In some cases, negative performance of absolute return funds matched market declines, despite the promise of positive returns over time and less volatility. But there are examples of so-called absolute return funds beating the index during this period.

Although the objectives of different hedge funds, including absolute return funds, vary, most aim to provide investors with positive returns in most market conditions, even when equity markets fall.

Also known as "flexible" funds, absolute return funds are similar to regular managed funds in that investments are pooled and professionally managed. But such funds don’t follow a benchmark – a characteristic those in the industry often refer to as being "benchmark unaware" or "benchmark agnostic".

Absolute return funds may use derivatives, including short positions, arbitrage and other strategies to cushion portfolios during market downturns and minimise volatility. This level of added oversight and complexity comes at a price for investors, with absolute return funds often charging higher fees than traditional managed funds.

Performance differences emerge

Australian share prices plummeted 36 per cent during the worst period of the coronavirus sell-off, between 21 February and 23 March. During the same period, Australian equities flexible funds within Morningstar's coverage universe fell by at least 30 per cent.

“There has been a spread between the ‘absolute return’ or ‘flexible funds’ that have performed relatively well and quite positively, and those that have disappointed and haven't justified the extra cost,” says Morningstar senior manager research analyst Andrew Miles.

This under-performance by some flexible strategies has been disappointing.

Long-short funds combine traditional long positions in some companies with the use of derivatives to take short positions in other stocks. But most of these strategies experienced sharp losses during the sell-off, many faring worse than the index, which Miles says is surprising given they should have lower market exposure.

“The same is also true of flexible funds in the global equities space, while multi-asset funds have tended to do better overall, as some have been positioned quite defensively for quite some time,” Miles says.

Risk controls are crucial

Sean Fenton, managing director and founder of Sage Capital, says extreme volatility often exposes managers that have been " riding a thematic trend" rather than displaying genuine investment skill.

But he says it can also magnify simple bad luck.

"These periods of extreme volatility highlight the need for strong risk control in portfolio construction, which is even more important in the long-short space."

Fenton, who was a portfolio manager at Tribeca Investment Partners managing the Tribeca Alpha Plus (15451) long/short fund before founding Sage, says periods of high volatility can also expose weaknesses in absolute return strategies.

As an example, fhe points to the popularity of leveraged systematic strategies, which were popular in the lead-up to the GFC.

"Many of them blew up spectacularly, even threatening the stability of the financial system," Fenton says.

"The performance of quantitative hedge funds across this period tarnished the reputation of the sector and it took some time to recover.”

Having launched CC Sage Capital Absolute Return Fund in August 2019, Fenton says the pandemic has been a good testing ground for the strategy.

Over the admittedly short timeframe, the fund returned 8.56 per cent between January 31 and 30 April, and 9.50 per cent since inception.

But investors pay for performance: the fund charges an annual management fee of 1.29 per cent, a 0.1 per cent administration fee and a 20.5 per cent performance fee.

Some funds outperform

Andrew Lord, a director at wealth management firm Sherbrook Private, highlights a few Australian and global equities funds that have outperformed this year and over the longer term.

Though none of these strategies are part of Morningstar's research stable, some of Lord's preferred funds are:

  • Bennelong Long / Short – up 4.26 per cent over the year to 30 April
  • VGI Partners – which declined by just 1.40 per cent over the period
  • Bronte Capital Amalthea – up 14.37 per cent for the period.

Lord predicts a "stampede" to funds that consistently produce alpha through skill and process, in a world where benchmark returns are likely to be mid-single digit
over the medium to long term.

In terms of multi-asset funds, the Schroder Real Return Fund and the Schroder Absolute Return Income Fund (8922) have performed well, and broadly in line with expectations during the recent sell-off. Investors aren’t charged performance fees.

“Performance for both strategies during the COVID-19 crisis to date has been consistent with performance in market corrections since its inception in 2008 (in the midst of the GFC),” says Simon Doyle, head of fixed income and multi-asset at Schroders

“Specifically, the drawdowns have been modest in contrast to equity markets and other strategies more broadly (with the obvious exception of sovereign bonds and cash). This performance reflected the interplay between overall asset allocation and the positions implemented to mitigate downside risk – something core to our approach.”

Fees may be worth it

While some absolute return funds charge higher fees, that can be a small price to pay if an investor’s capital is kept intact, says Martin Randall, senior investment analyst – alternatives at Crestone Wealth Management.

Fee rates for hedge fund strategies vary greatly from a flat 1 per cent of assets under management to the ‘2 and 20’ model involving a 2 per cent management fee and 20-per-cent-performance fee model.

"As such, there will certainly be strategies that are expensive and some that are cheap – however in many cases you will find expensive managers that are worth the cost and cheap managers that aren’t," Randall says.

Schroders’ Doyle adds that if investors want to achieve real returns with a high degree of volatility control and effective downside protection as part of the investment strategy, then the fees charged can deliver value for money.

Lord agrees that the fees can be worth it – but that’s not true in all cases.

“There is no problem when performance is absolute or above index.

"But where I do struggle is with managers that have cash or cash-plus a margin as their benchmark, while running a predominantly long only portfolio."