With yields on vanilla bonds skirting around all-time lows, it is difficult for investors to justify allocating material amounts to traditional fixed interest instruments.
The upside from here is limited and, over the long term, it is likely that investors will experience capital losses as interest rates eventually normalise.
In what is a generally low-yield environment, there are areas of the investment universe that continue to offer the possibilities of long-term appreciation, some yield and an element of capital protection.
Absolute return funds encompass a broad range of investment strategies, ranging from convertible arbitrage to relative value. They offer diversification within a multi-asset portfolio, thereby acting as a risk dampener, as well as a potential source of return.
One of the benefits of an absolute return approach, particularly in the fixed income space, is the use of a wide range of instruments and strategies to generate return.
For example, within an absolute return bond fund, it is not uncommon to see currency trades, inflation trades and short-index trades.
This allows fund managers to take advantage of the unbalanced nature of the global recovery and the various monetary stimulus measures that stem from this; much more so than traditional long-only managers.
Look at Japan as a simplistic example. The Bank of Japan is implementing additional stimuli to help the economy, and one of the more obvious outcomes of this is a weak yen.
With the ability to short the currency, an absolute return manager can take advantage of the weakening and make a profit. In addition, with inflation slowly creeping up in Japan following the consumer tax rise in April, a manager could go long Japanese inflation.
In keeping with the adage – with great power comes great responsibility – the inclusion of these relatively complex instruments (when compared with more traditional equities and bonds) does require a level of sophistication and resource that not every fund manager can confidently claim to have.
Shorting currencies or indices can end very badly indeed if it is not managed within a robust risk framework.
With this in mind, investors should look for managers with a strong and proven history of running funds along these lines.
Many long-only managers have attempted to switch to running hedge fund-like mandates in the hope of stellar personal reward. The outcome for the end client has, on occasion, been ugly.
For those that do have the expertise, the results tend to be slow and steady, rather than spectacular, not unlike fixed income markets of years gone by.
James McDaid is an investment manager within Gam’s discretionary fund management business
