The Olympics are nearly upon us. Elite athletes from across the world are descending on Brazil for what remains the definitive test of athletic excellence. Reputations and PR will count for nothing when the starting pistol goes – results are all that matter.
The same can be said, of course, for investment. No matter what the reputation of a manager is, in the end, all that counts for investors is the return.
In this edition of Investor Insights we take a look at absolute return investing – a highly attractive proposition in theory, but one that is prone to risks and flaws in practice. Indeed, as you will see, an absolute return (capital stability with reliable, low volatility returns) can frequently be better achieved by some much more transparent and straightforward strategies.
Absolute return investment – a brief history
It is well known that absolute return investment has its roots in the hedge fund industry. The connection between hedge funds and Australia is less well known. The man generally known as the founding father of the hedge fund industry, Alfred Winslow Jones (born on the 9th of September 1900), was the son of an expatriate American who ran General Electric’s operations in Australia.
Initially, Jones showed little interest in or affinity for finance and investment. Indeed, it was not until the relatively old age of 49 that he launched the world’s first hedge fund. In the years prior, he’d been a sailor, joined the foreign service, flirted with Communism and worked as a journalist and academic, specialising in sociology.
When he eventually did launch his “hedged” fund in 1949, it spawned an industry. By utilising a mix of so-called “long” positions (buying a security in the expectation that its value will increase over time) and “short” positions (positioning to profit from a security’s decline in value over time), Jones sought to achieve positive returns for investors even when markets were declining. To use Jones’ words, his fund was looking to use speculative tools (short selling) for conservative ends.
In the decades that followed, a raft of other managers replicated Jones’ strategies, then developed them further. By the 1990s, starting a hedge fund was almost a rite of passage for a young investment banker. Strategies were diverse and frequently complex. Increasingly, particularly when these strategies were offered to retail (“mum and dad”) investors, they became known as ‘absolute return funds’).
Absolute returns – key characteristics
As absolute return investing became more popular, regulators and the financial industry generally tried to define its key characteristics. ASIC defined a ‘hedge fund’ as having two or more of the following characteristics:
- Complex investment strategies
- Ability to short-sell
- Ability to use leverage
- Ability to use derivatives
- Ability to charge a performance fee
The financial industry focussed more on the investment objectives of absolute return strategies. Thus, international ratings agency, Morningstar, defined absolute return funds as those that seek “... to make a positive absolute return for investors ... regardless of underlying market conditions ...”
The fundamental objectives of absolute return investment include:
- Capital preservation: absolute return funds are squarely focussed on Warren Buffett’s first rule of investment: lose no capital (and second rule of investment – refer rule one!).
- Positive, low volatility returns in all market conditions: whilst returns will always fluctuate, absolute return funds should do so less than other strategies, providing a highly reliable investment profile.
- Low correlation to key markets and benchmarks: when analysts talk about ‘diversification’ they are talking about finding assets that do not all perform badly at the same time. In other words, they are looking for assets that have low ‘correlation’ to other assets. Absolute return investing aims to deliver this low correlation – absolute return funds should not be significantly affected by fluctuations in financial markets.
The strategies used to achieve this are many and varied. All asset classes – shares, bonds, commodities, real assets and currencies are used by absolute return managers. Long and short positions are taken, trades are executed both via public exchanges, ‘dark’ or private exchanges and via private sale (‘over the counter’). All manner of derivatives and leverage tools are used. In many cases, qualitative judgments of the managers are supplemented or even replaced entirely by complex mathematical models and computer driven trading.
Absolute returns – the risks
The attraction of absolute return investing is obvious. Imagine that you could find a form of investment that both preserved your capital and produced a strong, reliable return or income. However, it is also important to be aware of the risks. Some of the key risks are as follows:
- Understanding the strategy: it is a truism that one should understand something before investing in it. Yet many absolute return managers operate in secrecy to protect their ‘winning edge’. In effect, investors are asked simply to trust their expertise and honesty.
- Counterparty risk & leverage: the nature of absolute return strategies means that a high degree of reliance is placed on other parties (e.g.: so-called ‘prime brokers’, who help the managers complete their trades) and leverage. This magnifies risks for investors. If something happens to affect the counterparty, the strategy can be significantly adversely affected.
- Track record still matters: new absolute return strategies are being released regularly and, in many cases, the jury is still very much out as to whether they will succeed across the economic cycle.
- Hidden correlations: despite having a key objective of avoiding correlations, absolute return funds frequently fail this test. Indeed, a study between August 2008 and January 2016 by JANA asset consultants showed that the correlation between the main index of hedge & absolute return funds and the US equities markets was an extraordinary 0.8.
- Black swans: most absolute return strategies work by exploiting relationships between securities based on historical analysis and probabilities. “Black swan” events – defined by Nicholas Nassim Taleb as being unforeseeable outliers that have extreme impacts – can break down these historical probabilities and cause serious problems for absolute return managers. History is replete with examples of supposedly ‘bullet-proof’, low risk absolute return strategies that proved to be anything but in the light of new circumstances.
Fundamentally, the risks of absolute return strategies coalesce around complexity. The greater the complexity in an investment strategy – the more moving parts there are involved – the more difficult it is for even sophisticated investors to properly assess risks and monitor the execution of the strategy. The GFC is a prime example of strategies growing too complex to be managed properly. To quote Warren Buffett once again “Investing is not like Olympic Diving, you don’t get bonus points for degree of difficulty.”
La Trobe Financial and absolute return investment
La Trobe Financial is not generally thought of as an absolute return manager. Frankly, our strategies are too simple and ‘old-fashioned’ to be thought of in that way. However, the returns that the La Trobe Australian Credit Fund has delivered for its investors over the years certainly fit the key objectives of absolute return investment.
Take the performance profile of the Pooled Mortgages Option. Since inception in October 2002 it has never returned a cent of capital loss to investors, has offered flawless liquidity and paid market leading returns. The graphs below tell the tale.
What’s more, La Trobe Financial’s robust peer to peer offerings are Australia’s only independently rated and are Australia’s largest (over $300m).
So – in this Olympic year – remember that track record matters.