FE Trustnet - Busting the five big myths around absolute return frameworks

Former Odey fund manager Freddie Lait, who heads up the Latitude Horizon fund, breaks the misconceptions many investors have about how risk-adjusted return funds should operate.

By Lauren Mason, Senior reporter, FE Trustnet

Bottom-up stock selection, double-digit cash weightings and the avoidance of any short positions or derivatives are not strategies commonly associated with funds that have absolute return frameworks. But, for Latitude Investment Management’s Freddie Lait, these ideas are key components of his Irish-domiciled DMS Latitude Horizon fund.

The manager, who ran money at Odey Asset Management for several years before launching his own boutique business, focuses on portfolio diversification as opposed to leveraging or shorting in a bid to achieve the highest possible risk-adjusted returns for investors.

This is in stark contrast to many well-known absolute return mandates – such as the behemoth Standard Life GARS fund – which tend to use a combination of traditional assets, advanced derivative techniques, pair trading and short positions to minimise volatility for their clients.

Performance of sector vs index over 5yrs

Source: FE Analytics

In the below article, the manager busts some of the assumptions many investors have about funds with absolute return frameworks and how they should minimise risk for investors.

Funds with absolute return frameworks shouldn’t have concentrated portfolios

Many absolute return, total return and diversified growth mandates run hundreds of positions across numerous asset classes at any one time to ensure their clients are covered on all grounds. 

Lait’s fund adopts a far more concentrated approach, however, with its equity allocation (which currently stands at 43 per cent of the portfolio), consisting of around 20 stocks. In fact, the fund’s top 10 equity holdings account for more than 28 per cent of the overall portfolio.

“We only own 20 stocks so it’s a very high conviction portfolio, but they are very diverse. We don’t follow thematic investing, which has become a bit of a buzzword,” the manager (pictured) said.

“A majority of people that I’ve found who are trying to defend active management defend it by taking bolder bets within active management, so they may take a large bet on one particular outcome or theme such as reflation.

“They tend to work as much as they don’t – the industry is full of people who are right once in a row. You can get those big calls right with your stocks, but then all you need to do is get one or two wrong and you have permanently impaired your shareholder’s capital in quite a meaningful way.”

Alongside equities, the fund has allocated capital to gold, emerging market debt, inflation-linked bonds, emerging market currency and cash.

Concentrated absolute return-framework funds aren’t diversified enough

While DMS Latitude Horizon has only 20 equities accounting for more than a quarter of the overall portfolio, Lait said it is still diversified enough to achieve strong risk-adjusted returns.

For instance, he will never hold a style bias within the portfolio in a bid to minimise drawdowns when they fall in and out of fashion.

“It’s about diversifying using across as many axes as you can think of,” the manager said. “We hold some things which are doing really well and some things which are not, and we don’t mind that.

“It is always going to be the case that stocks, even when the underlying business is doing fantastically, will have a couple of years where they can underperform quite substantially or lose a lot of money in the share price.

“We think about it more by business model as opposed to sector or region, because if you buy Unilever for example it’s not a UK or Dutch stock, so region is difficult.”

In terms of diversifying by sector, Lait said it is also possible to find a highly-defensive stock within a cyclical industry, which means it is therefore more important to focus on a company’s fundamentals first and foremost.

“We look at cyclicals and defensives, we look at turnarounds as well where businesses have been misunderstood or are undergoing corporate change because we can take that longer-term view,” he reasoned.

Examples of the fund’s largest equity holdings include Unilever, Alphabet, Nokia and Tesco.

Performance of UK stocks over 5yrs

  Source: FE Analytics

Absolute return frameworks should always be fully invested

Many investors believe absolute and total return funds shouldn’t need to hold cash, as their chosen strategies should protect them from any downside. However, DMS Latitude Horizon currently has a hefty 22 per cent cash weighting.

While the track record on the named fund only dates back to November last year, its high cash level isn’t simply because its capital hasn’t been fully deployed yet (the mandate was carried over from Odey, when it was named CF Odey Atlas).

“That is a true reflection of where I stand today. That’s a sign of there being less than we want to buy,” Lait said. “If I could, I would probably want to put 10 per cent of that into equities but we can’t find anything at the moment and I am patient and will wait.

“To invest countercyclically is one of the key things for a long-term investor as well. You have to wait for those prices to come and that can take years. We will run with levels of cash at times, although this is probably as high as it will get to at any point.”

The manager described cash as a “great asset” because it allows him to utilise any market opportunities when they do present themselves. He also pointed out that it is better to hold cash than buy into assets he doesn’t truly believe will benefit investors over the long term.

“Patience is very important and our current cash level is a sign of that. Investors would need to be patient with that but I think it’s a great asset. For funds which can’t leverage, using cash as a tactical asset class is very relevant,” he added.

Absolute return frameworks need to use derivatives and long/shorts to minimise risk

Holding short positions allows managers to diversify their portfolios and make positive returns during falling markets. The use of other common absolute return strategies, such as pair trading, can also offer a portfolio market neutrality.

However, Lait has chosen to run a long-only mandate and argued there are several advantages to this.

“Firstly, additional fees and costs such as roll costs and option premium costs go into some of these more complex derivative strategies,” he explained.

“I have structured funds using them in the past so I really do understand them quite well. There’s a lot more money in those types of trades for the house than for the client.

“I think the overall fee for a more complex fund is going to be higher, so even if I’m just a similar level of ability to that manager, I think my return will be higher by virtue of not taking so much out.”

Lait added that a long-only strategy allows him to focus more on the individual components of the portfolio and trade less frequently.

“We can take that long-term time horizon and have that focus and patience to invest for the long term,” he continued. “We can say the only driver of price is value in the long term, whereas other funds could be focused on what is going to drive prices over the next quarter or so, whether it’s earnings revisions, sentiment or momentum.

“The only thing we’re going to be spending our time focusing on every month is value. If we see prices substantially below value we will invest, otherwise we won’t.”

Funds with absolute return frameworks shouldn’t hold too much in equities

Equities are traditionally renowned for being one of the highest-risk asset classes and, as such, many investors can be sceptical about funds with absolute return frameworks that have large equity weightings in their portfolios.

“As far as I’m aware, there’s never been a 20-year period where you’ve lost money on equities,” Lait said. “People say that the fact there’s no other alternative is not a fundamental reason to hold equities, but it’s actually a pretty good fundamental reason to think about allocating for the long term.

“You do not want to own bonds for a long period of time most probably and, if you do, that implies that bond yields are going down further not higher, so almost certainly back to zero.

Performance of index over 5yrs

  Source: FE Analytics

“In a scenario where you do want to own bonds, you should want to own equities more because, even if they’re trading expensively today on – for instance - 16x earnings, that’s a 6.6 per cent earnings yield and it’s growing, it’s inflation-protected and, if you’re buying global companies, you are not at the mercy of one government regime or any targeted regional risks.

“You’re just in a much more sensible asset class which, on a relative basis, is looking increasingly attractive.”

While the fund has existed for more than six years, Lait significantly restructured the portfolio in November last year. As such, our data from FE Analytics only shows performance data stretching over the last few months.