Will the charges cap force absolute return funds to change their approach for use within defined contribution schemes? Louise Farrand investigates
Absolute return funds are doing rather well, on the face of it. Gars, the star fund in Standard Life Investments’ (SLI’s) stable, has done wonders for the sector’s reputation.
The same fund manager has recently launched Global Focused Strategies (GFS), a new absolute return fund aimed specifically at institutional investors, with a more aggressive return target.
Meanwhile, absolute return funds topped the Investment Management Association’s list of the types of funds institutional investors bought during five months of 2013 (see table).
However, absolute return funds are in danger of losing popularity in today’s brave new pensions world.
Confusion over what exactly is meant by ‘absolute return’, the introduction of a charges cap and whether such funds are suitable for defined contribution savers are fuelling a discussion about whether absolute returns have reached their zenith in the institutional world.
DEFINING THE INDEFINABLE
“It’s a rag-tag of different strategies, really,” says Laith Khalaf, head of corporate research at investment platform Hargreaves Lansdown, when asked to define absolute returns.
He goes on: “At the core, what you’ve probably got are funds which are by and large trying to achieve growth with less volatility than the market. That’s as far as you can go in terms of drilling down into what they do, because there are lots of different ways that the funds go about it.
Gars takes a hedge fund-type approach to investing, whereas you’ll get some companies with a more traditional approach
“Gars takes a hedge fund-type approach to investing, whereas you’ll get some companies with a more traditional approach.”
Khalaf cites Newton’s Real Return fund as an example of an absolute return fund that invests in mainstream asset classes such as equities and bonds, but with an intelligent approach to allocation that differentiates it from its competitors.
Elsewhere, the National Association of Pension Funds considers absolute return funds to fall into the hedge fund category, because like hedge funds, they try to produce a positive return, irrespective of what’s going on elsewhere in the stock markets.
Volatility can differ sharply between different funds
“They are almost synonymous with hedge funds,” says Paul Lee, the NAPF’s head of investment affairs. The types of investments absolute return funds make differ sharply and it’s difficult to generalise about the sector, which doesn’t make schemes’ jobs easy when it comes to picking the right one.
There are further inconsistencies. For instance, volatility can differ sharply between different funds.
SLI’s new absolute return offering, GFS, has a higher return target than Gars: GFS targets cash plus 7% compared to Gars’ cash plus 5%.
Andy Dickson, an investment director within SLI’s UK institutional business, says: “Correspondingly, it’s got a higher volatility tolerance built into the overall process. So we would expect it to have higher volatility than Gars, but the other side of that coin is that it has a higher return expectation.”
However, when asked whether an absolute return fund should typically offer low volatility, Peter Fitzgerald, head of multi-assets at Aviva Investors, responds: “It should be [typical] because it’s difficult to deliver an absolute return for clients if you have high volatility because again, their returns will be delivered to a large degree by periods when they buy or sell the investment. When you’re seeking absolute return, you need to do so with relatively low volatility.”
So while some funds aim for low volatility, others behave on the understanding that short-term volatility adds up to longer-term returns. Further confusion surrounds the difference between absolute return funds and diversified growth funds.
“Quite a lot of the time they are conflated. I can see why, they are similar-ish, but they tend to use different tools,” says Khalaf.
These inconsistencies add up to a sector that is often criticised for being almost impossible to characterise
Dickson adds: “The approach that different managers take to constructing an absolute return fund strategy can range from a multi-manager approach, where there can be significant use of external managers’ funds – that has an impact on the operational costs and that’s reflected in the total expense ratio – to our approach where we don’t use any external managers [and] it’s all managed in-house.
“The return objectives can vary from cash plus, which is our approach, and an inflation-plus approach, and so forth. So for investors it can be a bit of a challenge in comparing and contrasting, because you have different return objectives.”
All of these inconsistencies add up to a sector that is often criticised for being almost impossible to characterise, making choosing the right one very difficult for pension schemes.
A QUESTION OF DEFINITION
The IMA tried to address some of these concerns in its review of the sector, which concluded in February 2013. The trade body specified that: “All funds in the sector must, at a minimum, target positive returns in any market conditions. They may choose to set more demanding targets. Whatever target they set, it must be specified explicitly.”
The sector review also concluded that all funds in the sector should set a clear timeframe for reaching their target of a positive return, and that the timeframe should be no longer than three years.
At the time, the IMA was criticised for failing to address the fundamental problem with the sector: that investors often assume ‘Absolute Return’ comes with some sort of guarantee and that renaming it ‘Targeted Absolute Return’, as the review concluded, would not be enough to change perceptions.
Ultimately, every investor is looking for an absolute return
The review also missed a wider point. With so many widely varying investment strategies and expectations being used by asset managers, it is very difficult for pension schemes to narrow down all the highly diverse strategies that compete under the ‘absolute return’ banner.
Simply asking investment managers to aim for a positive return within a given timeframe does not solve this problem. Strategies and delivery timeframes will still vary, making this so-called ‘sector’ more disparate.
“My belief is that ultimately, every investor is looking for an absolute return,” says Aviva’s Fitzgerald. He’s right: no investor, institutional or retail, ever invests to lose money, which renders the idea of an absolute return sector meaningless.
THE CHARGES CONUNDRUM
The place of absolute return funds in a DC pension fund’s investment roster is further threatened by the recent announcement of a cap on charges. Anecdotal evidence suggests that SLI’s Gars is a popular default fund option for pension schemes, although concrete data is difficult to find.
I don’t think it’s likely to be adopted in DC schemes because of its overall return objectives
SLI’s new institutional fund GFS has a 1.2% annual management charge, well above the charges cap of 0.75%. SLI’s Dickson believes GFS will be more popular among defined benefit schemes, where the charges cap does not apply. He says: “I don’t think it’s likely to be adopted in DC schemes because of its overall return objectives.”
Dickson also makes the point that Gars can be blended with other funds to make it more affordable to DC schemes. He says: “[Gars] fits within default strategies. When it’s blended with passive equity and sometimes another manager’s absolute return fund or diversified growth fund, then the aggregate cost that a member would incur in the institutional arena is well below 75 basis points in the vast majority of arrangements.”
Nick Smith, a director within Fulcrum Asset Management’s institutional team, has a similar view.
He says: “What I think [the charges cap] will do is encourage innovation, get sponsors, trustees and ultimately members to look at value for money, because I think there is still the opportunity to say: ‘We would like to pay for quality, we would like to have managers who can actually demonstrate they can add value.’
“But what we can do is design something that puts them alongside a lower cost option.”
Absolute return funds that charge pension schemes performance fees may be forced to change their structure in a DC environment. The NAPF’s Lee questions whether absolute return funds will ever play a big role in DC pension schemes’ portfolios.
He says: “I think at the moment most DC schemes are at the immature end of things, and therefore they have relatively simple asset allocations. They aren’t really looking to extend very far into the broader sweep of alternatives.
“I think probably most interest is among the DB schemes and particularly among those that have gone a long way down the route to de-risking – they’ve got a chunk of assets in a very de-risked portfolio and another chunk of rather more aggressive assets. It’s typically those funds that have got the more significant exposures to hedge fund and absolute return vehicles.”
Fulcrum’s Smith is much more optimistic about the role absolute funds will play in DC schemes. He believes that, post-Budget, savers will be able to stay in growth assets for longer, perhaps remaining partially invested through retirement.
You’re letting the complying with the charge cap tail wag the investment dog
However, the imposition of a charges cap may limit the amount schemes can invest in such vehicles. Hargreaves Lansdown’s Khalaf says the charges cap makes investing in an absolute return fund “no longer just an investment decision”.
He adds: “You’re letting the complying with the charge cap tail wag the investment dog. You might say that a 15% allocation may be prudent but actually we can’t do that, because it would increase the cost of our strategy to beyond the 0.75%, despite the fact we think that might be the best thing from an investment strategy point of view.
“That’s exactly the kind of unplanned consequence that you get from imposing something as blunt as a charge cap.”