Understanding how funds are run and what they actually aim to deliver is crucial to avoiding disappointment later, warns Nick Samouilhan, multi-asset manager, at Aviva Investors.
In the world of investment, labels can be confusing, especially when similar terms are used to describe very different products or instruments. A case in point is so-called “absolute-return” funds, the expression covering two quite separate investment concepts.
One type of absolute return fund concentrates on making returns for retail investors rather than following the traditional path of trying to beating the market or competitor funds. Another type offers hedge-fund like investment strategies not available to retail investors until regulatory changes a few years ago.
Questions of Definition
The traditional definition of a hedge fund is one that aims to make money regardless of how the market performs. The fund ‘hedges out’ the risk of the market moving against it by looking to exploit differences between asset prices rather than whether prices rise or fall. For instance, if Tesco is expected to outperform Morrisons, the hedge fund manager could buy Tesco shares and take a ‘short’ position in Morrisons’ shares. It is the different performance of the two supermarket groups’ share prices that will generate the manager’s return, not whether the market is going up or down.
Over the decades, of course, this relatively simple hedge-fund model has been overlaid with extra features ranging from complex computer codes to intricate systems for selecting assets and interpreting world events.
Meanwhile, UK regulators relaxed their prohibition of the sale of products using these techniques to retail investors.
These hedge funds typically offer investors a premium over the bank deposit rate over say one or three years. For instance, “cash plus three” offers the deposit rate plus three per cent. So, such funds provide absolute returns expressed as a premium over bank deposit rates. But it is vital investors realise the subtleties involved in this type of description, as the “cash plus” figure is not guaranteed.
A Question of Management
With market risk hedged out, fund manager skill is crucial to the performance of absolute-return funds. In recent years, the vast majority of such funds have underperformed their targets. In part, this is because of changes in the factors driving asset prices.
When markets primarily focused on whether Tesco’s share price was more likely to outperform Morrisons, life was easier for hedge-fund type investment. But in recent years, the market has been driven far more by factors such as the likely path of US interest rates or the euro-zone economy. At the same time, the influence of company-specific factors has waned. Further, the prices of different assets have been far more likely to rise or fall together. In other words, asset prices have been more correlated, so reducing the scope for many ‘classic’ hedge-fund investment strategies to outperform.
Some hedge funds have done well. For instance, those exploiting differences between national economies rather than between individual companies, or the so-called “global macro” funds. While it is encouraging that retail investors have more investment choice, it is more important than ever to look behind a fund’s label and work out what you are really buying.