Alternative Ucits funds have seen an eye-dazzling €218bn of net inflows since 2012, according to Morningstar data, even though almost half of investors in alternative Ucits funds believe there are not enough good funds in the space to choose from (see chart below).
An important explanatory factor for these flows has been the record-low bond yields. As long-term return prospects for fixed income have been eroded, investors have been replacing part of their bond allocation with absolute return funds.
Focus on low-vol
Because most investors see absolute return first and foremost as a fixed income replacement rather than an alternative source of return, they prioritise low volatility and consequently opt for the most conservative funds in the area.
As the UK government now finds out as it seeks to negotiate its exit from the European Union, you can’t have the cake and eat it at the same time. So lower volatility tends to go hand in hand with lower returns. This is exactly what Praveen Joynathsing, director hedge fund selection at Lyxor AM, has been observing. “The funds that raise the most assets all are low-volatility funds. This leads to the launch of more low-vol funds,” he said during a panel debate at the Expert Investor Alternative Ucits Congress, held in Noordwijk, the Netherlands, last week.
“Unfortunately, this will probably carry on, and the consequence is that there are not enough good high-vol alternative Ucits funds.”
Too big to deliver
This problem of lagging returns is reinforced by the fact that the alternative Ucits space is extremely concentrated, with the top-three funds harbouring more than 50% of assets in many strategies. These funds therefore get too large for their own good, said Michalis Fessas, head of fund selection at Eurobank in Athens, speaking during the same panel debate.
“If a fund gets really big, the possibility of a manager extracting the same amount of alpha is significantly reduced, because the universe he can invest in also gets smaller. In the alternative Ucits space, this is more evident than elsewhere because of the use of leverage,” he said.
Claudia Roering, head of research at the German asset manager Lupus Alpha, agreed: “Once funds get huge inflows, manager behaviour can change. Usually it results in a reduction of alpha, and large flows in and out cause disruption. Last year we saw some of the big alternative Ucits funds underperform.”
Many fund selectors also believe the concentration of flows is a problem (see chart to the left), and Roering’s remark (see graph below) suggests the panellists have a point. That large absolute return funds have struggled to produce any returns over the past two years could possibly be due to their size, and of course to their volatility targeting. Volatility of absolute return funds has indeed come down, as has the correlation of absolute return funds with the MSCI World index.