If last year’s financial markets were characterised by uncertainty, this year has grabbed that sentiment and cranked it up a notch.
We kicked off with volatility not seen for some time: the Chicago Board Options Exchange (CBOE) Volatility Index, often referred to as ‘the Vix’, or for some, the ‘fear gauge’, looks at the implied volatility of S&P 500 index options. This means it provides a measure of the market’s expectations of stock market volatility, looking forward to the next 30-day period.
The first week of trading in 2016 saw the Vix jump from its 19-20% levels to up above 27%.
Investment Opportunities in Volatile Markets
But every investment cloud always has a silver lining of opportunity and the natural beneficiaries of unpredictable markets are absolute return funds.
The Investment Association designated sector, Targeted Absolute Return, groups together funds designed to make money in all market conditions, tending to benchmark themselves against a set level – usually cash or Libor-plus a certain percentage premium - rather than a peer group.
IA quarterly net retail sales show the sector is still drawing in assets. In Q4 2015 – the most recently available – the sector almost doubled its sales to £1.1 billion compared with £643 million in Q1 2015.
The sector also showcases many different labels; real return, targeted return, market neutral, absolute alpha… it can get all rather confusing.
Gavin Haynes, managing director at Whitechurch Securities says: “Given the market volatility, the absolute return space is an area into which we have diversified, but it is important to look at each fund on its own merits. There is significant disparity of the risk/reward profiles in that sector.”
Haynes opts for funds that even within a single product offer greater diversification like “the originator”: Bronze Rated, single-starred Standard Life GARS, and the ‘me too’ offerings that followed when various ex-GARS team members landed elsewhere, launching Invesco Perpetual Global Targeted Returns and Aviva Multi-Strategy Target Income.
“These funds will have 20 or 30 different strategies working within them, with sophisticated risk management techniques, using stress tests so all the trades aren’t pointing in the same direction, to see how they operate in different financial conditions,” Haynes explains.
One of the diversifying techniques used might be to tap into volatility as an asset class in its own right – making a bet on levels of implied versus real volatility levels and making money off that.
Head of investment specialists – equity at Amundi, Alexandre Drabowicz, explains the heightened appetite for volatility-based strategies.
Using Volatility to Gain Diversification
“One of the dilemmas for fund of funds managers is the lack of defined diversification. Historically fixed income would be used to protect your equity bucket during market turmoil but with interest rates close to zero, there is less to expect in terms of long-term decline of interest rates,” he suggests.
“Credit spreads are starting to widen so we are seeing negative returns on fixed interest, on equities, also cash is showing negative returns. Gold can be a good hedge but not a perfect hedge, whereas the one that always has a negative correlation with equities is volatility. It is now being considered as an asset class in its own right and can be a powerful brick in portfolio construction.”
Whether seeking to harness that with a direct offering or as an element of a broader multi-strategy vehicle, it gives investors another lever to pull.
So if by their very nature absolute return funds are designed to weather difficult market conditions, which ones are standing up?
The Best-Performing Absolute Return Funds
Randall Goldsmith, fund analyst at Morningstar says those that have done particularly well in the past few months would be those with a higher exposure to government bonds to counter the sell-off in global equities.
One fund that made money in January against all the odds was the Bronze Rated, single-star fund run by Vincent Devlin, BlackRock European Absolute Alpha.
“As well has having a very good 2015 in general with an 8.9% return, Vincent also kept his head above water in January. He only made 0.23% but given that hardly anything made money last month I think most investors would be happy with that.”
Goldsmith also cites Bronze Rated, single-star fund Newton Real Return. While one of the more volatile of the sector funds that Morningstar rates with 5%, Iain Stewart’s fund is still cautiously run compared with UK equities’ 11% over the year. The fund also made money in January, delivering 0.7% to investors, which Goldsmith says should be seen as impressive when so many funds were in negative territory.
“Most of the ones we rate have come out okay through this period of volatility, but in particular, the more market neutral the fund was positioned, the better it has done.”
Because of their ‘all weather’ constitution, absolute return funds tend to be good core holdings in a blended portfolio; held for a long time, therefore consistency of returns is desirable.
Goldsmith says: “So if you take [Bronze Rated, single star] Kames UK Equity Absolute Return, that is run in a very market-neutral way. Its volatility has been kept low at around 2.4% on average over past three years, but in January that was down even further, to 0.1%.”
