In part two of our series on absolute returns, Charlotte Moore explores how they should be used within a portfolio and the importance of careful monitoring

The natural home for an absolute return fund is within the growth component of a portfolio. These products often appeal because their return profile is not highly correlated with more traditional asset classes, such as equities.

Bonds-index

These funds are employed in different ways by defined benefit pension schemes. Matt Siddick, hedge fund research specialist at Aon Hewitt says: “Absolute return strategies are often used to provide a diversified source of returns which help to reduce the risk of the growth portfolio.”

As pension schemes become more familiar with the approach, they are starting to use specific strategies within certain asset classes.

Siddick says: “Typically this would be more a liquid strategy, such as long-short equity hedge fund alongside a more traditional long-only equity investment.”

Using swaps effectively frees up the pension scheme’s capital”

The return profile of an absolute return fund will often fit well with a liability-driven investment strategy.

Mark Humphreys, head of UK strategic solutions at Schroders, says: “LDI strategies need funds which generate returns in excess of Libor to fund the swaps programme.”

Absolute return funds also fit well with the philosophy of an LDI strategy which uses swaps rather than bonds to provide protection from interest-rate risk. Humphreys says: “Using swaps effectively frees up the pension scheme’s capital.”

To read more about what absolute returns are and why trustees should consider them, read part one of our series

He adds that the scheme can then use its greater capital reserves to invest in absolute return funds to generate positive, but relatively smooth, returns to help to narrow the pension deficit.

Absolute return funds can also be used by defined contribution schemes. The new pension freedoms mean that DC scheme members will want to stay invested in riskier markets, both in the years approaching retirement and post-retirement.

Absolute return funds can also be used by defined contribution schemes”

Malcolm Jones, investment director of absolute return and multi-asset investing, Standard Life Investments says: “One of the challenges of more traditional equity investments is that market volatility can have a very damaging effect on the sustainability of a pension pot.”

Using an absolute return strategy that aims to produce good returns but at lower volatility than equities is a good solution, he suggests.

Monitoring the funds

The primary concern for trustees is to ensure the absolute return fund will generate value after the fees. Robert Howie, principal in the alternatives boutique of Mercer Investments says: “Without that, there is no point in investing in the product.”

Trustees need to dig into the details to ensure they are receiving returns that are driven by skill. Siddick says: “Ultimately these funds should be generating alpha so a trustee needs to be confident they cannot find similar returns from a cheaper strategy.”

It’s possible to determine whether a fund is generating genuine active asset allocation returns by looking at how the performance of the fund would be affected by a fall in the value of a particular asset class.

Trustees should choose those funds that are easier to monitor”

Humphreys says: “If, for example, the trustees struggle to see how a fund could achieve its target if the value of equities were to fall significantly, then this is more a single directional bet than an absolute return fund.”

Trustees should choose those funds that are easier to monitor. “These funds are transparent, provide institutional style reporting and have good risk management,” says Howie.

Close scrutiny of the fee structure is also important, as it can ensure a better alignment of the interests of the investors and the fund manager.

Luke Newman, manager of the UK absolute return fund at Henderson Global Investors, says: “Managers’ remuneration should be closely tied to the success or failure of the fund.”

Deferring a manager’s fee can have a motivational effect. A claw-back provision could also encourage the creation of more consistent returns.

Newman says: “This gives the manager no incentive to front-load a portfolio with investments that will work well today but perform badly in the future, as the managers are also invested in the future.”