Targeted Absolute and Real Return funds misunderstood: Plexus

The Targeted Absolute and Real Return funds subsector received the second largest volume of inflows during the fourth quarter of 2009. However, according to Dr Prieur du Plessis, chairman of the Plexus Group, these funds are probably the most misunderstood by the investing public.

According to statistics released by the Association for Savings & Investment SA (ASISA) for the fourth quarter of 2009, investors have entrusted most of their savings to asset allocation funds (money-market funds excluded). Not only does this sector have the bulk of assets under management (R174,2 billion as at 31 December 2009), but it also experienced the largest net inflow of R9,1 billion over the December quarter.

The second largest subsector within the asset allocation sector, both by assets under management and number of accounts, is the subsector for Targeted Absolute and Real Return funds. However, according to Dr Prieur du Plessis, chairman of the Plexus Group, these funds are probably the most misunderstood by the investing public.

“The fact of the matter is that the investment mandates, performance objectives and investment strategies of funds in this sector differ vastly, and if prospective investors do not understand what exactly it is that the fund manager is trying to achieve and how he goes about trying to achieve this objective, they may well end up being very disappointed,” says du Plessis.

“The different investment mandates and performance objectives also result in the portfolio compositions of funds in this sector varying considerably,” he adds. “Some funds invest only in fixed-interest securities (enhanced in-come funds) to more balanced portfolios with a low equity exposure, while others tend to have a relatively high exposure to equities.”

According to du Plessis, the common denominator that results in funds being classified as targeted return funds is the fact that they strive to achieve positive returns over a specified period irrespective of market conditions, while limiting the risk of capital loss as much as possible. “These funds make use of different investment strategies to achieve this, including the use of derivative instruments, highly active asset allocation, stringent risk-control measures and share-selection criteria, as well as exposure to inflation-linked bonds,” he says.

Targeted return funds have absolute benchmarks (i.e. a benchmark linked to cash or the inflation rate) as opposed to relative benchmarks such as an equity or bond market index. “Because the benchmarks (or performance objectives) vary considerably – they can range from a very modest target such as inflation plus 1% per annum to a target as high as inflation plus 7% per annum – investors should not compare the performances of these funds with one another without taking cognisance of the risk characteristics of the various funds,” warns du Plessis.

According to du Plessis, investors need to understand that the higher the benchmark or performance objective, the more risk the manager must accept to achieve the objective. “A high performance objective can be achieved only by having a relatively high exposure to equities, and this ultimately results in higher volatility in returns and a higher probability of capital losses when markets are buffeted by financial instability.”

A study of the returns achieved by the funds in this subsector reveals that over the past year ended 31 January 2010, the returns yielded by these funds varied from a positive 41,0% to a paltry 3,0% – a difference of 38% between the best and worst performers. Even over the longer period of three years, the returns varied from 20,1% to a negative 1,8% – an astounding difference of almost 22%.

“The most important consideration for choosing a targeted return fund is its risk-adjusted returns,” says du Plessis. “A fund that achieves a real return (i.e. after inflation) of 3% per annum with a volatility (or standard deviation) of 10% is a better risk-adjusted per-former than a fund that achieves a real return of 4% per annum but with a volatility of 15%.”

Du Plessis’ advice to investors who intend investing in targeted return funds it that they should first decide on what their investment objectives are and then compare the risk-adjusted performance of funds with corresponding objectives. They should also make sure they understand what investment strategies are followed by the various funds they are considering, and also how strictly the funds comply with their mandates. Investors who cannot afford or tolerate any significant loss of capital should also analyse the fund’s drawdown history, especially during times of financial and economic crisis.

Lastly, investors should accept the fact there is no guarantee that a targeted return fund will achieve its objective all the time. “This is especially true when we experience rare occurrences such as the 2007/2008 credit crisis, which affected virtually all asset classes negatively,” says du Plessis. “And to make matters worse, South African targeted return funds have at the same time been competing against a stubbornly high inflation rate, which makes it extremely difficult for managers to achieve their objectives.”

According to du Plessis targeted return funds nevertheless deliver some of the best risk-adjusted returns in the industry and therefore deserve a place in a well-balanced investment portfolio. “Make sure your financial adviser has the necessary expertise and tools at his disposal to make the right choice for you,” says du Plessis.