In a piece first published in FT Adviser Sam Liddle, Sales Director at Church House looks again at what is Absolute Return Investing

In the years prior to 2018, investors had not needed to be particularly smart about the way they invested to preserve the capital value of their investments.

Bond markets rose, as did equity markets, so a straightforward 60/40 equity/bond split would have preserved capital and given investors some growth to boot. This environment can breed a sense of assumption – commonly known as ‘the mother of all mistakes’ - and 2018 provided a unique set of circumstances which left not a single asset class in positive territory (in terms of real return) by year-end - even in 2008 that did not happen.

Some investors looking for positive returns have been drawn higher and higher up the risk scale in search of income and/or growth. This phenomenon was also seen in absolute return funds. You do not have to search the news too hard to find recent reports warning that some absolute return funds were taking too much risk, and, therefore, potentially subjecting investors to major and unexpected losses. 

Click here for information on the Church House Tenax Absolute Return Strategies Fund.

Quantitative easing had allowed investors to hide in higher risk strategies, reaping the rewards while not having to take the pain. This cannot be sustained in an environment of tighter monetary policy.

As a result, the absolute return sector is suffering an identity crisis with fund performance varying wildly across the sector. In a sector of over 120 funds, there are more than 40 different benchmarks and 28 funds with no benchmark at all.

This prompts the question: ‘what is absolute return?’

To my mind, an absolute return fund should have several key characteristics:

Firstly, it should start with cash; after all, the purest form of absolute return is compounding interest. Every investment beyond cash should offer a compelling excess return potential for an appropriate level of risk. If there are relatively few opportunities that meet those criteria, it is sensible to hold higher weights in cash and near-cash instruments.  

Employing “patience” as an investment strategy seems an under-used practice but reverting to managed cash when valuations in other asset classes are untenable, and simply waiting until they become compelling seems the pragmatic approach when seeking absolute returns with avoidance of the worst excesses of short-term market volatility. This is important because of the impact significant drawdowns can have on long-term returns.  

The greater the amount lost, the higher the gain required to break even. While a 10% loss in any one year would require an 11% gain to break even, a 30% loss requires a rise of 43% to break even. In other words, even relatively short-term losses can have a lasting impact on long-term returns. Avoiding these losses is a vitally important feature of any fund that claims to be ‘absolute return’ in nature.

Floating Rate Notes have proved effective for this purpose. When UK interest rates fell to 0.5% and then to 0.25%, it seemed likely that at some point, the future direction of travel would be upward. In this scenario, it made sense to buy AAA Floating Rate Notes as the major part of a cash management strategy.

FRNs have four main attributes; they are free so keep costs low at a time of low returns from other asset classes; they keep portfolio volatility low at a time when other asset prices become increasingly volatile; the coupons re-set quarterly so they provide a free hedge against rising interest rates; and they are completely liquid so can be redeemed when attractive valuation opportunities become available in other asset classes. Most new issuance is referenced against SONIA (Sterling Overnight Index Average) which is currently 0.7%, and coupons of 1.4% are quite typical. Alright, it is not exciting, but it is an absolute return which in 2018 proved elusive in other assets.

View the published article in FT Adviser here.