Should You Invest in an Absolute Return Fund?

VIDEO: Morningstar analyst Francesco Paganelli looks at the rise and fall of absolute return funds, which have seen huge outflows in 2020

Holly Black 20 October, 2020 | 11:53AM
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Holly Black: Welcome to Morningstar. I'm Holly Black. With me is Francesco Paganelli. He's an analyst at Morningstar. Hello.

Francesco Paganelli: Hello.

Black: So, we're talking absolute return funds today. For the uninitiated, can you tell us what an absolute return fund does?

Paganelli: Sure. Well, absolute return fund is not really a term that we're very fond of because it's not perhaps very informative. But broadly speaking, these are strategies that attempt to deliver a predetermined return objective with unconstrained mandates and an ability to go long and short different assets. So, specifically, a lot of discretion in the managers' hands and each fund family offers perhaps its own version with different flavors, constraints, investment strategies, or risk characteristic. So, there is some variety in this broad group.

But in general, this fund should offer diversification benefits to investors and perform regardless of whether markets are going up or down. So, supposedly, they try to offer a return stream that's more or less independent of what traditional markets like equity or credit are doing.

Black: It's easy to see the appeal of that type of fund, and they were initially very popular with investors, weren't they?

Paganelli: Yeah, yeah, indeed. So, those were one of the industry success stories I guess post Global Financial Crisis. And as I mentioned, these funds were hailed as a key portfolio solution for investors looking to diversify their equity and bond exposure. So, assets under management really boomed as their popularity grew over time, especially in 2015 when inflows peaked at close to €40 billion, but they quickly reached a tipping point in early 2018, when something kind of broke down and they continued to bleed since then. In fact, the Morningstar alternative multi-strategy category, which is where these funds are classified, has experienced 27 consecutive months of net redemptions through the end of August 2020 and in March alone, this year, the category was hit with over €6 billion in outflows, which was actually the worst monthly tally in over a decade.

Black: Well, that is considerable. So, what is the reason for that? Why has investor sentiment turned, do you think?

Paganelli: Well, surely performance is all too often really not lived up to expectations, which partly explains their downfall in a sense. So, while there have been some exceptions, of course, on average, these funds have kind of failed the litmus test. So, when investors most needed them, that is when traditional funds were losing money. So, for instance, the average multi-strategy funds lost around 3.5% in the last quarter of 2018 and over 7% in the first quarter of 2020. And in fact, the very average fund has underperformed a bread and butter simple stock-bond portfolio each calendar year since 2010, and that surely took a toll.

Black: So, obviously, they have disappointed. Are there still some funds in this space that you like?

Paganelli: Yes. So, given what I've just said, I guess, in our view, investors should be particularly cautious and selective in this space. So, these strategies have kind of a tough hurdle to clear because they need to provide high liquidity and diversification. They supposedly have to limit losses in volatility and deliver a 4% or 5% annual return after fees all at the same time. So, moreover, the complexity of these strategies that often is derivatives also adds a layer of opacity for many investors. But our best ideas include established strategies such as the DWS Kaldemorgen and the Newton BNY Mellon Global Return. Like elsewhere, I guess, we think low fees, extensive team expertise, clarity and repeatability of the investment process are really key drivers of this fund's success.

Black: Francesco, thank you so much for your time. For Morningstar, I'm Holly Black.

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Holly Black  is Senior Editor, Morningstar.co.uk

 

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