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Alternative investments: absolute return dampens cyclical shocks

Alternative investments: absolute return dampens cyclical shocks

01-09-2015 | Insight

Absolute-return solutions can help to make your portfolio less sensitive to the economic cycle. It's difficult to navigate through the rapidly growing range of funds, with a larger portion of these funds bobbing along with the market than the name would suggest.

  • Klaas  Smits
    Executive Director Quant Allocation Products

Speed read

  • Absolute return strategies can position for both price drops and price gains 
  • The range of absolute-return funds on offer is increasing rapidly and is very diverse 
  • The term absolute return is no guarantee for positive returns in any market climate 
  • Liquidity and counterparty risk are issues that investors need to watch out for in this segment

By targeting positive returns regardless of the investment climate, absolute-return solutions are a popular option in a time in which interest rates are extremely low and equity markets have high valuations in historical terms. Some hedge-fund strategies possess absolute-return properties without the structural long-only tilt, but in the form of liquid alternatives, too, absolute-return solutions have been gaining greater attention in recent years.

In Europe, the assets under management of absolute-return funds in so-called Undertakings for Collective Investments in Transferable Securities (UCITS) grew from EUR 159 billion in late 2013 to more than EUR 260 billion a year later. According to the UCITS Alternative Index, there are already more than 800 different funds in this segment. This form of fund makes it possible to enter and exit on a daily basis. Most hedge funds apply a monthly trading term. Further, a lock-up period of several months to a year is common.

A wide range of strategies is used, with providers referencing these to all sorts of benchmarks. That means that the investment category has a very diverse character, so it's difficult to make any kind of uniform statement about the returns of absolute-return funds.

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Rising and falling markets

An absolute-return fund differs in a few key respects versus funds that are limited to a certain market. The biggest difference is that a position can be selected for price gains and falls on equities, fixed-income and currency markets. Setting up a portfolio therefore requires other competencies than with more traditional solutions, which are mostly involved with applying overweights and underweights at the level of individual securities.

“We start at zero”, as Klaas Smits, Fund Manager of Robeco GTAA explains the difference: “While for managers of a traditional fund, the composition of their benchmark index forms the starting point against which the portfolio composition and returns are compared.” Most absolute-return funds aim for a return that is higher than the money-market rate over a period of three years.

This period is shorter than the complete market cycle, but a strategy can generate a positive result in both good times and bad. That property makes absolute-return funds an excellent tool for reducing the volatility of a traditional investment portfolio, the returns of which are largely determined by price fluctuations on financial markets. 

Discovering and understanding patterns

The property of absolute-return funds to aim for a return that is to a large degree dependent on the direction of financial markets makes robust risk management absolutely essential. Key questions include who checks that risks remain within the set limits, and what happens if those limits are exceeded. Furthermore, for highly leverage funds that invest in derivatives and take short positions, it is crucial to monitor closely how counterparty and liquidity risks are managed.

Robeco GTAA is a quantitative multi-asset strategy with the key objective to realize attractive returns over the longer term. Using a model, it anticipates opportunities that arise on key markets by combining systematic decisions in the area of market timing within each investment category with relative valuations among the different categories. The model is made up of various components that each have long track records and are being constantly perfected.

‘The model avoids psychological pitfalls’

“The benefit of a model is that it can anticipate the psychological pitfalls on financial markets that are difficult for human investors to avoid”, explains Smits: “At Robeco, we believe that thorough research helps to identify and understand the key forces at work on financial markets. So it's not just about finding statistical patterns, but also about discerning what the economic explanations of these forces are.”

Limited field of activity

As managers, we at GTAA are of course interested in the normal distribution of returns”, said Smits: “But we primarily want to understand what can happen in the tail of the distribution. For us it is an important condition that we can also exit or rather enter positions easily during periods in which liquidity dries up. The content of the portfolio is fully determined by the model. However, we do monitor that the risk limit is not exceeded. Moreover, we develop and test ideas for further improving the model.”

‘The universe comprises extremely liquid index instruments’

GTAA therefore keeps its field of activity limited to a number of extremely liquid index instruments at equity, (government) bond and currency level. Apart form the desire to adjust the portfolio in all market conditions, the selection of very liquid instruments is also driven by the format in which Robeco GTAA has been created. The fund has a UCITS form, with daily liquidity being one of the conditions.

Correlation: away from the vagaries of the market

Absolute-return solutions are gaining popularity due to a growing caution among investors when it comes to exposing their lot to a large degree to the vagaries of a certain investment category. However, many funds found among the absolute-return category are in practice still strongly influenced by market fluctuations. “Many long/short equity funds and hedge funds that anticipate mergers and acquisitions sometimes have s significant overlap with equity prices”, said Smits: “A correlation of 60 to 70% is not uncommon.”

Since the launch of Robeco GTAA in May 2010, the fund's correlation on government bonds is 0% on a monthly basis. The correlation with equities and with an investment portfolio that comprises half equities and half bonds is around 40%. The high correlation is a result of the rise of the stock markets during this period. Smits expects the correlation in a weak market to be negative and to roughly reach 0% over the longer term.

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