Absolute Return Fund Performance Improves but is Dependent on Volatility

Over the past three years, short volatility strategies have been most successful as market volatility declined. However, longer term, funds that deploy different strategies for low and high market volatility provide more stable, longer term returns. The most successful funds employ short volatility strategies, for example exploiting relative value and carry trades to make more money when volatility is low and directional strategies when volatility is high.

Absolute return funds, which seek to produce positive returns whatever the direction of the markets, and do not compare performance to a benchmark index, continue to be popular among investors.

Assets under management almost doubled to close to EUR200bn since end-2010, according to Lipper. The growth was driven by strong inflows, from investors who are keen to diversify sources of performance, in a context of low return expectations across traditional long strategies and asset classes.

"Most absolute return funds use short volatility strategies, which have fared better than long volatility strategies since end 2010. Carry and relative value performance engines (overall short volatility) supported higher return than directional strategies (overall long volatility), in a context of declining market volatility," says Manuel Arrive, Senior Director in Fitch’s Fund and Asset Manager Rating team.

Relative value strategies have also benefited from the market normalisation at the country and asset class level while relative value at security levels suffered from low dispersion, or a low variability of relative returns. Absolute Return fund managers have proved cautious on trading market exposures as a return driver, for lack of conviction and clear trends.

Absolute Return funds experienced drawdowns in May-June 2013 that relative to the market, were more severe than 2011, as a result of the rise in asset correlation and the funds’ long credit exposure. Funds also better captured market rebound, which suggests that portfolios may have kept their risk exposure constant instead of de-risking and re-risking in an abrupt and untimely manner.

Indeed, in Fitch’s view, anchoring allocations and avoiding excessive churning can prove beneficial in periods of sell offs and quick rebounds.

This approach suggests a higher acceptance of short term drawdown from investors to protect alpha in the longer term.