Protect and serve

Absolute return strategies, which aim to deliver a target return regardless of any identifiable benchmark, are one of the approved and popular methods for shielding investors’ capital from turbulent equity markets. Even though the emergence of these strategies was largely a reaction to the market downturn at the beginning of the decade, some wealth managers have had these in their product portfolios for much longer, including them in their core offerings.

James Fairbairn, portfolio director at GAM in London, explains that his company, now part of Swiss bank Julius Baer, has been running absolute return strategies for more than 20 years.

“What we learned over the years is that clients are prepared to forgive you for potentially not performing pound per pound – or dollar per dollar – with markets during periods of strength, if you can provide preservation during periods of weakness,” he says. So, while investors will get a return lower than equity indices during period of high-performing markets, the compensation for that will be a much higher degree of protection when things prove to be more difficult, he says. “The protection of wealth is always the key consideration towards the structuring of our clients’ portfolio, whether in good times or bad times.”

Dynamic allocation

A very dynamic asset allocation, combined with an investment process across a broad range of liquid asset classes, characterises the investment process at the hedge fund firm.

GAM has the “mildest touch” when it comes to strategic asset allocation. “We are not aggressive market timers,” says Mr Fairbairn, emphasising that the firm’s investment process is monitored on a daily basis. But it is the tactical tilt that adds a different dynamic to the portfolio.

About 17 per cent of assets in clients’ portfolios are held in a tactical asset allocation vehicle, he explains.

“Timely repositioning and realignment of portfolios, often on a short-term basis, can generate additional gains and can play a key role as a powerful risk management tool, particularly during periods of high market stress when asset class correlations tend to rise strongly.”

Hedge funds and alternative investments have always accounted for a high percentage of clients’ portfolios at GAM. “Over time, we have achieved a better risk-adjusted return from alternative investments , than through either cash or bonds,” he says.

A mix of alternative investment managers, operating different styles and strategies, when blended correctly, provides greater diversification and smoothes the volatility of returns, he says. The objective of the managers employed is always absolute return – this is how they are assessed on their performance and determines how they are remunerated by their fee structures.

Currently, in GAM’s absolute return portfolio, alternative investments represent 36 per cent of total assets, equities long/short account for 21 per cent, equities long are 31 per cent, bonds 8 per cent and liquidity 3 per cent.

But absolute return does not mean that the strategy is risk-free. “The drawdowns are inevitable consequence of that engagement with risk and capital guarantee is a very dangerous label to be attached to an absolute return strategy,” says Mr Fairbairn. “We are pragmatic investors who recognise the risk of stepping away from markets completely. There are very few asset classes that can contribute so well to the growth of the portfolio than getting a call in equity right.”

To give an idea of the parameters within which GAM’s active allocation operates, Mr Fairbairn says that at the end of 2002, at its most bearish, the exposure to equities was 15 per cent. More recently, it has had an allocation of up to 35 per cent.

“Our typical clients investing in absolute return are prepared to be engaged with risk and accept real capital losses at any time during the cycle of the strategy. There is a degree of volatility which itself is very closely monitored in portfolios,” he adds.

Over the long term, a directional portfolio is likely to generate superior returns over an absolute strategy but it is the tolerance for volatility that makes the investor decide for one or the other, says university professor Stefano Preda, chairman and founder of Banca Esperia Group, a joint venture between Mediobanca and Mediolanum, active in private banking and institutional client management. The Italian group, which manages more than E12bn of total assets, offers both directional and total return strategies to its clients.

“The first important factor is the investor’s time horizons,” says Mr Preda. “If an investor has a long investment horizon, certainly an asset allocation biased towards equities tends to be a winning bet. But as equities are the dominant asset class not only in terms of return, but also in terms of volatility, an investor will have to accept the fluctuations of the market, and bear the negative periods, not just the positive ones.”

Banca Esperia relies heavily on funds of hedge funds as investment instruments to deliver a target return and leverages on the service offered by its London-based hedge fund advisory and selection firm, Duemme Capital. Hedge funds of funds currently represent 30 per cent of Banca Esperia’s total return portfolio and they are employed in a core-satellite fashion.

The core elements tend to remain stable over time, while the satellite elements tend to adapt to the changing market environment, says Mr Preda. “For example, we are currently increasing our exposure to the distressed strategies, because we believe the current crisis will make it more interesting to operate in that area. But that is marginal, as it will be just 5 per cent of the portfolio.”

However, the need to look for best managers and funds determined a 40 per cent turnover of hedge funds at the Italian firm over the last two years.

“Some strategies such as convertible arbitrage and fixed income themes have been less popular, whereas we have favoured distressed and some long-short strategies in emerging markets recently,” says Mr Preda.

Interest rate dependent

Target returns of an absolute strategy depend substantially on the level of interest rates. The benchmark, set above the return of government bonds, hovers around 4 per cent. That is the minimum performance objective to beat, he adds. In past years, absolute return strategies have returned between 4 and 7 per cent. “It is difficult for an absolute return product to generate significant returns, because of the risk management constraint,” says Mr Preda.

Claus Jørgensen, head of European private banking at Nordea in Luxembourg, questions what real difference there is between an absolute return strategy and a risk-expected return portfolio.

“I would argue that an absolute return portfolio targeting libor+ – which promises a return plus something else – can also be seen broadly as a risk-expected return portfolio. That is how our strategic asset allocation works,” he says. He explains that Nordea’s clients, once their risk-return profile has been assessed, are told they should expect certain returns over a given time horizon, with a probability of 95 per cent. “But I would not say that at Nordea we run any real absolute return discretionary portfolio,” he adds.

‘The protection of wealth is always the key consideration towards the structuring of our clients’ portfolio, whether in good times or bad times’ - James Fairbairn, GAM	‘We are increasing our exposure to the distressed strategies because we believe the current crisis will make it more interesting to operate in that area’ - Stefano Preda, Banca Esperia
‘I would argue that an absolute return portfolio targeting libor+ can also be seen broadly as a risk-expected return portfolio’ - Claus Jørgensen, Nordea	‘Absolute return performance should be considered over a period of time’ - Guillaume Poli, Edmond de Rothschild Financial Services

Not that all investors want to discuss their attitude to risk, says Mr Jørgensen. Those who employ different banks to manage their wealth may want to have a defensive portfolio with one provider and employ Nordea for high risk investments, for example.

“Swedish investors in particular are very equity focused. A lot of wealthy Swedish people feel that they make a good investment when they buy into Swedish companies – for them, the way to preserve their money is to have an equity portfolio,” he says.

Guillaume Poli, chairman of the management board of Edmond de Rothschild Financial Services, states that an active asset allocation, biased towards more liquid, less volatility and correlated asset classes in periods of market turbulence, is ultimately what can provide higher protection for the investors. This would be much more effective than investing into specific instruments such as capital guaranteed products, although the demand for these types of products is definitely higher in uncertain market conditions.

Structured products

Structured products, such as the ones shorting volatility, are also highly suitable in these fluctuating markets. Leveraging on the increased implied volatility on the equity market, the French group, which has E30bn under management, has launched a structured note that has proved popular both with private bankers and clients, says Mr Poli.

The latest version of this product is an eight-year investment, which gives an 8 to 10 per cent coupon every year, provided that the Eurostoxx 50 is above 50 per cent of its initial level – otherwise there is a guaranteed minimum coupon of 0.50 per cent.

At maturity, investors will get 100 per cent of their capital back, unless the Eurostoxx 50 is below 50 per cent of its original level. In this case, the investor is exposed to the downside of the index. “Assuming a catastrophe scenario in eight years, investors are taking the equity risk, but the return is in the region of the normal equity returns, with conditions that are less demanding,” says Mr Poli. “That is just the effect of accepting volatility.”

Philip Watson, head of the investment analysis and advice group at Citi Private Bank, EMEA, confirms that clients’ interest in structured notes has been a long-term trend. But some particular features of structured notes have recently become more sought after, he says.

“In terms of the type of structures, we have seen a lot of interest in look-back features. For an investor who wants to invest in the FTSE 100 but is not certain whether he should invest today, tomorrow, next week or next month because the index is very volatile, a look-back feature sets the entry point into the investment at the most favourable point in time. That offers clients a lot of confidence in a very volatile market,” he says.

Technology of this kind has also been applied to meet clients’ financial needs in non-directional trades, for which also there has been increasing appetite, says Mr Watson.

Investors may have a specific view on a sector within the market, or particular groups of companies, but they may not be certain whether the equity markets are going to rise or fall. One example of a non-directional trade that Citi Private Bank has produced is an investment that captures the outperformance of the FTSE 100 over the FTSE 250.

“While clients may not be clear whether the FTSE 100 or the FTSE 250 will go up or go down, they will hold the view that the FTSE 100 will outperform the FTSE 250,” says Mr Watson. “So whether they are both negative makes no difference to this trade. If the FTSE 100 falls by 10 per cent and the FTSE 250 falls by 20 per cent at maturity, then you effectively receive 10 per cent times by a specified participation rate.”

The guarantees of capital protection offered by a structured note are different from those that a dynamic asset allocation can give. There is no doubt that asset allocation is the key determinant of performance and it accounts for more than 90 per cent of returns on medium-long term horizons, says Mr Watson. But diversification is not necessarily a capital preservation strategy, he says. The effectiveness of capital protection depends of course on the type of allocation. A portfolio investing only in equity and hedge funds may suffer from capital erosion. A type of asset allocation more diversified, with higher weight in cash, fixed income and a small percentage in equities will preserve an investor’s capital a lot more.

“Asset allocation is quite a wide mechanism to actively buffer against capital losses but it does not state like a capital market note that at maturity the investor will have 100 per cent of his capital back,” says Mr Watson.

Protection strategy

Thomas Tilse, head of portfolio strategy for private clients at Cominvest, draws attention to the importance of distinguishing between a capital protection strategy and an absolute return strategy. “Protection, in our view, means that we guarantee to the client 100 – or 90 or 95 – per cent of his capital.” This implies a different management style from that of an absolute return portfolio, where the target is libor+ but there is no guarantee on capital protection.

“In the capital protection strategy, 80 per cent of the money is bound in safe investments such as zero bonds and then to generate the extra returns you have just the remaining 20 per cent, which you try and invest in a mix of the most promising asset classes.”

Investors are very interested in this type of management style, says Mr Tilse, because they know that their capital is protected. This strategy offered by the German bank beat money market return significantly in most years, he says. He admits though that last year was an exception. This poor performance triggered questions from a lot of clients, who asked why the bank could not beat the 4 per cent offered by a direct bank. “Sometimes you cannot beat the offer of a direct bank, because often it is subsidised, sometimes you can. But we are not in direct competition with a direct bank; we are in a total different business of managing client wealth.”

Absolute return outflows

Because of their poor performance last year, funds targeting an absolute return are suffering major outflows in Europe. These funds are supposed to be a safe haven from benchmark-driven investment approaches but, ironically, they seem not to be able to deliver positive returns at a time of market volatility. So what is the true rationale behind these instruments?

“The theme of absolute return is perfectly understandable provided that you are not expecting this absolute return every year,” says Guillaume Poli at Edmond de Rothschild Financial Services.

The French group manages a fund labelled absolute return, which performed negatively last year, like many others. This fund of funds investing around the value theme, in bonds, in high-yield credit and in equity, has delivered 5 to 7 cent return every year for the last six to seven years, says Mr Poli. But in 2007 it failed, delivering instead a negative return of -2 per cent, making investors very unhappy, he says.

“Absolute return performance should be considered over a period of time, not just a year,” he adds. In certain years, the manager can make the wrong bets; also the investment guidelines within which the manager operates can be unfavourable at certain times.

“If you are only authorised to go long because some clients don’t like the idea that you can go short, for instance, you are not allowed to play with energy or raw material prices.”

In certain years the manager is not just going to make money, investors have to know that, says Mr Poli.