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Graham Bentley: Absolute return has had its day

By Graham Bentley

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Aug 31, 2018
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Do you believe a return in excess of deposit rates, with no risk of loss and low charges, is a realistic investment aspiration?

Returns are simply compensation for an investor’s loss of use of the money, and the risk of not being compensated is inherent in the transaction. Debt markets work on the basis that returns in the form of interest payments compensate lenders for lost opportunities to spend their excess capital elsewhere. Borrowers deemed less likely to make those interest payments, or to repay the principle, have to pay more interest to compensate for those risks.

Medieval merchants wanting capital to finance trading trips recognised the risk their ships might sink and suffer a total loss was high, so offered investors an ongoing share of the profits with no guarantees, rather than a flat interest payment and the return of their capital. The potential profits therefore had to be much higher than a prevailing interest rate, to compensate for the risk of total loss.

Centuries later, the industrial revolution created manufacturing companies bearing similar excess risks and spectacular opportunities, and today modern economies rely on both debt and equity markets in order to function effectively.

There is risk in any financial transaction. Indeed, the fund management industry has spent 150 years telling us risk and return are inextricably linked. Throughout that period, professionals have sought to persuade investors they can either provide excess compensation for a given level of risk or offer a given level of return alongside a risk discount.

Alas, few managers have been able to demonstrate an ability to do that with long-term consistency.

Sailing is relatively straightforward with a quality boat, a fair wind and calm waters, but the nature of the sea is to exhibit extremes of conditions, weather and geography combining to drown the most skilful mariner. Market conditions can similarly overwhelm managers and their investors, yet there are some who claim to provide a positive return through them all.

One can, of course, beat a benchmark by losing less money but the primary aim of the targeted absolute return manager is to generate returns greater than 0 per cent, whatever the weather.

Investment strategies that combine low-correlating assets are used alongside derivatives, arbitrage and leveraging in an attempt to get that best-of-both-worlds.

However, as capital markets became ever more sophisticated, utilising computing power and information delivery to an extraordinary degree, this has allowed managers to invent ever more complicated tactics. We should be careful not to confuse the words “complicated” and “complex” in this context. Misunderstanding the difference between the two can lead investors to misinterpret the likely outcome of an investment “system”.

Systems theory describes how systems can be observed in two dimensions. The first reflects the “set-up” or process, which can be very easy to understand (simple) through to very difficult to comprehend (complicated).  For example, a glove is simple but your watch is complicated – try taking it apart and re-assembling it.

Systems then exhibit a level of predictability of outcome, depending on the initial set of conditions:

  • Ordered, showing total predictability and no surprises (both my glove and my watch)
  • Complex, i.e. quite predictable but with some surprises (the education system)
  • Chaotic, very unpredictable with constant surprises (the weather)

A double-rod pendulum is a simple system that is easy to assemble and to understand – it is one pendulum attached to the bottom of another. The outcome (i.e. their motion) is chaotic, however, because of the high sensitivity to the initial setup of the pendulum.

When investment managers purport to offer routes to investment success, bear in mind that a simple product like an Oeic is linked to a chaotic system – the stock market.  While complication does not have to lead to less predictability – as in our watch – actively managed investment strategies are not fixed like the components of a watch. Like a double-rod pendulum, as the behaviours of the moving parts become more complex, the predictability of outcome decreases.

Predictably positive returns in all conditions must be a less-likely outcome from complicated processes linked to the chaotic system that is the stock market.

In its Asset Management Market study, the FCA chose to criticise TAR funds in particular as opaque, complicated, not meeting objectives and generally exhibiting poor performance.

If that withering criticism was not enough, the regulator went on to chastise managers for not using their stated benchmarks in marketing material, for being hazy about their objectives and the associated time horizon and, worse, using comparative measures in marketing material that show the funds in a better light than if they had used only their stated benchmarks.

Despite TAR funds having proliferated during a positive market environment driven by quantitative easing, a significant number have produced investor detriment rather than surpassing a, frankly, low hurdle.

The easy money has (or should have) been made but, as we see policy tightening, we are moving into a likely lower-return environment that will further test TAR managers’ abilities.

Active management is about aims and hopes, not promises or guarantees. When it fails, managers apologise but keep taking the fees.  Investors’ outcomes are variable on return, over a variable time period with no maximum. The investor they are aimed at actually wants a variable positive return over a fixed period, or a fixed positive return over a variable time horizon.

Absolute return, on the evidence, provides neither. There is an alternative – but more on that next month…

Graham Bentley is managing director of gbi2

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