Maximise returns or minimise risk

The financial services industry works by making products with names that resonate with investors’ emotions.

Before the crisis, it was all about boosting return, with little regard for risk; now the focus is on minimising risk, with little regard for return.

Just a few years back, people queued up for highly structured products. A post crisis report by the UK regulator pointed out that many of these products used terms like “safe”, “secure”, “protected” or “guaranteed” to hide substantial risks. *

With market volatility and tracking error very low at that time, product makers also marketed “active extension” or “130/30” strategies to boost risk taking. The problem was that these investments were based on the faulty assumption that market risk always remains the same. Many people are now living with the consequences.

These days, investors tend to be more risk averse.

The focus has turned to preserving capital and ensuring a “guaranteed” minimum return above the risk free rate. So the financial services industry has come up with “absolute return” funds.

Sometimes called “all weather” vehicles, absolute return funds aim to deliver reliable returns in rising or falling markets. They market themselves as highly diversified funds that bring together a dizzying range of asset classes—including commodity futures, swaps of various kinds, mortgages, currencies and other exotic instruments. Many use leverage and shorting to achieve their goals.

Great in theory, but…

The intention with these products is to provide investments that are “uncorrelated”—meaning they behave differently at different points in the economic cycle—to traditional stocks and bonds. Consequently, they are supposed to decrease your risk of a negative return by increasing the diversification in your portfolio.

That’s the theory. But there are a few problems in practice. For one thing, as we saw in the financial crisis, past correlations and estimated volatilities are not necessarily the best guides to what might provide the best diversification in future. During extreme stress, a discount tends to be applied to all risky assets, decreasing prices and increasing correlations as volatilities spike. Distinctions are not made.

Secondly, investors are mistaken if they think volatility and correlations are the only measures of risk. Extreme events can occur. Some of those events can be sourced to the financial system; others not. Who would have thought, for instance, that Japan would suffer a catastrophic earthquake, a hugely destructive tsunami and a terrifying nuclear crisis at the same time?

A third issue is that supposedly risk free portfolios should really receive the risk free rate of return. That they don’t—and we shall evidence of that in a moment—highlights the contrast between past correlations, simulated track records and reality. Simple logic tells you that any difference in expected returns between “real”, as opposed to supposedly risk free investments, will be arbitraged away at short notice.

The facts

Despite all of this, the moniker ‘absolute return’ is a great marketing strategy. And it appears to have worked. In the UK, for instance, the absolute return sector was the second most popular among retail investors in 2009 and the third most popular last year, according to the Investment Management Association. **

In the US, the absolute return label is also proving a magnet for nervous investors. According to Morningstar, there are now 32 mutual funds in the US with “absolute” in their titles. Twelve of those have started up since the start of 2010. ***

The sheer complexity of these funds and the vast differences in their underlying investments make comparisons difficult. But Bloomberg has reported that of the 10 existing US absolute funds in 2008, all except two have lost value. Fees also differ markedly, from less than 1 per cent to almost 3 per cent.

In the UK, research by independent advisory firm AWD Chase de Vere found that 13 absolute return funds were set up in 2009 in the wake of the financial crisis. Only two were set up in 2007. By the end of 2010, the absolute return sector had moved in the same direction as the FTSE100 in 29 of the previous 36 months. And in 34 out of 36 months, the absolute return funds had moved in the same direction as balanced managed funds with a maximum of 60 per cent in shares. ****

So it’s not clear from all of this that absolute return funds are living up to their names: Opaque strategies, reliance on simulated returns, assumed correlations that might not hold up in another crisis, a large variation in fees, and returns that do not differ greatly from what can be achieved in underlying shares and bonds.

When risk appears on the horizon…

When risk appears on the horizon and these “all weather” portfolios do not live up to expectations, their defenders may blame “the black swan”, the “six sigma” event or the once in a century storm. But the real problem is pretty simple: It is the very idea of delivering risk free premiums over the risk free rate.

At Swindells we get to know our clients, which means we understand their future plans and their appetite for risk.  This enables us to advise and invest appropriately. If you would like to arrange a complimentary discussion please call 01825 76 33 66 or complete the contact form

* Review of the Quality of Financial Promotions in the Structure Investments Products Marketplace’, UK Financial Services
Authority, October 2009
** Asset Management Survey, Investment Management Association, 2011
*** Complexity of Absolute Return Funds Makes Picking Difficult, Bloomberg, April 13, 2011
**** Absolute MixUp Over Fund Names, Scotland on Sunday, May 8, 2011