Education

Introduction

Portfolio theory from the late 20th century suggested that one could mitigate the volatility risk of owning equities by buying fixed income stocks (bonds). Some investors would add real estate, usually commercial property, as well. That basic model had long been modified in the institutional investment market by the use of hedging techniques and the investment firms that market products to retail investors have for some 30 years now been offering ‘tamer’ versions of hedge fund investing in the form of absolute return (AR) funds. That phrase is rather UK centric and in the USA a more common classification is ‘alternatives’. Morningstar has pigeon holed funds into a range of alternative categories.

Some changes in Morningstar categories for Alternatives

That firm recently reviewed the classification against a background of general consensus that many funds thus described were not really doing what they promised. I recently listened to a presentation that explained what they had discovered in Europe and the UK and what they were going to do about it.

Here are the main points as I noted them:

• AR or alternative funds are complex and many have disappointed
• New categories would better describe the way such funds are supposed to work
• In the past there has been a very high attrition rate as funds have failed and closed (or rarely, used one technique so successfully that it could not be repeated!). More funds closed than opened in 2019 and 2020 and only one in 5 funds in all their current alternative categories is more than 10 years old.
• Some funds (for example many listed as long/short) are not actually being run any differently to mainstream equity funds, so should be recategorised in the relevant equity category. This I had observed years ago with the Newton Real Return fund, which was presented as an absolute return fund but was really just a tactical international equity fund.
• There has been inconsistency at Morningstar in the categorisation of such funds across global markets. I think that UK investors would have maybe been using the Investment Association category (Targeted Absolute Return) anyway, so would not have been overly concerned about Morningstar’s global policy. That IA category also includes a mixed bag and should be treated with caution, by the way.
• They are taking action that puts funds of a similar style together and with simpler definitions, where possible.
• Their overall definition of what makes a fund ‘alternative’ now takes on board the concept of expanding portfolio diversity or eliminating dominant risk factors in traditional markets, having low correlation but some flexibility. One might guess that is what the average retail investor understands hedging to mean, so great!
• A new category addition will allow for some managers using currency as a specific risk mangement technique

Inplications for us

I think this is good news. I have explained to investors how difficult it is to identify the different styles in funds that are marketed as useful for diversification and risk control.

I have had to tell people that some products in the markets are using techniques like selecting non correlated global macro themes that are not recognised as Absolute Return objectives and so those funds are hard to research. The JP Morgan Global Macro Opportunities fund which I have owned for many years is one such.

The new categories will bring together funds like that (Macro Strategy) and assist our research. Moving funds that were pretending to be clever at handling risk back into groups with general managed equity funds will get rid of some funds that were not doing what they said on the tin!