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25th February 2016
Lifeboats on the Titanic

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Whipsawing equity and bond markets are shredding investors’ nerves, resulting in a huge spike in absolute return fund sales.

The Investment Association’s Targeted Absolute Return sector took in £4 billion of net new assets in 2015, making it the second bestselling after UK Equity Income.

But if the stampede continues, will capacity constraints restrict investors’ choice as some of the most popular funds struggle to cope with surging inflows?

Capacity concerns

Wealth Manager revealed earlier this month that Kames Capital is reviewing capacity on three of its market neutral funds, including its £586 million UK Equity Absolute Return fund, following ‘significant’ inflows.

And Ryan Hughes, a fund manager at Apollo Asset Management, is concerned about how others will react to a deluge of capital.

‘Broad-based global macro funds like Standard Life Investments’ Global Absolute Return Strategies (Gars) can run a lot of money, but there does come a tipping point,’ he said.

‘My concern is more about equity strategies. For instance, long/short market neutral strategies as they will have different capacity concerns. We have seen Kames explicitly warn on capacity for its market neutral funds and I know Henderson are aware too.’

Hughes added: ‘We expect this year to be even harder than last year and that is making people think about how they diversify their portfolios.

‘There are a lot of good managers in the sector but there are only a handful that have consistently delivered good returns. I think they will continue to be winners and therefore continue to attract money.’

This sentiment is echoed by BRI Management head of portfolio management Daniel Boardman-Weston who sold his holding in the £27 billion Gars fund in 2015 as he believes its size is now starting to hamper performance.

‘Everyone in the industry has held Gars at one point or another. We sold of out of it about a year ago because we were concerned about its capacity,’ he said.

‘I don’t know what the capacity of Gars is. It is big already, and then there are global mandates and a lot of the SLI pension money is in it, so we don’t actually know how big it is. If you look at its performance, it is actually down from the beginning of the year. It is starting to struggle compared to other absolute return funds.’

However, AXA Wealth head of investing Adrian Lowcock is unconcerned about Gars’ size, given the liquid strategies it pursues.

‘In the absolute return sector there are a lot of assets but Gars is a broad strategy that has a lot of capacity,’ he said. ‘They use a lot of different strategies, so it is highly diversified and has a lot of options.’

For Three Counties head of investments Andrew Alexander, size can bring additional problems beyond pure capacity. ‘It is almost too big to fail,’ he said. ‘The issue I have is that the company depends on it now. Standard Life Investments is almost a vehicle for Gars, not the other way around.’

Front run funds

Alexander also points to the potential problem of large funds being front run by other investors if they are pursuing a predictable trading pattern, a concern famously raised around Fidelity’s flagship Magellan fund, back in its heyday.

‘Say a good absolute return fund gets to a certain size and makes the same covered call, the same day of every month with the same bank,’ he said.

‘Inevitably traders will spot them and move against them and we could see some basis points get shaved off as the effectiveness of shorting is then diluted.

‘When Neil Woodford left Invesco Perpetual and millions of shares in Rentokil had to be sold, people were rubbing their hands because they knew the sale had to happen.

‘If enough people know, some will try and benefit from the other side of things.’