Absolute funds or targeted return funds have very diverse risk profiles, with some funds investing in fixed interest and others in equities. It is important that investors understand exactly what they are investing in, writes Dr Prieur du Plessis, Plexus group chairperson.
Targeted absolute and real return funds is one of the largest subsectors in the unit trust industry, yet these funds are probably the most misunderstood by the investing public. While most people think of these funds as low-risk investments aiming to deliver above-inflation returns, the fact is that the investment mandates, performance objectives and investment strategies of funds in this sector differ vastly. If investors do not understand exactly what the fund managers are trying to achieve and how they try to attain their objective, the investor may well end up being disappointed.
Divergent returns and strategies
A study of the returns achieved by the funds in this subsector over the past year ended January 31 2010 reveals a variance in return from 41% to a paltry 3% — a difference of 38% between the best and worst performers. Even over a longer period of three years, the returns varied from 20,1% to negative 1,8%, an astounding difference of almost 22%. The divergence in returns is due to the different investment mandates and performance objectives. While all targeted return funds aim to achieve positive returns and limit capital loss, these funds use different investment strategies to achieve this, such as the use of derivative instruments, highly active asset allocation, stringent risk-control measures and share-selection criteria, and exposure to inflation-linked bonds.
Understand the benchmark
Targeted return funds have absolute benchmarks — namely a benchmark linked to cash or the inflation rate — as opposed to relative benchmarks, such as an equity or bond market index. The benchmarks — or performance objectives — vary considerably: targets range from a modest inflation plus 1% per annum to inflation plus 7% per annum. Investors should thus not compare the performances of these funds with one another without taking into account the funds’ risk characteristics.
Investors need to understand that the higher the benchmark or performance objective, the more risk the manager must accept to achieve the objective. A high-performance objective can be achieved only by having relatively high exposure to equities. This ultimately results in higher volatility in returns and a higher probability of capital losses when markets are buffeted by financial instability.
The most important consideration for choosing a targeted return fund is its performance relative to its risk. A fund that achieves a real return (i.e. after inflation) of 3% per annum with a volatility (or standard deviation) of 10% is a better risk-adjusted performer than a fund that achieves a real return of 4% per annum but with a volatility of 15%.
Identify your own objectives
- Determine your own investment objectives and then compare the risk-adjusted performance of funds.
- Understand the investment strategies of the various funds they are considering.
- If you cannot afford any significant losses, analyse a fund’s history of losses, especially during times of financial and economic crisis.
Adjust expectations
There is no guarantee that a targeted return fund will achieve its objective all the time. This is especially true when we experience rare occurrences such as the 2007/08 credit crisis, which affected virtually all asset classes negatively.
South African targeted return funds have at the same time been competing against a stubbornly high inflation rate, which makes it extremely difficult for managers to achieve their objectives. Targeted return funds nevertheless deliver some of the best risk-adjusted returns in the industry and therefore deserve a place in a well-balanced investment portfolio. Just make sure your financial adviser has the necessary expertise and tools at his disposal to make the right choice for you.