If the fund management industry exists to provide its end customers with attractive savings products then any fund that can combine the preservation of hard earned capital with asymmetrical participation in market upside is intrinsically desirable. The problem for the industry is that traditional equity funds are designed to be fully invested, with an aim of delivering market beating returns, and that the equity market is just too volatile: demanding either market timing or a long-term investment horizon in order to satisfy most of its participants.
Until relatively recently, equity “hedge” funds which attempted to smooth returns by short selling stocks were only available to very wealthy individuals or institutional investors, in illiquid, unregulated, offshore jurisdictions, accompanied by aggressive fee structures. Since 2009, the Argonaut Absolute Return Fund – along with similar funds launched around the same time – has attempted to meet this previously unmet demand in an onshore vehicle; packaging our stock-picking abilities in a savings product that was not overly dependent on the market direction of European stock markets.
Market reaction to (now “Targeted”) Absolute Return Funds has, however, been at best underwhelming, with insufficient efforts by the industry to explain the realistic aims of the funds and justify the fee structures. According to perceived wisdom, too many funds either did not deliver positive returns or delivered too little positive return relative to volatility. Moreover, even when funds delivered attractive returns they have often been criticised for being insufficiently uncorrelated to market returns. We think that many of these now ingrained perceptions are unfair, particularly with regard to our own product and that there are a number of common myths about Absolute Return funds which need to be addressed.
Myth 1. Absolute Return Funds don’t deliver attractive positive returns
The Argonaut Absolute Return Fund has delivered a positive return in every calendar year since launch and 66.25% since launch nearly five years ago. Moreover, in 2011 when the return on the European stock market was significantly negative (-8.75%), the fund delivered a positive return (+5.98%).1
Myth 2. Absolute Return Funds should only deliver modest returns
An Absolute Return Fund should target low volatility not low return: high returns with low volatility (rather than low or negative returns with high volatility) is the holy grail of Absolute Return investing. Volatility is most commonly measured by standard deviation. The standard deviation on the Argonaut Absolute Return Fund since launch has been less than half of the market volatility.
Myth 3. Absolute Return Funds cannot deliver superior returns with lower volatility
Over the last three years the Argonaut Absolute Return Fund has delivered an average annual return of 16.85% vs. the market average annual return of 7.89%. We have delivered this with a standard deviation of 7.85% vs. the market at 14.46% (by contrast the average European long short has delivered just 5.07% return with 7.12% standard deviation).2 In other words, over this time period, we have generated more than twice the market return with nearly half of the market volatility.
Chart 1: Annualised Return vs Standard Deviation2
The most common way to measure an Absolute Return Fund Manager’s skill at generating positive returns with low volatility is by assessing the return relative to volatility. If we divide our annual average return (above the risk free rate) by our average standard deviation over this time period we get a Sharpe ratio of 2.0. This compares to a market Sharpe ratio of 0.5.2
Myth 4. Absolute Return funds only make positive returns when market returns are positive
Since launch the market has delivered a negative monthly return in 21 out of 58 months. We have delivered a positive return in 10 out of these 21 months and have beaten the market return in 19 out of these 21 negative months.1 In these negative months the market has delivered a compound return of -56.27%. In these 21 negative months for the market, the fund has delivered a compound return of +2.81%.2
We have also got better at generating positive returns in negative market return months. If we just look at the last three years, the market has delivered negative returns in 13 months out of 36. We have delivered a positive return in 8 of these 13 months.1 The compound market returns in these 13 negative months for the market has been -37.57%. The compound return for our fund returns in these 13 negative months has been +8.23%.2
If we analyse monthly market returns further we see that since launch when market returns have been positive the fund has captured 31.24% of the upside, whilst when market returns have been negative the fund has in aggregate captured none of the downside (a -4.0% downside capture ratio).2 We have also had negative downside capture ratios in 2011 and 2013 (whilst still maintaining positive upside capture ratios in those years). During 2013, our downside capture ratio was -57.0%, whilst our upside capture ratio was +92.1%.2 In other words, although we have made higher positive returns when market returns have been positive, we have also made positive returns when market returns have been negative. Our returns are therefore uncorrelated to the market and we have demonstrated our ability to make absolute returns in differing market conditions.
Myth 5. Absolute Return funds don't control draw-downs
Investors are logically more concerned about downside than upside volatility. The preservation of capital through the avoidance of drawdowns is therefore a key skill. Over the last 3 years the maximum monthly draw-down on the fund has been 1.49% vs. a maximum monthly draw-down on the market of 20.59% (and the sector at 8.46%).2
Just as a Sharpe ratio measures return against total volatility (standard deviation) the Sortino ratio measures return against only downside volatility. Over the last three years the fund has generated a Sortino ratio of 6.8 vs. the market at 0.8 and the sector at 2.1. In other words the fund has been very good at controlling drawdowns and managing downside volatility.2
Table 1: Return and Risk Metrics2
Myth 6. Absolute Return funds don't add value through shorting
It is possible to deliver returns which are less volatile than the market through either using a market hedge (most commonly selling index futures) or by running gross exposure of less than 100% with no short book or hedge. In our view these funds are low-beta long funds. An investor could achieve the same outcome as the manager by committing less capital to the fund.
We only take short positions in individual stocks (there is no use of market hedges) and only in stocks where we have identified compelling downside. We have consistently generated alpha from our short book. In 2013, even though the market delivered a positive return of 22.76%,1 we made a small positive absolute return in our short book (i.e. significant alpha generation) over the year and positive returns solely from our short book in 5 months (in contrast to 4 market negative return months).2
Myth 8. Bond funds can deliver better risk adjusted returns than long/short equity funds
Since 2009 bond funds have in general delivered positive returns with low volatility, certainly with superior Sharpe ratios than most long/short equity funds. There are, however, signs that this is changing with Sharpe ratios from bond funds deteriorating and those from long/short equity products improving.
A long/short equity fund is in a sweet spot when it is generating positive returns on both sides of the book. This is only possible when correlations between stocks are low (which normally only happens with low market volatility). We believe this is a fundamental reason why 2013 was such an exceptional year for the Argonaut Absolute Return Fund.
As the financial world normalises following a period of exceptional volatility (from a historic perspective), we believe that Sharpe ratios for long/short equity products should also improve. As such we see long/short equity replacing bond funds as diversifiers within portfolios.
Myth 9. Absolute Return funds have opaque investment processes and invest in complicated derivative instruments
The Argonaut Absolute Return fund only invests in high conviction stock ideas on the long and short side. We use no derivatives (aside from CFDs), index futures or options. We also use only limited leverage.
Our fund is transparent in how we are generating our returns from Alpha generation. We believe that earnings surprise (both positive and negative) drives stock returns. We go long stocks which we believe can earn more than the market expects and short stocks where we think earnings estimates are too high.
Myth 10. Absolute Return Fund Structures are unfair to investors
The sector is often seen as having "rip-off" fees. As with all of our funds, not only are all returns quoted after all fees, but returns are also quoted after the highest fee share class. Given that most investors can now access the product through a 75bps annual management charge share class (rather than the 150bps highest fee share class) there is also “hidden” annual performance of 75bps for these investors in terms of quoted performance vs. performance actually received by the underlying investor. We hear a lot in the industry press currently about “hidden fees” but the reality is often “hidden performance”.
We are also not currently charging a performance fee (though reserve the right to do this in the future). When we do so, the performance fee will take 20% of positive returns over 5% per annum subject to a high water mark (rather than 20% over 0% which is more common). So at the end of every calendar year the fund price will have to be at least 5% higher than in any previous year for any performance fee to accrue. Performance fees incentivise the fund manager to think about fund performance, not just growth in assets under management. They are therefore appropriate for any capacity constrained product in aligning the interests of the fund investors with those of the fund manager.
The Argonaut Absolute Return Fund also offers daily pricing and daily dealing. The minimum dealing size is £500. The fund is also regulated by the UK Financial Conduct Authority. In a post-Madoff world of limited public trust in the providers of savings products, these factors are important.
Although there is no guarantee of future success, we believe that the Argonaut Absolute Return Fund is an attractive savings product combining compelling returns, limited volatility and sensible fees. It is time for the industry to engage is an informed and sensible debate.
1Lipper, 31/12/2013, A Accumulation Share Class performance, in Sterling with Net Income reinvested and no initial charges
2Argonaut Capital Partners
3Sector Median consists of European long short UCITS funds that have been open for investment over a similar timeframe as the Argonaut Absolute Return Fund.
This document has been provided for informational purposes only solely for Professional Clients as defined by the FCA and does not constitute investment advice. Information and opinions expressed in this material are subject to change without notice and to the best of Argonauts knowledge are correct at the date of producing the document. They have been obtained or derived from sources believed by Argonaut Capital Partners LLP to be reliable but Argonaut Capital Partners LLP make no representation as to their accuracy or completeness . The writer of this piece may have conflicts of interest as may have personal holdings in the companies mentioned.