Most of the funds promising to protect investors from volatile stockmarkets have produced dismal returns, says Max King.
After the excellent returns of 2016 and 2017, most equity investors steeled themselves for a difficult 2018, as the course of profitable investment never runs smoothly. And so it proved, with the FTSE All Share index losing 9.5% (including income). The MSCI World index, protected by the better performance of Wall Street and by the weakness of sterling, lost just 2.5%. A typical British investor, with less exposure to the US than the MSCI’s 56% and more to the UK and smaller companies, will be down more than 5%; perhaps a bit less if the portfolio includes a good allocation to government bonds, alternative funds (such as infrastructure), or cash.
Still, three-year returns remain good: the average return of investment trusts in the global sector is 42%, while the worst performer returned 18%. Investors may have been shocked by double-digit percentage declines in value in the last quarter of 2018, and will be nervous about the outlook for 2019, but on any multi-year perspective, the stockmarket has been a profitable place to invest.
However, in recent years many investors, scarred by the 2008 financial crisis, have been persuaded to adopt “lower-risk” strategies. They invested in funds that missed out on much of the 2016-2017 upside in the expectation that they would be cushioned in more turbulent times. The basic idea behind these lower-risk funds was to sacrifice some upside in the good times but temper the downside in the bad times. Ideally, the long-term return would be the same, but the ride would be much smoother, especially in a volatile environment when absolute performance might be modest but would compare very favourably with the losses being suffered by conventional terms.
Funds with these strategies were declared to be seeking “absolute returns”, as opposed to returns relative to the market indices. As you might expect, this approach found particular favour among trustees of pension funds and charities and the consultants who advise them. These investors are entrusted with looking after other people’s money, and hence tend to be more focused on short-term risk, not least to their reputations, than on longer-term returns. Last year provided an opportunity for these funds to prove themselves but, unfortunately, many have failed the test.
Investment trusts with the “absolute-return” approach are grouped together in the “flexible investment” sector and have mostly performed satisfactorily. Their average 2018 return of -4.6% was similar to the average return in the global sector, but the three-year return, at 27%, was much lower. However, their performance in the final quarter of -5% was much better, indicating that though they lagged badly early in the year, their caution was later vindicated. Caledonia Investments (LSE: CLDN), RIT Capital Partners (LSE: RCP) and Capital Gearing (LSE: CGT) were the best performers, with positive returns for the year, while Ruffer Investment (LSE: RICA), with dismal but still positive three- and five-year returns, was the dog, losing investors 11%. But “at least with Ruffer, as with Personal Assets Trust (LSE: PNL) or Capital Gearing, you can understand why they have done well or badly”, says Mark Dampier of Hargreaves Lansdown. Ruffer’s November fact sheet shows an allocation to index-linked bonds of more than 40%, a chunky 12% in Japanese equities, 7.5% in gold and gold equities, but 72% in sterling, which suggests currency hedging was expensive for Ruffer in 2018.
GARS: complicated and confusing
Among open-ended funds, classified as “multi-strategy”, no such clarity exists. The largest of these is Standard Life’s Global Absolute Return Strategies (GARS), which once had £25bn of assets plus perhaps another £25bn in similar funds or parallel accounts. Its initial success spawned imitation funds from Aviva, Invesco and others, but nearly all are floundering. In the three years to the end of November, GARS returned -6.6%, Aviva -2.9% and Invesco -1.2% for the institutional share classes. These funds were conceived to mimic macro-trading hedge funds, but without the extortionate fees, traditionally “2 and 20” (2% annual fee plus 20% of all performance). They claimed an “absolute-return” approach, targeting returns of 5% over interest rates, before fees, over rolling three-year periods.
The problem is that investors don’t understand these funds, as they are too complex, with 25-30 different trading strategies at any one time, says Dampier. “Macro-economic and strategic forecasting is way harder than stock-picking, and you can’t de-risk an investment strategy without losing the returns,” he says. But Dampier doesn’t just blame the managers. “The problem is that clients by and large want low risk… They are looking for equity-type returns, but don’t want full equity risk, as they are not good at coping with volatility. The investment industry spends much of its time trying to turn lead into gold and, not surprisingly, ends up disappointing investors.”
Terence Moll, head of strategy at Seven Investment Management, is a long-standing sceptic about hedge funds and their open-ended mimics. These funds ought to perform better owing to their lower fees, but the best strategies tend to go into the hedge funds, while the open-ended funds are left with the more liquid but lower-return ideas, he says. They also take less overall risk than the hedge funds, which results in their performance being no better. “GARS was sold as a way to invest in clever, complex strategies,” he says. “Now faith has been lost.”
The alpha managers
Moll points out that the returns of funds that avoid market risk are dependent on “alpha” – the value added by managers’ skill – yet “after costs, there seems to be very little positive alpha in the world”. Additionally, managers look for market inefficiencies that can be exploited and valuations, whether of equities, bonds or currencies, that are out of line and will revert to fair value. But, as economist John Maynard Keynes observed, “markets can stay irrational for longer than you can stay solvent”.
Such is the number of investors and weight of money looking for anomalies or mining the historic data for patterns that can be profitably exploited, Moll points out, that the opportunity often proves illusory or, if not, the capacity is quickly used up. Besides, there are 325,000 subscribers with Bloomberg terminals worldwide, so desk-based investment strategies building on the information they provide are extremely unlikely to give any investor a competitive edge. As John Le Carré writes, “a desk is a dangerous place from which to view the world”.
From wretched to awful
The record of the “multi-strategy” funds ranges from wretched to awful. Yet one leads the sector by a mile: Veritas Global Real Return fund returned 7% in the year to 30 November, and 41% over three years, using a simpler strategy than competitors. It invests in high-quality global equities for the long term, hedging out equity risk as appropriate through options and futures (arrangements to buy assets in the future, either as a right or an agreement). Unsurprisingly, Baillie Gifford’s Diversified Growth Fund is also better than most. It returned 9.6% over the three years to the end of November, and 18.4% over five. This is below the target of inflation plus 3.5% per year over five years, but isn’t wildly off. It invests in other Baillie Gifford funds, as well as directly in bonds, commodities and closed-end funds. Schroder’s Diversified Growth Fund had a higher returns target of inflation plus 5% per year, indicating greater appetite for risk, but managed just 6.5% over the same three years and 14.7% over five years. The returns from BlackRock are lower still. The record for Investec Asset Management’s copycat fund is even worse: negative over three years even for institutional investors, before December’s tsunami of red. “Diversified growth” is clearly a misnomer for most of these funds.
If few multi-strategy, absolute-return or diversified-growth funds have performed well in either the good or the difficult times, when will they deliver? “I don’t see them catching up easily,” says Dampier. Despite this, “investors are not good at coping with the very volatility we are seeing now”, so disappointing performance won’t stop investors demanding the impossible: risk-free returns. He wouldn’t be surprised to see new fund launches and another cycle of hubris to nemesis launched.
Stick with a mixture of equities and cash
By contrast, the “with-profits” funds, which once dominated the market (owing to the ability of the insurance companies that managed them to smooth returns over the years) are unlikely to return, as they lack transparency and the withholding of returns in secret reserves is unfair to investors. “Balanced” or “cautious-managed” funds, which invest in a constrained mix of equities and bonds, once flourished, and might return to favour, but Dampier is sceptical. “They did well in the multi-decade bull market for bonds when equities were also trending upwards,” he says. But the long bull market is over and bonds, particularly in the UK and Europe, may now represent what James Grant, editor of Grant’s Interest Rate Observer, called “return-free risk”.
Dampier’s longer-term advice to investors is to go for a mixture of equity exposure and cash. The more cautious the investor, the more cash should be held. This not only limits the erosion of capital in bad times, but also means there will then be cash available to top up equity exposure. Current market weakness provides an excellent opportunity for those holding GARS-type funds out of choice to switch into conventional equity funds. Those locked into such funds through collective pension schemes need to put pressure on their trustees if they want to avoid a delayed and miserable retirement.
“In the short run, the market is a voting machine, but in the long run it is a weighing machine,” said legendary investor Benjamin Graham. In other words, investors should ride out market turbulence to harvest the long-term returns that equity markets offer.
Why did anyone ever believe that a complicated fund dependent on managers with the Midas touch juggling a broad range of elaborate trading strategies could possibly work any better?