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How absolute return investing differs from real return, alternative or multi-asset investing

The different techniques managers use to try and generate an absolute return

How to go about researching absolute return funds

Learning outcomes: 1. How absolute return investing differs from real return, alternative or multi-asset investing 2. The different techniques managers use to try and generate an absolute return 3. How to go about researching absolute return funds CHRIS CHILDS: Well, Mark, we live in a world of jargon and semantics, and there probably isnt a single definition. Although of course you can go back and do a Google search and say well what is absolute return? Well in our world its simply the return from an asset or a strategy or a fund over a finite period of time not much more than that. PRESENTER: So you really, if there isnt any consensus you really need to make sure that what you mean by the terminology is what the produce provider means by it? CHRIS CHILDS: Yes, and as I say theres a lot of jargon and theres a lot of confusion in this whole space, and I guess our job today is to try and bring a little bit of clarity to that. PRESENTER: But when you hear a lot of talk as well about things like alternative assets, things like aircraft leasing, different forms of property, where do they fit with absolute return? CHRIS CHILDS: Well of course the knock-on thought from absolute return is its absolute but how does, where is that return coming from in the context of the economic markets or the financial markets? So most people then think OK absolute return, that means Im going to make a positive return irrespective of whats going on in other markets, for example in the equity market. So coming back to for example aircraft leasing, its not so much is that an absolute return strategy, its more a case of how does that particular strategy or that asset class behave when for example equities are struggling? PRESENTER: Now, were in a period of pretty low inflation at the moment, is an absolute return, does that on the whole imply you should be getting a return once inflation is taken into account, or is it a nominal return that could look? CHRIS CHILDS: Well I think most people look at returns in a nominal sense. But of course the real return is whats important, certainly over the longer term. But most people, were going to talk about the funds in a little bit, but most people think about absolute returns in a nominal sense. PRESENTER: I suppose the other one is target return, is that just an aspiration, a sort of marketing? CHRIS CHILDS: Well it is a little bit of marketing isnt it at the end of the day? Target returns, the question is where is the return coming from? And I think the investor should ask himself OK whats the return mechanism or the generation behind this return? PRESENTER: And just for clarity, youre running what you would describe as an absolute return fund, whats the style and approach that you use? CHRIS CHILDS: Right, well, for full disclosure purposes I actually wear two hats. One is I reside in a multi-asset team, and the other thing is that I am the co-manager on a market neutral absolute return strategy, and the connection there is that we actually employ that strategy within our own multi-asset funds. Now the absolute return strategy is a market neutral strategy that employs global equities, so we are long and short but were market neutral. Another differentiator is that its entirely systematic. So theres no discretionary fund management in there at all. But the key thing is very few people buy a fund in isolation. Its a case of this fund is going into my portfolio, so if I put on my multi-asset fund manager hat Im thinking how does this strategy fit into my multi-asset portfolio? PRESENTER: So absolute return for you is something that can go into a multi-asset fund. I ask because multi-asset is such a big asset class these days. Theres so much of it about. CHRIS CHILDS: Well multi-asset is about diversification, and if you can find strategies, lets not call them necessarily absolute return strategies, but if you can find strategies that are uncorrelated with your principal risks, and in the context of multi-asset portfolios your principal risk is typically equity, then thats a good thing, it brings diversification. PRESENTER: And you mentioned a little earlier when youre looking at absolute return its an absolute return over a time period; any rules of thumb over which an absolute return strategy should be delivering? CHRIS CHILDS: Well again theres no definition, but I think realistically you would want to look over say a three-year period, keeping an eye on the rolling 12 month return, and thats very much in line with some of the definitions within the peer groups. PRESENTER: And where did absolute return come from originally? CHRIS CHILDS: Well I guess absolute return was where investment started in a way, because people approached the market and said I want to make a return. And absolute returns cousin if you like is relative return, and relative return only comes because you start comparing an absolute return with a benchmark. And therefore you get this concept of relative return. I think if you go back to the grandfathers of investment they never thought in relative terms. They were thinking about growing your capital in an absolute sense. PRESENTER: So are the two actually indistinguishable? If say 50 years ago someone said well Ive bought this company because it produces an income, and over time itll go up. CHRIS CHILDS: Well you might well argue that its about your own expectations, your own ambitions. But I think the industry these days makes some quite clear distinction between assets that are more cyclical in nature, i.e. equity, and those strategies that are attempting to get away from that cyclicality, and thats what absolute return strategies should endeavour to do. PRESENTER: But now that extra level of complexity if you like has come in as investment analysis has taken off in the last few decades. What are some of the implications of that? CHRIS CHILDS: Well I think the investor has a lot more choice. Theres a lot more scope for confusion of course as well. And that means that ultimately at the end of the day they can build better portfolios. PRESENTER: But again looking back to the origins of absolute return, is this something thats come originally from the hedge fund world? CHRIS CHILDS: I think in the context, if you move away from the strict definition, if you move away from the fact that in the past people were interested in making absolute returns irrespective of what they were investing in, then a lot of it does come from the hedge fund community. Maybe its the push into the more UCITS vehicle world. I think theres also some other things that have happened along the way, so the UCITS structure is far friendlier now than it used to be to implementing absolute return strategies. PRESENTER: Well talk us through, because UCITS is a term thats out there a lot, why has that been so important? CHRIS CHILDS: Well the UCIT of course is the principle vehicle for the private investor, and the majority of anyone buying a unitised type product. The UCITS label if you like ensures that it adheres to certain rules and regulations. The simplest one being that its sufficiently diversified for example. But increasingly over the last couple of evolutions of UCIT vehicles theyve become far more sophisticated in the way that they look at risk for example. And the knock-on effect of that is how you can use derivatives in the context of a UCITS vehicle. So the UCITS vehicle has really gone from being a long-only traditional thing to something that can actually hold a genuine absolute return strategy. PRESENTER: But youve talked a couple of times about why people would want to generate an absolute return. But markets move around all over the place all the time, isnt it really chasing after a false god, can you really do it? CHRIS CHILDS: Well I think thats an excellent question. Its can someone, an individual, consistently produce absolute and therefore really positive returns? It is challenging, and really youre looking to fund groups to find their very best fund managers to run these strategies. Is it possible? Yes of course, it is possible, but I think its far more difficult than running say a passive portfolio which is incredibly simple. Is it more difficult than a traditional fund manager trying to outperform his benchmark? Not necessarily. You need to employ other techniques, so a key differentiator between an absolute return strategy and maybe a total return strategy would be that fund managers ability and willingness to short assets. And thats, you really have to look at the strategy itself to see if it is genuinely absolute by looking to see what sort of activities the fund manager is prepared to do. PRESENTER: The reason I ask is that there always seem to be a big surge of interest in absolute return pretty much immediately after a market crash, so its people wanting something they wished theyd had 12 months ago. Is that the best way to think, is that a good way to think about what you want to buy for the next five or 10 years? CHRIS CHILDS: Well I mean thats human nature isnt it? Where that comes from is that we tend to chase returns, and hence the concept of momentum. I think fund managers and investors generally should focus on building good portfolios for the future, irrespective of whats happened in the past, because the past is the past. Of course if absolute return strategies produce good returns, and at the same time traditional assets produce very poor returns, then youre going to have a growth in that asset class. PRESENTER: To what extent do you think this is perhaps being driven by the fact that were 30 years into a bond bull market, theres not a lot of upside left in bonds, and government bonds traditionally did produce a consistent nominal return to investors? CHRIS CHILDS: Well of course it wasnt just that they produced a return, its they also formed a nice hedge against equities. Thats not always been the case but certainly in recent history theyve formed a very nice hedge in the context of a multi-asset portfolio. Perfect, theyve produced a strong positive return, and theyve protected you at those times when equity has struggled. And people are concerned by two things. One the outlook for bond returns, and secondly whats the correlation going to be between bonds and equity? And that forces people into other ways of achieving diversification within their portfolios, and one way of doing that is to buy alternatives or to buy absolute return strategies. PRESENTER: Now you mentioned earlier you yourselves are running a systematic strategy, how much has this growth come because of just the rise in computing power, and the fall in the costs of computing power? CHRIS CHILDS: Well I think there are different types of alternative strategies. Some are highly computing intensive, and others are actually more traditional in a discretionary sense. But I think generally the industry has benefited, grown, been dependent on the growth in computer power. If I compare what I sit in front of today with what I sat in front of 20 years ago in terms of IT and technology, its quite stark. PRESENTER: So, in terms of where we are today, again a bit of a rule of thumb, are there some fairly clearly defined types of absolute return strategy that investors can choose from? CHRIS CHILDS: Well this is interesting, because if you look in the general peer groups theres not a lot of differentiation. They tend to get all thrown in together and you get the multi-asset portfolios thrown in with some absolute return strategies as well. So my thought there is actually to go away and lay your hands on some proper alternative and absolute research, and there is some good research out there, just to gain an understanding of the, if you like the sub-categorisation of these strategies, such as market neutral, long short, macro, etc. etc. And there is some good research out there. PRESENTER: Well you mentioned good research, any names that are worth just having a look at? CHRIS CHILDS: Well recently Ive been looking a lot at the Kepler Partners work, and thats very useful. If youre new to the absolute return space, or new to the alternative space, and you wanted to spend half an hour reading something that gave you a really good leg up, then thats an excellent starting point. PRESENTER: And when youre talking about that peer group, are you talking the IA absolute return funds peer group as a bit of a catchall sector? CHRIS CHILDS: Well Kepler Partners have their own peer group, which is probably more useful to someone whos going to focus on absolute return and alternative strategies. The IA peer group is interesting, because it defines the target returns as being over an absolute or a positive absolute return over three years. And that of course should move you away from having traditional, too much traditional asset exposure. But if you look in the peer group its a large peer group, its over 100bn of assets in there, but its dominated by a limited number of funds that most of us would look at as being multi-asset type vehicles. So I think again the investor has to be a little bit careful as to what he buys from that peer group. PRESENTER: And again as you look at that peer group, how long are some of the track records; have they been seriously stress tested in periods like 2008, 2009? CHRIS CHILDS: Well most of the funds are probably launched post 2008, although theres a very interesting question for a research individual is to ask the fund manager whats the genesis of the strategy, where does it come from? Very often the strongest strategies come from an internal effort thats worked internally, and then has been externalised in the form of a fund. But I think where strategies come from and the evolution of those strategies is very important, and the individuals involved. PRESENTER: So turning to your own example, youve got a market neutral absolute return approach. But when you were putting that together how sure could you be that the data that youd seen, the past track record was something that could be, you had a high level of confidence it could be repeated in the future? CHRIS CHILDS: Well my confidence was really driven by working with the individual who put it all together, which is Eric Rubin whos the other, the manager on the fund. And theres a tremendous amount of academic literature out there. So we tend to go back and look at academic literature, and see what has been highlighted by the academics. And then we will test that using real world data if you like. But its got to pass a sniff test, does it actually make sense, does the strategy make sense? So our strategy was very much born out of a desire to have an absolute return strategy that was uncorrelated with traditional assets in our own multi-asset portfolios. And we were fortunate we had a very good, still do have a very good head of systematic strategies who was able to take what we wanted to do and implement it extremely well. PRESENTER: But just sticking with systematic strategies, again the world is always changing, does a systematic strategy have to be tweaked over time, or once youve worked it out does it, is it just left there to be absolute? CHRIS CHILDS: Well I think it depends on the nature of the strategies. So in the case of our strategy weve very much picked factors that were identified a long time ago, and therefore were going to stick with those factors and believe in them over the long term. Other approaches may be evolving far quicker than our own. And in some cases, and again I dont have great experience of this, they may be evolving extremely quickly. And thats a good question to ask if youre interviewing the fund manager is how, what evolutions, what steps have you taken, and what are you expecting to do in the future? Is there something that youre working on now that might improve returns or the risk profile in the future? PRESENTER: Now you mentioned factors there, could you give us examples of a factor? CHRIS CHILDS: Factors these days are extremely well known and theyre the value, the size and the momentum from those classic academic papers of the early 90s. And of course they are the factors that many smart beta indices are using these days. We have a couple of additional factors, but theyre very well-known and well-recognised factors. Other houses will be slightly more opaque in terms of the factors they use, and they might be more dynamic in terms of the factors they use. And that is a differentiator, because absolute return is not just solely about rules based or systematic investing, far from it. We are just one subset of absolute return funds. We happen to be entirely systematic. PRESENTER: But now everybodys catching on to factors, you hear a lot more about them. Are you worried that any advantage you might have had up to now just gets arbitraged away? Theres a wall of money heads for low volatility or income or whatever it happens to be. CHRIS CHILDS: Well I think for every factor thats done very well and is very popular, and like you mentioned low volatility, thats probably the most obvious one. Theres a factor thats well-known that hasnt performed particularly well, and value would be the classic counterpoint to that; hence you need to build a portfolio of factors. I think also theres a lot of more excitement about these things, theres a lot more talking about factors, risk premier, styles etc., than actual money flowing into this space. Of course we worry about crowding in certain factors, but we believe that its something that will come and go over time. PRESENTER: I suppose the other element around absolute return is the issue of fees. Again, talk us through, how are fee levels changing in this space? CHRIS CHILDS: Right, well you might argue that its a way for fund management groups to earn back some management fee, given how management fees have moved over the last few years. Looking at, if you look at the Kepler report, actually the fees are remarkably attractive for what funds are trying to achieve. The majority of funds are charging somewhere between ½ and 1%. A lot of funds in terms of numbers of funds are charging an outperformance fee, and thats a little bit like Marmite for people: some people like the idea of outperformance fees, others dont. But if you look at the assets, then its reasonably split between those charging an outperformance fee and those charging just a flat fee. But I was actually quietly surprised that the majority of fees by AUM is somewhere between about ½ and 1%, which I think is reasonably good value. The important point there is though for the investor, if he is paying say 1%, thats 1% of what? And the of what is the alpha or the excess return that is in that fund. So you have to look at the fee in the context of the volatility of the strategy, the efficiency of the strategy and therefore the expected return of the strategy. PRESENTER: And again any good rules of thumb on how you should think about whether a performance fee is value for money or not? CHRIS CHILDS: Well I think with performance fees peoples concern is that if there is a performance fee the manager is encouraged to take risk, excessive risk, which could work against the investor. And so part of, my thought is that part of the decision is can the manager actually just increase his risk dramatically? And if you take, thinking about our own strategy, we target an explicit level of volatility. So if we launched a share class or a fund that had a performance fee, we cant up the risk because we are running at a given level of risk. Other strategies, where its perhaps more discretionary, you could have that scope for the fund manager to chance his arm, because there is an asymmetry there. But as I say outperformance fees are Marmite to people. PRESENTER: But isnt volatility, weve talked a lot around the return side, but on the risk side isnt volatility itself pretty volatile? Are there years where whatever level of volatility youre targeting you think gosh this puts us down at the really low end of risk, and other years you think my goodness weve got a huge amount of discretionary we didnt have last year? CHRIS CHILDS: Well you touched upon a couple of issues there. Within traditional assets such as equities and bonds of course volatility does vary quite a lot. Hence you get this notion of the volatility of volatility, and thats ultimately what the VIX is all about. Less so when you are running a more market neutral strategy, because there you are long and short something. And we are certainly of the view that its easier to control risk than it is to actually find returns. Hence we are very explicit, we say look we are going to give you a level of risk, and the returns are, like it or lump it, what they are depending on the efficiency of the strategy. But you do touch upon another point which is if you are blindly driven by your risk numbers, and your risk numbers are getting low and of course these days you can apply a leverage to things, and you just up the leverage within the fund, i.e. take more risk just because your risk numbers are low, then thats ultimately dangerous. And again coming back to our own strategy, we actually have a cap on the amount of risk we will take in the form of leverage that we will actually take within the structure. PRESENTER: With all of this analysis that can now take place, is there much scope for alpha, or is that ultimately, we ultimately discover that all alpha is really beta we havent worked out how to capture yet? CHRIS CHILDS: Well thats again a good point, and of course if you read any smart beta literature youll see that classic graph where they decompose returns into beta, factors, and then alpha. And that makes the traditional fund managers job that much more difficult. I mean its been a challenging time for traditional active managers. Are factors an alternative to beta? Well of course they are in a mathematical sense, but the question is: are they correlated with your main risks, your main beta risk being equity? So it doesnt really matter where your returns come from, its that theyve got to be there and hopefully they should be uncorrelated. PRESENTER: And we talked a lot about the background on it, but if youre looking at doing some due diligence on absolute return and getting involved with that, what would your advice be to somebody whos coming new to this? How do you go about that process? CHRIS CHILDS: Well I think the starting point is to lay your hands on some high level research about the sector. What are the main funds out there, what are the classifications, how have funds generally performed, what level of risk are these funds running in terms of volatility? Are they a 10 vol, are they a 5 vol? What level of return have you had for that level of risk? Because thats, the funds are quite different in nature, and you must always normalise the returns for the level of risk that is being taken. I think you then start looking at some of the literature that is produced by the fund groups. And some people are very good in terms of the literature they produce. If you go and speak to the fund managers directly, just ask them some sensible questions. If they cant explain the strategy in the elevated pitch time, then is that a strategy you really want? I think the other thing is to just be aware of stories. Just try to be aware that we like to hear stories, and a fund manager sitting there telling you how hes going to generate lots of alpha for you can be quite an enticing story, and you probably just want to stick to the facts. PRESENTER: Well you mentioned a little earlier with the absolute return sector theres some very big funds in it. Again we hear a lot in the long only market about capacity and size constraints, how important is it to work out what the capacity of an absolute return strategy is? CHRIS CHILDS: Well I think its a very good question to ask the fund manager, how he goes about thinking about the capacity of his strategy? And to be honest we have seen some what I might call capacity creep, i.e. people have soft closed funds and then 12 months later the fund is significantly larger. Working out the capacity of a strategy is quite challenging, but its an important discipline to go through. Obviously the big risk is that if youre a successful fund manager you produce the returns, the assets come to you, you yourself may not be greedy but the fund group will be greedy and will want to maximise the opportunity from a revenue perspective. And the danger is you take in too much asset and you start killing your own returns. That is the danger. Where that tipping point is is very strategy dependent. Some strategies are actually quite restricted. If you were just doing long/short European equities, then you may not actually have that much capacity. Were global equities and we broadly know where our, or we think we know where our capacity is. But youre right, there are some very large funds out there that are, they must be hitting capacity. PRESENTER: And when you look back over a track record, how important is it to look what the distribution of those returns is, and over what time period? CHRIS CHILDS: Well thats very important because coming back to an earlier comment I made, very few people buy a strategy in isolation, its how that strategy sits within your own portfolio. And therefore its not just the volatility of the strategy that youre buying thats important, its how it fits in the portfolio, i.e. how highly correlated it is with the other things that you have in your portfolio. In addition to that its worth looking just at the distribution of some of these strategies, because they may well have very nice smooth returns, but every now and then have a horrible bump, i.e. its quite a skewed distribution. And you should be aware of that. So looking at the correlation, looking at the distribution of the returns is very important, and inspecting the performance at times when your other risks have really struggled. So look to see how a strategy performed when equity was struggling, and try to understand why the strategy did well or did badly in that environment. PRESENTER: Do you worry that theres quite a lot of beta dressed up as alpha in the sector, is that just a sceptical concern any potential investor should have in any sector? CHRIS CHILDS: I think its always right to be sceptical. Im not going to be drawn into the debate as to whether hedge funds to take a group are ultimately beta dressed up as something different; I think theres plenty of research out there that will help people come to their own conclusions in that regard. Of course one, we havent really spoken about different approaches to absolute return. And Ive talked about we are ourselves market neutral, hence were absolute return by structure. So were long and were short, that takes us into the absolute world. Other strategies are far more discretionary. A manager will say look – and macro would be the classic case here – I really like equities, Im going to buy equities. So hes long equities. The key test there is does he ever go short equities? PRESENTER: Yes, so hes got an asset allocation discretion if you like; whereas you, thats been taken away from you. CHRIS CHILDS: Yes, weve said OK look weve got a universe over here, and the way were going to approach the universe is were going to be as long as we are short from a risk perspective. Other strategies will be very much more traditional discretionary strategies, whereby the fund manager is trying to make market calls. Thats very much more your classic alpha-type strategy. PRESENTER: But within that, I mean even within a market neutral one presumably you could get it doubly wrong. You go, the long position is wrong and the short, and wouldnt you then have just doubled a single bet in a way? CHRIS CHILDS: Thats always a risk that your longs go down and your shorts go up. That comes with the territory. And again it comes back to expectations. If someone is expecting an absolute return strategy to be positive every month, hes probably likely to be disappointed. And it comes back to the question over what is a reasonable window to assess a strategy? Well three years you should be positive I would have thought. But you would want to keep an eye on the rolling 12-month performance. And I think you want to be on top of drawdowns. Any strategy will suffer, but what is it thats particularly driven the drawdown? PRESENTER: And within this universe again are there particular environments that will favour certain absolute return strategies, but not others? In the same way a value manager can do very well at some point in the long only world, and theres other periods where we say hes a great manager, its just not working, its just not the right market for him. CHRIS CHILDS: Well I suppose in our world of, in our particular strategy we deliberately build the fund to be uncorrelated with the general macro risks. So were a bit of an explicit case. But if youre a macro fund manager obviously you need markets moving around a bit. You need markets to move on a trend such that you can jump on it and play with it. If m