Investment Road Test: Schroder Real Return Fund

PORTFOLIO POINT: Though short of its goal, returns are well ahead of the market, making the Real Return Fund worth watching.

It’s hard to think of a moment in the past few years when investment hasn’t been caught in same type of confusion that prompted Dickens’ immortal words: “It was the best of times, it was the worst of times '¦ it was the spring of hope, it was the winter of despair.”

Global and Australian equities continue to disappoint, and the massive Australian holdings in cash deposits speak of widespread investor capitulation from stockmarket investing. The “astute” investor – who recognises and understands the concept of the equity risk premium – has not been rewarded by the stockmarket since 2007.

Neither the “buy and hold” nor the active trading style have worked in that period, and many are questioning whether they will work ever again. This has created a second order problem for many financial advisers, for whom the value proposition of building a diversified portfolio (using the tools of modern portfolio theory) is severely under question.

Schroders has created an interesting new “benchmark unaware” fund, the Schroder Real Return Fund, which aims to provide a total return of 5% over inflation, advocating a new investment approach that hopes to bypass the problems of a fluctuating stockmarket.

There is much to find pleasing in the Schroder Real Return Fund, even though the performance returns since inception don’t get near to its stated return objective of inflation plus 5% pa. Since inception 18 months ago the fund has returned 5.79% after fees, compared to inflation of 2.8% pa, or 4.2% for the 18 months, as measured by the RBA’s Trimmed Mean inflation data.

Returns for the past 12 months have been 2.58%, just in line with inflation but significantly better than the overall stockmarket!. Although that is a long way short of the targeted 5% margin over inflation, it is significantly better than the ASX 200 return of –10% for the same period, and about the same return that can be enjoyed in a term deposit.

Since the Real Return Fund holds a wide selection of assets, it is significant that it can match the cash rate even though it invests in far riskier asset classes.

Publicly available data shows that the Real Return Fund uses an “absolute return” style to investing, including a modified “volatility targeting” approach to the selection and management of its portfolio. This is an innovative approach, albeit one that is borrowed from hedge fund and derivatives traders who have been practising the technique for at least a decade.

The innovation extends to the screening and selection process for the underlying investments, which is described as using an approach that values the risk premium attached to each asset before investing. Specifically, the Real Return Fund does not have preset asset allocation guidelines, meaning it can choose to depart significantly from the “normal” portfolio construction of a traditional balanced portfolio.

The Real Return Fund is therefore a classic example of a fund that is managed to be “benchmark unaware” – since the profile of usual asset classes aren’t used to construct the portfolio and the investments of the fund. Performance data shows that the one-year volatility of the Real Return Fund is slightly more than half of a traditional balanced fund – a pleasing outcome for investors, and one that is explicitly targeted as a key outcome for the fund.
Let’s start by looking at how the Real Return Fund goes about building its portfolio. Standard modern portfolio theory blends shares (local and international), bonds, property, and cash to “optimise” returns and to seek to manage downside risk through holding assets, which are to some extent uncorrelated with each other. The problem is that in times of crisis, modern portfolio theory doesn’t work! During and after the GFC all major liquid assets fell in value by around the same levels – showing that in market crashes, the diversification which is sought by modern portfolio theory becomes illusory.

This trend has been noticed and commented on for some time – even blue-blood brokers like JB Were commented nearly two years ago that modern portfolio theory wasn’t a reliable tool in times of market disruption. Like most asset consultants, the JB Were prescription post GFC is to hold up to 50% of the portfolio in cash, with a permanently lower allocation to equities, and an increase in hedge fund-style investments.

For many investors the prospect of investing in a range of hedge funds will be anathema. Even though there are some truly amazing hedge funds around the world, the best are typically closed for new investing. Most retail investors look askance at the lack of transparency, high fees, and illiquidity of hedge funds – as well as leaning to the view that hedge funds may be a root cause of global financial instability. Instead of playing in the exotic world of hedge funds, selects investments which it sees as most likely to generate its targeted return of inflation 5% pa.

Schroders has made a major design breakthrough with the Real Return Fund – it speaks the language of the disaffected investor, as well as that of the sophisticated asset consultant, through its process of benchmark-unaware investing, specifically designed to reduce volatility and “negative surprises”.

This important, new branding approach recognises the disconnect for most investors – spooked by wild markets and sometimes bizarre trading activities – who see hedge funds as a cause or symptom of financial turmoil, and not as a cure. So this is an absolute return fund, purpose built for investors who are sceptical about the markets, and which in its design takes account of the fears of these investors.

The Real Return Fund has a wide mandate to invest in a broad range of asset classes, focusing on the risk premium that attaches to the selected asset. This is shorthand for looking for value when investing – the higher the risk premium is for an asset, the lower its price is compared to its past (or expected future) levels. By paying a relatively low price for an asset, the return (yield and/or growth) is boosted.

In line with its objective of reducing volatility of returns, the Real Return Fund overlays asset selection with a volatility management process. Although the details are proprietary, the volatility management process would involve buying and selling assets as a way to maintain a constant level of riskiness within the fund. This is significant, in that it brings some of the risk management tools used by hedge fund managers, to the design of a portfolio that shuns the exotic assets and leverage normally used by hedge fund managers.

Herein lies a problem that investors should be aware of, when contemplating the Real Return Fund. Publicly available data shows that the composition of the Real Return Fund portfolio is dominated by investing into other Schroders funds. The most recent portfolio construction data available for the Real Return Fund shows over 75% invested into other Schroders’ funds.

The balance is invested directly into physical securities and/or derivatives. With base wholesale fees of 0.9% pa applicable to the Real Return Fund (add more if you invest through a financial adviser who charges “platform” fees), coupled with the fee loads on each of the base funds, costs and expenses become the main drawback for the Real Return Fund.

The Real Return Fund is an excellent example of new funds management thinking designed to deliver investors what they want, rather than volatile returns based on outdated investment concepts. Although it has a relatively short track record, the early signs are encouraging. This is definitely a fund to watch.

The score: 4 stars
1.0 Ease of understanding/transparency
0.0 Fees
1.0 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile/risks
1.0 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services with Alpha Invest but does not receive any benefit in relation to the product reviewed.