Updated: May 18, 2022
I am an advocate of the principle of ‘keeping it simple’. The three funds that my team at Seneca and I manage are all multi-asset, investing in equities, bonds, and specialist investment trusts that themselves invest in such things as property, infrastructure, wind farms, airplanes, and loans to SMEs (small and medium sized enterprises).
"The trade-off between return and volatility is embedded fundamentally in markets"
They are more than just traditional balanced funds but they are still simple. We don’t invest in complicated things such as structured products, hedge funds, derivatives or arbitrage strategies. In other words, our funds are absolutely not absolute return funds.
But what on earth are ‘absolute return funds’? The industry talks about them as if it knows what they are and what they do. But do we? ‘Absolute’ means ‘positive’, so presumably they’re aiming to produce positive returns. By implication, funds that are not absolute return funds are seeking to make negative returns, which is absurd. I despair frequently at my industry’s poor use of language.
Of course, it is generally understood that absolute return funds (ARFs) are seeking to generate positive investment returns over shorter time frames than traditional funds, but how short?
Here are the investment objectives of three of the more popular onshore ARFs:
“to target a level of return over rolling three-year periods equivalent to cash plus five percent a year, gross of fees”
“to provide positive absolute returns in Sterling share class currency over a 3 year rolling period, utilising a variety of asset classes and regardless of market conditions”
“to achieve a positive absolute return over a 12-month period independent of market conditions”
In other words, ‘shorter time frames’ means anywhere between 1 and 3 years.
So, we now know what ARFs are trying to do, but what are they actually doing? In the case of the above three funds, they are all failing dismally to achieve their stated aims (in fact, excluding money market sectors, the IA Targeted Absolute Return Sector is the worst performing over 2, 3 and 5 years). This is tragic, given how much money has been committed to them, much of it individuals’ retirement savings.
The problem is, the idea of good returns with low volatility is so alluring. Indeed, it is the Holy Grail of investing. Investors are generally greedy and want their cake as well as to be able to eat it. This is human behaviour but it is flawed behaviour. We don’t like seeing our savings going down in value over, say, one year even if we know we don’t need them long into the future. Unlike a TV, which can be fixed, one never knows for sure if markets that go down will go up again (statistically, they do).
No, the trade-off between return and volatility is embedded fundamentally in markets. Volatility should be viewed simply as the cost of good long-term performance, not a risk to be avoided - unless you have a short investment time horizon that is.
I know of only two fund managers who have achieved high investment returns with low volatility. One is Jim Simons at Renaissance Technologies. Jim is a rocket scientist (literally – he used to work at NASA). Jim’s company houses, he claims, the world’s fastest and most powerful privately owned super computer. Jim and his team of ultra-intelligent geeks use their big brains and their big computer to spot very short-term patterns in the prices of financial assets.
How short term? We’re talking seconds, minutes, hours. On average, they make tiny percentage returns off each trade, but because they are making hundreds of thousands of them each year, it all adds up to rather a lot. Year in, year out, their flagship Medallion fund made returns around the 30% mark. Eventually Renaissance closed the fund to outside investors, as they didn’t need them or indeed want them anymore. They were being greedy – but rationally so.
Who is the other? Bernie Madoff. But we know why he produced high returns with low volatility.
The central flaw with ARFs is that they are applying fundamental analysis to predict short-ish term prices of financial assets - whether equities, bonds, currencies or commodities – when the reality is that these financial assets are unpredictable over such time frames (meaning that they follow a random walk).
The prices of financial assets tend to be predictable over very short and very long time frames but unpredictable over anything in between – the successes of Jim Simons and Warren Buffett as well as many lesser known others stand as testament to this.
But how can something have pattern (non-randomness) at some time scales but no pattern (randomness) at others? Take the example of a photograph. Under a microscope you would see the pattern of pixels. Holding it in your hand, you’d see the subject of the photo. Looking at a tiny part of the photo, you’d see no pattern, just noise.
The managers of ARFs may well be saying in effect that they can look at a small part of a photo and discern pattern. What tosh! ARFs in recent years have gained a cult following. Sadly, escaping the cult unscathed will for many be impossible given losses, whether opportunity or real, that they are sitting on.
So, why is it that financial asset prices are predictable over some time frames but unpredictable over others?
Over short time frames, financial asset prices tend to reflect the behaviour of high frequency trading (HFT) algorithms. Since there are rules that govern these algorithms – that’s what algorithms are – they create patterns in prices. If you have a more powerful computer than your competitors, you can profit by being ahead of them.
Over long time frames, financial asset prices tend to reflect so-called fundamentals.
Movements over medium-term time frames however do not reflect the behaviour of HFTs. Nor do they mirror fundamentals, which tend on these time scales to be priced in.
The lesson in all of this is to keep things simple, focus on valuation, and be long term. Don’t be tempted by funds that pledge high returns with low volatility – stick them where they belong along with alchemy and leeches. The quest for the Holy Grail should be a monastic one: simple and patient.
Published in Investment Week
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.