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Leap of faith: the trouble with judging absolute return risk

Leap of faith: the trouble with judging absolute return risk

Does an investment’s expected return adequately compensate for the risk being taken? This is perhaps the most crucial investment question of all. And there are never easy answers to it.

Even so, there are varying degrees of complexity when assessing the risk-return profile of assets. With equities, for example, we can consider market risk, and with bonds we can look at interest rate risk.

These are hardly foolproof approaches. But we broadly know where we are with these kinds of investments.

We cannot, though, say the same about absolute return funds. David Appleton, investment director at Cornelian Asset Managers, pointed out: ‘Some absolute return funds invest in things with correlations to mainstream assets. Others have explicit risk parameters that constrain such correlations.’ Assessing the risk-return profile of absolute return funds appears more complex.

With equity funds, performance can be benchmarked against a relevant index. And bond fund performance can be compared to the returns of government bonds.

What, though, is the relevant benchmark for absolute return funds?

There are some, such as HFRX indices, as Matthew Hoggarth, head of research at Thesis Asset Management points out. But he said these are not representative of all absolute return funds.

FTSE has recently moved to a cash-plus-2% benchmark for absolute return funds. ‘This is useful as a general indicator,’ Hoggarth said, ‘but an adviser looking to benchmark a particular absolute return fund would probably need to be more specific.’

The head of research said, with absolute return, the investor is largely looking for pure alpha. ‘You’re often relying on the fund manager’s skill for the whole of the return,’ he said, ‘and you may not have the market to give you an initial forward shove.’

But if alpha is measured against a benchmark, how can it be calculated if no reliable benchmark is available? ‘The problem is assessing this alpha is difficult with an absolute return fund,’ said Appleton.

Fund-pickers selecting absolute return funds must have confidence in the manager’s views, said Hoggarth. ‘You need clarity on the volatility and performance they’re targeting’, he said, as well as confidence in the fund’s process. This includes the way investment ideas are generated.

Fund process also includes risk controls on portfolio construction. These concern how risk is spread and what safeguards are in place to ensure there is not, for example, too much exposure to any individual holding.

The information ratio cannot be applied to absolute return funds, as it requires a reliable benchmark index, but Hoggarth says the Sharpe and Sortino ratios can be used. ‘However, it’s trickier for funds with shorter track records,’ he said.

Risk of being ignorant

The fact most absolute return funds were launched after the financial crisis is also a concern. ‘There’s been little downside since the crisis,’ Hoggarth said, ‘so many of these funds haven’t faced testing conditions.’

Even so, Thesis holds four absolute return funds: Premier Defensive Growth, Fulcrum Fixed Income Absolute Return, Absolute Insight and F&C Global Equity Market Neutral. And Cornelian holds Jupiter Absolute Return, run by Citywire + rated James Clunie: ‘We think he’s a good operator,’ said Appleton.

But Abraham Okusanya, director of research consultancy FinalytiQ, does not recommend absolute return funds. He thinks, while the objectives of these funds are similar, their investment strategies are very different.

Although some are in equities, and different sectors within sectors; others are in bonds. Some use currency and commodity strategies, and many use options.

‘The risks are often difficult to understand,’ Okusanya said. ‘You have the additional risk of being ignorant about what these strategies are meant to be doing.’

This brings us back to our starting point. For it makes it harder to assess whether an absolute fund’s expected return compensates for the risk being taken.  

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James Clunie
James Clunie
39/72 in Alternative UCITS - Long/Short Equity (Performance over 3 years) Average Total Return: 8.30%
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