A reported surge in investor interest and a proliferation of funds available have heralded a period of popularity for absolute return strategies. Ijeoma Ndukwe explores the role of absolute return strategies within pension funds' portfolios today

Pension fund investors are increasingly attracted to the absolute return fund sector whose growth is largely attributed to the financial crisis a few years ago. Many industry experts say there has been an increase in interest due to disappointing returns from equities and high levels of market volatility.

Henderson Global Investors director of institutional business David Morley attributes this popularity to the instability of equity markets stuck in volatile but sideways trading ranges since 2008: "This makes an attractive environment for strategies which are able to generate returns for investors irrespective of market direction, perhaps through the ability to take long and short positions."

Morley also points to Henderson's diversified growth strategy where asset allocation decisions are made using a three-point process consisting of asset selection, efficient implementation and diversified portfolio construction. Morley believes that the more diversified approach "has delivered positive absolute returns in excess of equities for a level of volatility much more akin to investing in bonds".

OMAM head of institutional business Jenny Segal also argues that diversification is an aspect of absolute return strategies that is particularly suitable to pension funds. "Pension funds have a matching portfolio that matches their liabilities. If you're 100 per cent funded you have what you need for assets. However pension funds are not in that position, and therefore want to match where they can and then get what they need from the cash-plus return to cover their shortfall. That's where absolute return comes in, which is very appealing."

Furthermore, she attributes the move towards these strategies as a necessary step for pension fund portfolios to adapt to the current economic landscape. In reference to the returns they can hope to achieve Segal says: "Five per cent per annum is incredibly appealing. However 10 years ago that would have been a disaster. The whole expectations of return have been reduced. It's all about preserving capital when markets are falling."

There are a number of factors that make these strategies ideal for pension funds according to many fund managers. Morley outlines its ability to deliver returns that are uncorrelated with "traditional" equity and bond markets, and which exploit less well researched investment opportunities. He also discusses the reduction of the volatility of returns.

Natixis Global Associates head of UK/Ireland business Terry Mellish says: "The benefit absolute return strategies can bring is that they are not benchmark constrained and can generate positive returns over a cycle through smart risk and volatility management, possibly utilising hedging and leverage to generate risk adjusted alpha. In particular, with today's volatile market conditions the inclusion of absolute return strategies and volatility management in pension fund portfolios is all the more crucial and should be seen as a strategic asset allocation as well as manager selection decision."

Despite the attractive proposition of returns during periods of volatility, there is data which suggests that the sector has not performed as desired. FE Analytics, which provides investment data, software and performance analysis to the financial services industry says that in the 12 months to 31 August 2011, just 25 per cent of funds in the IMA absolute return sector beat inflation as defined by both RPI and CPI to deliver positive returns in real terms.

Although the absolute return funds surveyed by FE were retail funds, one may argue that it does provide some insight into how the sector is performing. According to their data, 73 per cent of funds would have lost money in real terms. Furthermore, an even higher percentage of funds would have failed to keep up with inflation once costs were calculated, as performance figures do not take account of fees.

Morley explains that as fees will often be higher than in "traditional" asset classes, it is essential that pension funds look at all absolute return opportunities on a net-of-fee basis. He says: "[This] will ensure that on the one hand they do not discount very good investment opportunities that look to be expensive on the face of it; whilst at the same time ensuring that higher fees do not erode the value of the opportunity on offer."

Disappointment in the performance of absolute return strategies are sometimes a result of what Segal describes as "regret risk" - an unavoidable human element of pension fund investors. According to Segal, absolute return strategies, like many other investment strategies, do not hold any guarantees and "pension fund trustees are humans and humans don't like that. The returns are great in falling markets, but market cycles come and go. When we come into a rising market, absolute returns will underperform in comparison to relative returns, then people regret it and ask themselves 'why don't we have the benefits of relative returns?'"

SWIP investment director for UK equities James Clunie also attributes disappointment to unrealistic expectations. He says: "I suspect that we always overestimate expected return in absolute return funds... It's a typical mistake that we as a community of investors are making and I think the risk is that people end up becoming disappointed with these funds because they don't do what they hoped they would. I say that as a generalisation because some funds will do exactly as people want."

According to Clunie, this issue can be addressed by people making sensible assumptions about returns and to be coldly realistic about their return expectations. He advises investors to examine it from an evidence-based standpoint. "They should examine the evidence and understand the practical problems in selecting a good absolute return fund and fitting it into their existing assets."

Most importantly risk management and due diligence are considered essential elements of absolute return strategies and industry experts say it should be integral to decision making and considered at all stages of the investment process. Mellish states: "Confusion relating to absolute return strategies can be mitigated by providing investors with a thorough understanding of the return drivers and how these are brought together to provide positive returns over an investment cycle. What's more, a successful absolute return strategy will ensure risk taking is balanced with risk management, and investors should ask managers to explain how this is incorporated into their investment process."

Segal warns that the term absolute return can mean many things and pension fund investors need to fully understand the strategies employed by their manager. She explains whether one invests long-only in bonds, or in equities which is very volatile both fall under the umbrella of absolute returns. She says, "It's a very broadly used term. You have to understand what the underlying implications are."

Many experts cite the skill of the individual managers as key to good performance of the asset class. Standard Life's UK institutional business director Len Currie explains that as strategies differ from one investment manager to another significant research and understanding is necessary to compare each manager's approach. He states: "Investment manager selection is therefore a more crucial component than many other asset strategies that focus solely on providing returns relative to a benchmark index." Currie sees merit in combining two or three investment managers to mitigate the selection risk due to widely different approaches.

Segal notes the work of one of their global managers who responds to positions quickly increasing the appeal of the fund due to his ability to put on negative duration positions to short bond markets to make money even when the bond market is falling. She says: "The ability to be nimble is one of the ways funds can survive."

Most experts agree that the skill of the manager and their individual strategy are key to a fund's success. Clunie states: "Almost by definition the secret to the success of the fund is the manager. You have to be able to identify a manager with skill to make it worthwhile for your portfolio. It sounds easy, but it's actually hard. Just because someone has done well doesn't mean that they're skilled. It comes down to skill. Without it there's nothing there."

Written by Ijeoma Ndukwe, a freelance journalist

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