By Sam Liddle, Sales Director, Church House Investment Management
The absolute return sector has always had its critics and, in the case of several participants in the sector, rightly so. But in a year that looks set to challenge both equity and fixed income markets, could the strategy come back into its own?
So far this year, much airtime has been handed to discussions around which style of investing, asset class, or region will dominate from a performance standpoint in 2022. The reality is, it’s a uniquely difficult time for both growth and income investors, as both equity markets and fixed income assets face uphill struggles.
This is when a traditional multi-asset absolute return strategy, managed appropriately, may well prove a sanctuary for investors looking to beat inflation, while also offering capital preservation to income investors.
The number one challenge
Inflation is the main bugbear for the moment and a particularly difficult one to tackle. It is not just a UK problem, US inflation in December was reported at an annual rate of 7%.
The bounce-back in world economies last year led to an equally rapid rise in energy prices and this is now being made worse by supply constraints, which means we do not see an immediate catalyst for a correction of this rapid rise.
But we do expect economic growth to continue in 2022 on both sides of the Atlantic, which should lead to further earnings growth for companies. Ultimately, this is what will drive markets in 2022 (as ever) but we expect a bumpy ride. This lack of visibility can give rise to increased volatility, particularly in risk assets like equities, meaning returns easily become inconsistent.
How volatility and uncertainty affect investors
This may not be so much of an issue for younger investors, as they hopefully have time for investments to recover before they need access to their capital. But for older investors, particularly those looking to draw an income, it can become a significant problem.
Take a retiree making regular drawdowns from their pension pot to maintain their lifestyle. If a risk event sends equity markets horribly south, and they are heavily exposed to them, it could not only reduce the value of their savings, but also put them at threat of ‘pound-cost ravaging’.
This is a phenomenon whereby they are forced to sell larger and larger portions of their pension pot to maintain their preferred level of income while the underlying value of that pot continues to fall.
Contending with inflation, now sat at a decade-high level of 5.4%, means the income they are drawing down also has less spending power.
While this all seems rather gloomy, this is where the multi-asset nature of absolute return investing can really come into its own. Funds in the sector can vary considerably in style, objective and, indeed, success, but being able to invest across a spectrum of assets allows skilled investment managers to pick the right opportunities and weight their portfolios in accordance with their clients’ expectations.
This diversification, if done correctly, can help shield the risks associated with investing in an individual strategy, style, sector, or region and serve as an outsourced asset allocation solution in difficult volatile markets. It means investors can hope to avoid the risks of being overexposed to market volatility by having a large exposure to cash. Then, to mitigate the risk of capital erosion this creates, complement this cash allocation with growth and income positions in assets like equities and floating rate notes (FRNs).
How to identify absolute return ‘purists’
It is vitally important in this sector to separate the pure absolute return funds from the ‘quasi’ absolute return funds. The past has shown that when markets are volatile, it has been easier to see which funds have the most risk on the table. We have always believed that in a volatile environment, the pursuit of growth while disregarding capital preservation seems like a reckless strategy.
To our mind, an absolute return fund should have a number of key characteristics: first, it should start with cash. Then, every investment beyond cash should offer compelling reward potential for an appropriate level of risk. If, in volatile and uncertain market conditions, there are relatively few opportunities that meet those criteria, holding higher weights in cash or near-cash instruments seems sensible.
Investing on an absolute return basis should mean ensuring every investment is made with an awareness of the downside risk. Many funds adopt a ‘rolling three-year’ absolute return target, leaving investors to suffer significant volatility in the interim. There is always the danger that having waited three years, investors don’t get the absolute return they wanted either but by then it is too late.
Instead, we continue to target a positive return over rolling 12-month periods, employing ‘patience’ as an investment strategy – a seemingly under-used strategy of late. Reverting to near cash when short-term volatility looks extreme, or valuations in other asset classes are untenable and simply waiting until they become compelling, seems the pragmatic approach.
This is important because of the impact significant drawdowns can have on long-term returns. The greater the amount lost, the higher the gain required to break even, and who knows when markets might return to normal.
The above article has been prepared for investment professionals. Any other readers should note this content does not constitute advice or a solicitation to buy, sell, or hold any investment. We strongly recommend speaking to an investment adviser before taking any action based on the information contained in this article.
Please also note the value of investments and the income you get from them may fall as well as rise, and there is no certainty that you will get back the amount of your original investment. You should also be aware that past performance may not be a reliable guide to future performance.