Absolute Return funds are not delivering

• Targeted Absolute Return (TAR) funds were meant to be “all weather”
• TAR funds can be complex, opaque and inefficient
• We measure how four key TAR funds fare vs a Risk Parity approach

​Targeted Absolute Return (TAR) funds were meant to be “all-weather” funds that could deliver returns in up markets, whilst protecting capital in down markets.  If that sounds like a “goldilocks” strategy, it’s because it is.
However, the way these funds-of-strategies are managed can be complex and/or opaque, and the performance has been inefficient.  They are not delivering.
Given there’s been a lot of bad weather globally in the first half of this year, we look at how four leading (by AUM) TAR funds have fared against our Elston Dynamic Risk Parity Index.

Absolute Return funds
Targeted Absolute Return funds are designed to fulfil a diversification function within a portfolio.  This means performing in a way that is less or not correlated with equity markets, whilst offering greater return than cash or bonds.
The portfolio construction approach to TAR funds differs from manager to manager.  But the guiding principle is to achieve diversification by “spreading risk” across multiple, uncorrelated strategies, and “having the potential to make money in falling markets”.

Risk-based strategies as an alternative
Our view is that if the objective is diversification, a risk-based approach to portfolio construction makes sense, using strategies such as Risk Parity for diversification purposes.  Risk Parity ensures “true diversification” by allowing the ever-changing risk characteristics of each asset class to determine portfolio weights, such that each asset class contributes equally to overall portfolio risk.
Furthermore, by constructing the strategy as a straightforward “long-only” approach that does not use leverage, the holdings within the strategy are liquid, transparent and low-cost ETFs, whilst the dynamic weighting scheme is the tool for ensuring equal risk contribution and volatility constraint.

• To counter complexity, we believe in creating a strategy in a systematic, rules-based approach (i.e. as an index).
• To counter opacity, we believe in ensuring that a strategy can be implemented using transparent, liquid and low-cost instruments (i.e. physically-replicated Exchange Traded Funds).
• To ensure efficiency, unlike some institutional risk parity funds, we ensure our risk parity strategy is constructed a mixture of Global Equities and UK Bonds (rather than Global Equities and US Bonds hedged to GBP)

Whilst Targeted Absolute Return funds do not use Risk Parity indices as a benchmark – the fundamental principle – diversifying portfolio risk across a number of contributors of portfolio risk – is nonetheless similar at its core, albeit very different in its implementation.
So how have the strategies fared?

Relative Performance
Year to date, through an extreme stress-test, absolute return strategies have underperformed a Risk Parity approach by 2-4.5%.
Fig.1. YTD performance

Source: Elston research, Bloomberg data.  Total returns, GBP terms, as at end June 2020
On a 1 year view, these absolute return strategies have underperformed a Risk Parity approach by 6-8%.
Fig.2. 1 year cumulative performance

Source: Elston research, Bloomberg data.  Total returns, GBP terms, as at end June 2020
On a 3 year view, these absolute return strategies have underperformed a Risk Parity approach by 7-20%.
Fig.3. 3 year cumulative performance

Source: Elston research, Bloomberg data.  Total returns, GBP terms, as at end June 2020
 
Mixing metaphors: a goldilocks approach to an all-weather portfolio
To achieve all-weather diversifier status is a tall order for any investment strategy.  It requires a “goldilocks” portfolio that:

• Ensures that risk sufficiently rewarded
• Allows some volatility to achieve returns, but not too much risk to create excessive downside risk
• Constrains volatility to reduce downside risk, but not so much as to forego returns,
• Permits enough beta to keep pace with the market, but without too much correlation
• Reduces correlation to ensure differentiation, but without foregoing any of the above

As you can see it’s a tall order.  But we can measure how these absolute return funds fare relative to our Risk Parity index on those metrics by comparing

• Return per unit of risk (Sharpe ratio – is risk rewarded?) in absolute terms, and relative to Global Equities
• Level of volatility relative to a global equities (is volatility constrained?)
• Level of returns capture, relative to global equities (is there potential for returns?)
• Level of beta relative to global equities (is there sufficient reduction for downside protection?)
• Level of correlation to global equities (is there true differentiation for diversification?

On this basis, the Risk Parity approach

• Offers best risk-adjusted returns with Sharpe ratio of 0.67
• Improves risk-adjusted returns significantly vs global equities and a 60/40 portfolio (TAR funds provide poor risk-adjusted returns, as the risk taken is unrewarded)
• Reduces volatility by -60.0% (more than for a 60/40 strategy, but less than TAR funds (-65 to 80% reduction))
• Reduces returns by just -30.7% (similar to a 60/40 strategy, and significantly better returns capture than TAR funds)
• Reduces beta by -78.3% (less so than for TAR funds (~90%), but moreso than a 60/40 portfolio (-40.6%))
• Reduces correlation by -45.8% (less when compared to -60 to 66% for TAR funds, but substantially more than a 60/40 portfolio that do not provide “true diversification”).

On this basis, our Risk Parity strategy fares well as a decorrelated “diversifier”, without foregoing returns, for a similar level of risk to TAR funds.

What’s wrong with TAR funds? We can’t analyse the individual strategies within the funds, but in aggregate, the statistics below suggest that as a result of their complexity, TAR funds have potentially “over de-correlated”, with insufficient beta to capture the returns available for the risk (volatility) being taken.

Findings are summarised in the table below.
​
Fig.4. 3Y Performance Statistics

Risk-based strategies: an alternative to absolute return funds?
Targeted Absolute Return funds are opaque, complex and inefficient.

Creating a true diversification strategy is challenging but achievable.

A systematic risk-based approach that adapts to changing relationships between each asset classes is an alternative.

​By ensuring that each asset class contributes equally to the risk of the overall portfolio, without resorting to leverage, could provide a more dependable approach to incorporating a “true diversifier” into a portfolio, without necessarily compromising returns.

NOTICES
Commercial Interest: Elston Consulting Limited creates research portfolios and administers indices that may or may not be referenced in this article.  If referenced, this is clearly designated and is to raise awareness and provide purely factual information as regards these portfolios and/or indices.