Positive returns in volatile markets? Absolutely

Absolute return strategies are known for getting positive returns in volatile markets, with preserving capital a specialty of managers in the asset class. 

But who are they for? Well, ARCO Investment Management’s chair, Bruce Loveday, said if you got right down to it and offered investors a choice between having more or less wealth in 12 months’ time, they’d obviously choose the former. And given that’s what absolute return strategies are designed to do, you’d think it’s a no brainer. 

Looking a little further under the hood though, Gen Y probably isn’t too stressed about market volatility or taking risks, so you could say absolute return strategies would suit the more cautious investor. 

So, should you be a cautious investor or find yourself advising one, what do you need to be aware of, and what assets should you keep an eye on?

Absolutely focused on capital preservation

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The purest form of an absolute return benchmark is zero, according to Loveday, which means the strategy is successful if it produces a positive rate of return, irrespective of the market. While relative return strategies suit investors so long as their performance benchmarks are going up, they’re less appealing when markets fall and chew up investors’ capital. 

By contrast, Loveday said, successful absolute return strategies are designed to protect investors against capital loss, and grow their wealth irrespective of the market environment. 

Data from FE Analytics showed for the 12 months to 31 December last year, the S&P ASX 300 returned -3.06 per cent, but the Absolute Return sector sat slightly above, with -2.97 per cent returns. 

Performance of the ACS Absolute Return sector against the performance of the S&P ASX 300 for the three years to date

Source: FE Analytics

The top fund, Bennelong Wheelhouse Global Equity Income, significantly outperformed the S&P ASX 300, returning 7.36 per cent, with the second-top fund, Perpetual Pure Equity Alpha, similarly outperforming the relative return benchmark with 3.97 per cent returns. 

Loveday said absolute return managers employed many techniques to achieve continuous capital preservation, including:

Investing across more than one asset class, so that when one type of asset has a poor outlook, the are able to invest elsewhere;

Being prepared to hold large amounts of their portfolio in cash when the outlook of investment markets is weak; or

Being able to take short positions in either individual assets or indices, either to profit from falling prices or to hedge out risk (or both). 

The role of absolute return strategies in a portfolio

While absolute return strategies are going to preserve capital, investors in the asset class shouldn’t expect to outperform a relative return strategy when markets rally. 

“An investor with a very low appetite for risk or a very short investment time horizon may be most comfortable (‘sleep at night’) with a substantial exposure to absolute return strategies, because avoiding a loss is much more important to them than the prospect of making a windfall gain,” Loveday said. 

“The real answer is that the extent to which various investment strategies should form part of an investor’s portfolio is a matter for the investor and their adviser.”

Loveday flagged investors seeking some diversification could also invest in multiple absolute return strategies for that benefit. 

Getting stock-specific

Though Loveday said all investment assets have the potential to deliver improved returns to their owner over time, “good” absolute returns assets were those that were under-priced relative to their fundamental value, and vice versa. 

While that sounds a little all-too-familiar to the old “buy low, sell high” saying, the crucial criterion is actually the manager’s assessment of fundamental value relative to price, and their prediction as to whether there is likely to be a trigger to unlock the under (or over) valuation. 

When selecting stocks, ARCO looks for company specific drivers as well as broader market factors like sentiment, thematic bias, and global capital flows. 

“The risk taken, having regard to all of the above, for the return expectation we have for our clients is the critical stock selection criteria,” he said.