Inflation has moved well out of its target of 3% to 6% and looks set to stay that way for at least the next 18 months. At the same time volatility in the stock market has increased. During this difficult period, will absolute fund managers be able to meet their inflation-linked targets?
Many absolute return funds promise investors a positive return over 12 months, while over three years the fund will beat a specified target, linked to inflation. Considering that the next set of inflation numbers is expected to top 10%, a benchmark of CPI plus 5%, for example, would have to deliver 15% to meet its benchmark. This is the long-term average return from the equity market, which would require a higher level of risk.
Muitheri Wahome, head of Alexander Forbes Asset Consultants, which runs the Manager Watch surveys, says that until July last year the market was favourable for these funds. Inflation was contained and equities were booming. This meant low-risk absolute return funds did not have to have a high level of exposure to equities to meet their targets. The targets, however, have become steep now.
“Globally inflation has shot up. This will be a testing time and the inflation target will be tougher to beat,” says Wahome, who adds that investors need to understand the underlying strategies of a fund and how the strategies will deliver in more difficult periods.
Wahome says absolute return funds, although lumped together under one sector, have different strategies ranging from asset allocation with a value tilt to protective strategies. The higher the target, the higher the risk the fund manager will have to take. A fund with a CPI plus 3% target will need less exposure to equities than a CPI plus 7% fund. Wahome says when you look at the volatility of some of the funds they mimic the risk profile of a balanced fund and will experience increased volatility in turbulent markets.
According to the Alexander Forbes surveys, overall hedged-type strategies have done better than others in volatile periods. But unit trust funds are limited in their use of instruments to make money in falling markets and can only be defensive.
Pieter Koekemoer of Coronation and chair of the Association of Collective Investments says that when returns in the underlying markets are generally negative, managed funds, including absolute return funds, will produce lower returns as well. Cash becomes the only safe haven when times are tough.
The fund sector bias also has played an important role, with resource bias funds outperforming funds with a financial or industrial bias. Koekemoer says in the past year resources were the only asset class that outperformed cash, returning 50%. Bonds, local industrial shares and foreign equity were essentially flat, while listed property and financials lost value.
Sumesh Chetty, portfolio manager at Investec Asset Management, says it is important to remember that while absolute funds aim to protect capital in the shorter term, the inflation-based target is usually set over three years. So while there might be short-term underperformance of the benchmark, the funds are still likely to meet their target of beating inflation over a three-year period.
“All managers are struggling to meet their targets but hopefully they have done well enough in recent years to build up some fat for more difficult times,” says Garth Taljard, absolute return fund manager at Old Mutual. He says the challenge now will be to manage the expectations of investors who have become used to returns of between 15% and 20% and to remind them that the inflation target is based on a rolling three-year period.
The strategies
The Investec Absolute Balanced Fund has a target of inflation plus 5%. Chetty says the strategy is to buy equities, but to remove all market exposure by selling listed index futures against it. This takes out the market volatility, but aims to deliver based on the relative outperformance of the shares selected to the overall market. The fund has low volatility and expects to deliver a return of 2% to 3% above cash rates.
Eldria Wagenaar, chief investment officer at Prescient, says market conditions have become much tougher. The Prescient Positive Return Fund, which is available to institutional investors, uses derivatives to protect on the downside and has beaten its target of CPI plus 5% over the past year while posting a positive return in the three months from December to February in difficult conditions.
Although the fund guarantees a positive return in any 12-month period, meeting its benchmark of CPI plus 5% will be more difficult this year. “In an environment where inflation is rising, interest rates are adjusted upwards and equities don’t do well,” says Wagenaar.
The fund’s strategy has been to lock in as many returns as possible using derivatives so that they will meet inflation returns at least during tougher periods. If for example R100 in capital grows to R150, the fund increases its derivative cover, effectively banking returns and ensuring they can’t lose those returns built up in the fund. A normal balanced fund without protection can lose much of the capital built up over the period. But this does come at a cost. In order not to lose money in a 12-month period all equity exposure is protected whether the fund is carrying 40% equities or 75%. This costs money and in a bull run the fund would underperform against a balanced fund that is not carrying the cost of derivatives. Old Mutual’s dynamic floor fund provides a certain level of capital preservation.
Taljard says the worst-case scenario for the fund is to lose 10% in one year. In most years the fund is not allowed to lose money, but in extreme bear markets the fund must protect at least 90% of the capital.
Taljard says the fund, which has a target of CPI plus 6%, has always delivered a positive return. Considering its target, it tends to be a more aggressive fund but uses put options to protect capital. Although still delivering a positive return over the three months to February, it has lagged its inflation target in the past 12 months.
Assessing returns
Only four out of 50 retail absolute funds outperformed an inflation plus 4% target in the past year.
Pieter Koekemoer of Coronation and chairman of the Association of Collective Investments says all four funds have a reasonable level of resource exposure. Three of these, Cadiz Equity Ladder, Kagiso Protector and Contego B5 Protected Equity, follow a portfolio insurance or floor strategy, hedging against downturns in the same manner as Prescient. The fourth fund, Metropolitan Absolute Provider, follows an asset allocation model with capital protection targets.
Ten out of 50 funds performed better than cash over this period, while 40 produced returns less than cash. Only one fund, 35ONE Target Return, produced a negative return in the past 12 months because of exposure to small caps. Over three years the sector produced a mean return of 12,8%. This is 7% ahead of inflation and 5% ahead of cash, while volatility was less than 6% compared with about 16% for the equity market over the same time.
“Managed funds with between 30% and 65% equity exposure and an explicit undertaking not to lose money over a set period represent the heart of the category and are where most assets are invested. They have very stable returns and closely track cash returns,” says Koekemoer.
He says these funds are the only portfolios in the category that have the ability to significantly outperform cash in the longer term because of their equity exposure. While five-year returns are in a fairly tight range (between 15% and 18%), one-year returns vary between 13% and -1%.