One would expect TIM HAYWOOD, the chief investment officer of post-MBO spin-off from Julius Baer, Augustus Asset Managers, to talk up the prospects for absolute return funds. However in the following article he compares the characteristics of absolute return to those of each ‘traditional’ asset class, as well as the total return funds with which they are sometimes confused, to more specifically make his case.
Absolute return funds will acquit themselves better than Australian Commonwealth Government Bonds (ACGBs), corporate bond funds, total return funds, low volatility fund of hedge funds and deposit accounts in most cases.
Bonds could easily disappoint
With a steeply inverted yield curve – 15 year ACGBs yield 6 per cent (which is 1.5 per cent less than nominal GDP) while the Reserve Bank Of Australia’s cash target rate stands at 6.75 per cent – and a real yield on 10 year inflation-linked debt of only 2.5 per cent, traditional domestic bond portfolios offer a potentially poor source of both returns and inflation protection in the medium term.
If the RBA holds rates steady for a long period, bonds will rise in yield and fall in price. If inflation is less than 3.4 per cent over the next ten years, inflation-linked debt will underperform.
Keeping Poor Company?
Corporate bond funds have ridden the wave of credit spread contraction. Now, credit markets are proving to be more volatile. Trading in corporate debt is currently somewhat irksome.
Estimates of fair value in high grade and high yield markets do not yet reveal notable value relative to current spreads. Predicting the future balance sheets has never been so tricky: many companies change fiscal shape, or have their shape changed for them, before the term of their latest bond issues. To claim to always know better than others the future shape of a company is to risk counterclaims of insider trading!
Finally, lending money to companies in the very short term has heightened reinvestment risk without eliminating the default risk. Look at the profile of corporate bonds with low yields: they have limited upside as redemption nears yet far greater downside in the event of default, downgrade or unprotected change of control.
Shorting credit, where the specific risk / return looks compelling, makes intuitive sense, whereas shorting stocks has unlimited downside and limited upside.
Absolutely better, totally worse
So-called ‘total return’ describes a mandate type which is typically permanently long both duration and (primarily domestic US) credit exposure. This means that funds will struggle when yields rise, and will suffer when credit spreads widen.
All things being equal, the ability within absolute return to be long or short in both duration and credit will produce greater returns than total return mandates over time. Too many mouths to feed Many fund-of-hedge-funds produce tremendous excess returns, but some have not.
All such vehicles represent substantial fee drains on several levels. If the return outcome, or expectation, is bank bills plus 2 per cent to 3 per cent or less, then the level of risk required to be taken at the coalface to produce such marginal net returns on the surface looks wrong. Selling your quoted fund-of-hedge fund shares can take time, or reduce your net sales proceeds, if there isn’t the interest on the other side.
Having an absolute return fund with full liquidity at net asset value with no penalty, paying lower total expense ratios but yet having access to instruments and trade types seen within a hedge fund makes the latter type preferable over time. It is this breadth of the investment opportunity set which differentiates successful absolute return investing from traditional formats, with guidelines and risk restrictions formulated to permit managers the maximum degree of freedom under rules that have been tried and tested in the European Union.
Some managers operate at fixed levels of value at risk – or VaR ; others at peak levels. The irony of fixed levels is that the manager is forced to take risk when mathematically it is low (a currency peg holds until it doesn’t) but is constrained when risk is seen to be high, where, say, a bond that falls dramatically in price is seen as high risk (the very time when risk return profile improves and value is being created).
Within the fixed income oriented absolute return product, most managers apply a range of sources of excess return:
• Rates, which includes duration, yield curve slope and shape, plus cross-market spreads
• Foreign exchange, including both systematic and discretionary strategies
• Emerging markets, comprising spreads within the hard-currency markets and local currency yields and their yield curves, as well as currencies
• Investment grade and high yield credit, both physical securities and credit derivatives, including short exposure using the latter.
• Convertible bonds, combined with equity and credit derivatives.
Further, some absolute return funds add equity strategies, notably long / short trades. It is important to understand the nature of returns likely to be generated by this approach – absolute return funds are not ‘deposit accounts’ nor unsecured creditors to banks, rather they are a product designed to generate a net 2-3 per cent over deposit rates over the course of an economic cycle.
Evidence of good behaviour
Most absolute return funds are only a few years old, and so the jury is out. Some have started to prove that their designs can be translated into attractive return and risk profiles. The correlation between absolute returns funds and cash, bonds, international bonds hedged back into Aussie dollars and the All Ordinaries index has been seen to be no higher than 0.19 – and that means these sort of funds have historically given something substantially different to more well–travelled paths, whilst making attractive returns.
There is every reason to foresee ongoing value, and diversification, being created both over time, and over the alternatives.
Tim Haywood is the chief investment officer/chief executive officer of Augustus Asset Managers.