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Don't Write Off Fixed Income Absolute Return Funds

Emma du Haney

Henderson Global Investors

4 February 2008

Fixed-income absolute return funds have not had good press of late. Many of them are not achieving their targets of Libor plus 2 per cent or more, while some are in negative territory on the year. They were marketed as being able to achieve a positive return irrespective of market movements, so the question of whether the concept has failed seems justifiable. However, their performance needs to be viewed in the light of the extreme market conditions of August and November 2007. The problem was not that credit markets were selling off, as many absolute return funds are structured to be able to profit from falling prices. Rather, the problem was the lack of liquidity, as investment managers were unable to sell paper they no longer expected to perform well. In addition, credit indices based on derivatives (such as the Itraxx Crossover) performed independently of the underlying physical bonds they would normally effectively hedge. The performance of funds investing in corporate credit may also be artificially low due to mark-to-market effects. In the current environment, sellers of securities find that investment banks are marking prices down aggressively to ensure they do not have to take instruments on to their balance sheets. Similarly, buyers who have an appetite for some of the opportunities being created in this environment are finding securities are only available in token size. Funds are priced at the "mid" point of these two extremes, and the result is an unrealistic reflection of where value actually lies. As liquidity returns to the market, and the pricing becomes more efficient, absolute return funds will benefit. There is no doubt that 2007 was a poor year for the absolute return strategy, chiefly as a result of the issues discussed above. However, all strategies face difficult environments from time to time, and the experience in 2007 does not diminish the attractiveness of the absolute return proposition. Most funds are only down in the region of Libor less 1 per cent. This is hardly a disaster and should be recoverable for most. The new Europe-wide UCITS III investment regulations strengthen the case for absolute return, as they provide greater flexibility to investment managers. Under UCITS III a sophisticated fund has the ability to go short via the use of derivatives. This is key to being able to generate positive returns in falling markets. UCITS III also allows leverage. Neither being short nor using leverage needs to be risky. The ability to implement a bearish market view opens up a range of investment opportunities, particularly in credit markets where the risks are asymmetric as the potential loss on a corporate bond or emerging market bond is greater than the possible gain. The ability to go short these instruments reverses this asymmetry in favour of the investor. Leverage also allows micro relative value strategies, which are typically low risk in nature, to make a meaningful contribution to performance: an investor looking for the spread between five-year British Telecom and 10-year British Telecom to move by three basis points needs to invest a meaningful amount to make an impact on performance. The key to managing derivatives and leverage sensibly is to have a rigorous risk management structure in place. This is what the UCITS III regulations have imposed with the requirement for daily VAR (value at risk) reporting on each instrument held in a fund. Clearly there are lessons to be learned from the market turmoil. Credit market indices based on derivatives have not acted as reliable hedging vehicles because they have not been subject to the same selling pressures as physical bonds. Therefore, investors have had to look at other ways of reducing market risk: at the moment government bonds work well as a hedge for the corporate bond market as they rally at times of risk aversion. The last six months have been an exceptional period in markets and the impact on returns from the absolute return community should be seen in this context. Many can point to past periods of positive performance at times of market downturns. However, what recent history has shown is that it is difficult to uphold performance at times of market illiquidity. Nonetheless, the fact that most funds are still in positive territory points to their robust nature, given the extreme moves in asset-backed securities and other parts of the credit market in which some players are invested.