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Should absolute return funds always make a profit? Most investors buy absolute return products to realize positive returns, and to use them for diversification purposes. However, many often forget that these ambitions are realized over a business cycle, and drawdowns can happen just like in any other investment.
Robeco has managed a multi-asset absolute return strategy, Global Tactical Asset Allocation (GTAA) since 2010. Over the six years that we have managed the strategy and discussed it with clients we have seen two common perceptions. Following something of a rough period for GTAA, this has prompted us to provide a bit more context on how absolute return funds actually work over the long term.
Firstly, many investors in absolute return products often expect these products to always make positive returns – taking their title literally – in all market conditions. In fact, they work most of the time, and only over the longer term, where good patches outweigh bad patches and investors thereby take the rough with the smooth.
Secondly, many investors focus only on the absolute level of drawdowns when these occur, without putting them into the context of the risk profile that is inherent in the fund. The purpose of this article is to manage expectations about absolute return strategies.
Robeco GTAA is a tactical asset allocation strategy that allocates within and between asset classes. It takes long, short or no positions, depending on individual market direction and opportunities across asset classes. The strategy now comes in two fund offerings with different risk profiles:
Since its inception, the core GTAA fund has enjoyed a strong track record, with an annualized return of 11% at an average volatility of 14%. Over the last 12 months, however, the fund had a negative return of -9.25% on volatility of 15.75%. This was due to disappointing tactical allocations in long positions in the Japanese equity market, and short positions in the Japanese yen and US dollar versus the euro, which were partly offset by positive government bond allocations.
This drawdown was most visible in the second quarter of 2016. More specifically in May the fund saw a negative return because of the short positioning in European equities and German government bonds, in June the fund lost due to the short government bond positioning in the US. This is a risk that all absolute return strategies run with their asset choices.
GTAA has a strong track record since inception, with 2011 (the year of the Eurozone debt crisis) being the only calendar year with negative returns. It is important to remember that next to realizing positive returns, investors buy these products for diversification purposes, or put differently, to realize more stable portfolio returns. In this regard GTAA continues to deliver, and can use its tactical asset allocation to sometimes beat negative market conditions.
There are two examples of this happening in 2016. In January, equity markets suffered a significant setback on fears of Chinese growth and the oil price collapse, whereas GTAA realized a positive return. And in June, markets plummeted when the UK public voted to leave the European Union in the Brexit referendum, whereas GTAA realized a positive return on the following business day when capital markets again suffered a significant setback.
One of the main differences that absolute return funds have over traditional long-only strategies is the fact that these products can implement short positions which can capitalize on falling markets. This makes the fund more interesting for clients who are looking for diversification. However it also requires the fund manager to be in the right positions at the right time – and that cannot be guaranteed either. In essence, when one buys an absolute return product, one is exchanging market risk for manager risk.
It leads to a typical misconception in the market: that because absolute returns strategies can take both long and short positions, they should always return positively, every month, or every year. This is obviously too good to be true. In theory it takes a full business cycle to judge an absolute return strategy. In practice, however, market convention is to look at performance over three years, and judge it on that basis.
And given the difference in sources of return, one of the biggest reasons for using an absolute return strategy should be because it contributes to a more diversified portfolio, rather than expecting to make a profit every time.
Next to the need to focus on long-term performance, we also would like to draw investor attention to use of the success ratio as an indicator. This ratio shows how often the strategy returns positively as a percentage of total periods. Ideally we all want a number close to 100%; taking a naïve strategy of ‘flipping a coin’ leads to a success ratio of 50%.
Looking at the GTAA success ratio over its six years of life, based on individual monthly return, the success ratio is close to 60%. This is a very strong number, though of course it does also mean that return was negative 40% of the time. On a three-year rolling window, GTAA has a success ratio of 100% – it has always delivered positive returns, although bear in mind we should judge the return on a full economic cycle.
The second perception occurs if investors only focus on the absolute level of drawdowns. This is measured from when the asset value (e.g. equities) peaked to when it troughed, but it is a ‘standalone’ figure and doesn’t take into account the underlying volatility that is inherent in the risk profile of the strategy. To put GTAA’s drawdowns into perspective, we use the concept of a drawdown-to-volatility ratio. As a reference point we can compare this ratio with those of traditional asset classes and with an industry leader in absolute returns: Standard Life Global Absolute Return strategies (GARs).
Long-term equity investors have seen strong equity returns but also remember memorable periods when equities dropped 50%, for example during the tech bubble and again in the financial crisis. GTAA also has drawdowns, as seen in the chart below:
We have seen these drawdowns both in the live period since 2010, and during the simulation period before the fund was launched. This gives us the conviction that this is not an outlier. And each time before the fund has proven to strongly recover after periods of negative returns.
For absolute return products the focus is on the absolute level of returns and drawdowns, even when the risk profiles of the products are very different. We prefer not to use this method, but like to compare apples with apples instead. When we compare returns we prefer to use risk-adjusted returns. Similarly, when we compare drawdowns we prefer to use risk-adjusted drawdowns (drawdown-to-volatility), where a lower figure is better.
The following charts show the realized drawdowns and volatility since 2002 for the relevant markets. We make two comparisons: we compare the GTAA fund (which has an equity-like volatility) with the global equities index. We then compare the GTAA Medium fund with GARs (which both have bond-like volatility) and global corporate bonds. Absolute drawdowns can be compared because their risk profiles are similar.
As can be seen by these charts, adding comparisons with GARs makes it possible to compare like with like. Investors buy absolute returns expecting them to be better in managing downside risk than traditional buy-and-hold asset classes, and indeed this is borne out by the evidence. Both GTAA and GARs delivered on this, though GTAA’s drawdown-to-volatility ratio has been slightly better.
Obviously we are conscious of the fact that investors still lose real capital if any strategy does not deliver, and in that regard, GTAA is the same. But when comparing apples to apples, GTAA stands out by delivering a lower drawdown-to-volatility ratio than global equities or corporate bonds.
In conclusion, we advise investors that:
We are convinced the fund will recover and GTAA will continue to have a strong long-term track record. We look forward to continue to successfully work with investors in this exciting absolute return strategy for many years to come.