Home > News > 2005 > February 2005 > Absolute Return Strategies
Absolute Return Strategies
Barnett Waddingham LLP consider the Absolute Return Strategy approach to pension scheme investment.
Background
Normally, in setting investment strategy, a pension scheme will first consider an appropriate underlying asset allocation strategy (based on the term of the liabilities and the trustees' and sponsoring employer's risk tolerance) and then consider different investment management styles before appointing a manager (or more than one) of the preferred style(s). Whether a pension fund adopts a passive (or index-tracking) approach, an active approach to stock picking or a manager-of-managers approach, the manager's benchmark will be derived from the underlying strategic asset allocation, and will therefore move in line with markets (principally equity and bond markets).
A significant bear market in equities commenced at the beginning of 2000. Whilst there has been an increase in values since March 2003, the UK equity market is still well below its peak of December 1999. Other asset classes such as fixed interest, commercial property and cash have had their own challenges. Fixed interest yields have been hovering around a 40-year low, commercial property is priced at historically high levels and deposit interest has been at low single digit rates for many years.
Possibly as a result of the above, there has been increasing investor interest in hedge fund investments over recent years. A common view is that many hedge funds offer an ability to make positive returns irrespective of the direction of the primary markets. However, hedge funds are highly complex vehicles; often highly geared and utilising a plethora of derivative contracts. It is often difficult to understand how they work, the charges made and the position concerning custody, regulatory issues and investor compensation. In short, pension scheme trustees often regard hedge funds as too speculative.
Conventional fund managers offering absolute return strategies may provide an alternative solution. (By conventional we mean properly regulated funds holding identifiable assets with fully transparent charges and custody.)
These managers generally regard cash as the true investment benchmark, as with cash there is no risk of capital loss, and no fee to be paid. Absolute return managers therefore usually aspire never to lose money on a one-year rolling basis. For example, this type of manager might aim to produce a positive return, after expenses, of at least twice that available on cash. (If this is achieved then the fund should also have a good chance of comparing favourably with the primary investment markets, including the equity market, over any reasonable length of time - although there may be little short-term correlation with primary market movements.)
Tactical asset allocation (TAA)
If an equity manager is seeking absolute return, rather than aiming to beat an equity index, they should not feel obliged to take a position in each of the large cap companies and they could have a zero weighting in all stocks they don't favour. However, to obtain all-weather absolute returns, it is probably no good concentrating only on equities. The manager therefore needs to consider many different asset classes (UK and overseas equities, UK and overseas bonds, cash, commodities, currencies etc) depending on economic and market conditions, and avoid following any particular asset allocation benchmark. Derivative contracts may also be permitted, although this does not necessarily mean that the manager would be allowed to speculate by selling short (as most hedge fund managers would expect to be allowed to do).
This means an absolute return manager generally needs to be allowed flexibility on asset allocation (rather than being given a specific benchmark such as 50% bonds, 50% equities). They will then allocate according to those asset classes they believe are best suited to their objectives at any time (a process known as "tactical" asset allocation).
Absolute return managers usually establish a "core" global view to identify the areas of investment most likely, on the balance of probabilities, to make money. At the same time, it should be realised that predictions will often be wrong. The future is simply too opaque and complex to predict, especially over the short term. Accordingly, defensive or "offsetting" investments are usually needed to diversify the core holdings.
Whereas there may often be only a few core markets, sectors or stocks at any one time, there would usually be a number of ways that the core view can be wrong, and a corresponding number of offsetting investments.
The weighting of core assets to offsetting assets depends on the level of confidence in the core view, timing and valuations. Investments in offsetting assets are assessed closely for any mutual dependence or hidden gearing that could result in unexpected results from any given economic or market outcome.
A positive result of holding both core and offsetting assets is that it removes some of the pressure of market timing. The manager is always to some degree positioned to benefit from the expected market outcome, but also holds assets that should deliver positive returns either if the manager is wrong, or while the manager waits for the expected outcome to materialise. This means the manager's research team is able to look further forward.
Stock selection
This is often a dual approach to benefit from both top-down views and bottom-up ideas.
The top-down driven element aims to identify those stocks most likely to gain from either the core view or offsetting scenarios, and then undertakes in-depth analysis to identify the most suitable investments.
The bottom-up part of the process looks for special situation or valuation anomalies that could produce positive returns under either the core or offsetting scenarios.
Portfolio construction
The size of individual holdings is determined not only by the attractiveness of the current valuation of each investment, but also its potential volatility to the portfolio. A small allocation to a volatile stock carries the same risk of underperformance to a portfolio as a larger allocation to a less volatile stock. Therefore the size of each holding is adjusted according to the volatility of the investment.
The resulting portfolio should be positioned to gain if the core scenario plays out, but also robust enough to produce positive returns under a number of alternative scenarios.
Risk control
An absolute return manager's investment process is geared towards understanding the risks involved for every holding in a portfolio.
By eschewing traditional benchmarks, risk controls are not measured against market indices, which only reduce risk relative to a particular index that may rise or fall at any one time. Instead, risk is measured against cash and is assessed in terms of the impact of any holding on the portfolio in absolute terms.
Results
There is evidence over the last 10 years or so that absolute return managers have achieved their objectives. Performance compares well with the other asset classes whilst avoiding many of the potential problems of absolute return hedge funds that may have achieved similar returns over the same period.
Adapting the approach for pension schemes
Many absolute return managers have in the past tended to cater for private investors rather than pension schemes or other institutional investors. Private investors are often concerned to preserve capital as a primary investment objective and therefore absolute return strategies have always been potentially attractive to this market.
However, an absolute return strategy is not necessarily as appropriate from a pension scheme's point of view. This is because a pension scheme is investing to meet particular liabilities - and the value of those liabilities is not fixed but instead will vary according to long-term interest rates depending on the term of the liabilities. (This is why bonds represent the lowest risk asset for a pension scheme rather than cash.)
Therefore, pension schemes ideally need the absolute return strategies to be developed so that they relate to a "bonds+" benchmark rather than a "cash+" benchmark. Alternatively, where some of the liabilities are linked or correlated to price inflation, an "inflation+" benchmark may be appropriate. Segregated portfolios might be able to set a bespoke composite benchmark that reflects the term profile of the liabilities, rather than just choosing a published bond index. Even if suitable bonds do not exist to match the scheme's projected cashflows, interest rate swap contracts can be used instead. (A swap contract could allow the scheme's investment manager to buy cashflow matching the scheme's expected outgo from a counterparty investment bank. This effectively lays off the scheme's interest rate risk and leaves the fund with an effective investment objective of a "cash+" benchmark.)
Translating an absolute return strategy into performance relative to a benchmark based on the scheme's projected cashflow in this way is sometimes called "liability-driven" or "liability-led investing" (LLI). A "narrow" LLI approach might mean trying to add a modest "alpha" of, say, +1.2%pa to a bond benchmark through conventional active bond management. A "broad" LLI approach is likely to involve a higher alpha target of perhaps "bonds+3%pa" or "RPI+5%pa" by using the techniques described above, including tactical asset allocation.
Warnings
The absolute return approach usually requires trustees to give much greater investment freedom to the manager (even if in practice this often means the freedom to be defensive, rather than the freedom to be aggressive). Accordingly, much greater attention needs to be paid to selection and ongoing monitoring of the manager. Effectively, the "risk budget" is being allocated in a very different way, and this needs to be understood at the outset and monitored carefully on an ongoing basis.
Traditionally, the risk budget focuses on long-term equity market volatility. There may be an overlay of some stock selection risk (if active management is utilised) and there may also be some asset allocation risk, although often only at the margin. Under absolute return the risk budget is presented to the manager in a less specific manner - leaving the manager to allocate risk to those areas where they have most conviction at any one time.
There are many commentators that would argue that, on average, traditional investment managers have not added value through tactical asset allocation in the past. However, TAA is central to an absolute return approach and trustees need to be persuaded by a particular manager's conviction and abilities in this area. Even when trustees do believe that TAA can add value then we are firmly of the view that TAA should be undertaken only by an appointed investment manager operating to an agreed mandate - never by trustees (or their consultants) trying to judge market timing for themselves.
We believe that liability and term-matching considerations are still important to establish a suitable overall risk budget. It may also be appropriate for trustees to consider using absolute return managers for only a part of the total risk budget, and only a part of the total fund, working alongside market-benchmarked managers working to a scheme-specific strategic asset allocation for the balance of the portfolio.
Historically, absolute returns managers have generally been relatively small investment houses, perhaps with little experience in the pension scheme market. Terms and conditions may need special attention, charges may be high, and performance may have a limited relevant track record. However, an increasing number of the larger investment houses, more familiar to pension scheme trustees, are now competing in this area.
For specific advice on pension investment issues please speak to your usual contact at Barnett Waddingham LLP.
Glossary
Active management
Investment strategy which seeks to achieve portfolio returns more than the relevant market return, either by forecasting broad market trends or by identifying particularly mispriced sectors of a market or securities in a market.
Alpha
Value-added from active management over passive investing.
Asset allocation
Apportioning of investment funds among asset classes, such as cash, equities and fixed income.
Benchmark
Benchmarks act as a guide or objective for performance of an investment fund.
Benchmark risk
The risk that the benchmark for a fund is not an appropriate one for meeting future liabilities.
Bottom up
An approach to investment selection, based on analysing companies' qualities (such as profitability, cash flow, earnings and pricing power), to work out if they are a worthwhile investment for a portfolio.
Derivatives
A contract or option to buy or sell an asset or to receive cash at a date in the future, either for an agreed price, or in exchange for agreed assets.
Diversification
The practice of holding a large number of assets in a portfolio so as to reduce the portfolio's sensitivity to an individual asset's return.
Equity risk premium
The additional return expected from an equity (usually compared to Government bonds) that compensates for the extra risk of holding more volatile assets.
Investment philosophy
Investment philosophy is an investment manager's beliefs about which type of investments will produce a good performance for the portfolio.
Investment process
The process that decides the investment strategy and which stocks to choose.
Passive funds
Funds aiming to reproduce the performance of a relevant index. This is done by investing in securities in broadly the same weights (proportions) as the index and so acting passively (like the index).
Quantitative investing
Investment strategy which combines strategic quantitative analyses of countries, industries and sectors using sophisticated computer models to select particular stocks.
Total return
The return on investment which takes into account the change in price plus dividends or interest received. The total return for a fund reflects changes in net asset value and reinvestment of all distributions from holdings in the fund.
Weighting
Proportion of total funds invested in a specific category, usually with respect to class, sector or country.