk of the underlying asset classes. You have greater risk of accidents by trying to beat the market by timing.”
Investors wanting to implement absolute return strategies should choose a manager with a solid process who is stable and credible, as Mr Dalwood comments. “Sometimes people have a tendency to move with the fashions, but you need to be in it for the long-term.”
