The objective of an absolute return fund is pretty straightforward – to deliver a defined positive return whatever happens in the underlying market in which the fund invests. That sounds good doesn’t it, but how do they work?
There is a variety of methods absolute return fund managers can employ to achieve their objective. My preferred method is what is commonly known as ‘pairs trading’. For example, a conventional ‘long-only’ fund manager wishing to invest some of their fund in a food retailer may decide that Tesco offers the best prospects. They would then buy the shares and hold them until it was felt they had achieved their potential.
An absolute return fund manager would, in addition, aim to identify the company offering the weakest prospects in that sector. They would then enter into a contract to buy Tesco shares at today’s price at a fixed point in the future and match this with a contract to sell the shares of the leastfavoured company.
The result is that even if Tesco proved to be the best performing food retailer, the conventional fund manager could still lose money if the overall market fell. In contrast, the absolute return fund manager would make money as long as Tesco shares outperformed the least-favoured company, regardless of whether the share price had gone up or down.
Therefore, the return achieved by a conventional fund manager is a combination of skill (picking the right shares to buy) and circumstance (whether or not the overall market has risen or fallen). The return achieved by an absolute return manager is driven primarily by skill.
The general concept described can be applied to a multitude of financial instruments relating to equity, fixed interest, currency and commodity markets. Multi-strategy absolute return funds follow this approach.
In other words, it is just as possible for an absolute return fund to make money when markets are rising as it is when they are falling.
“As a consequence of the complexity of such strategies good risk management is essential”
If markets are volatile, absolute return funds can be a useful addition to a portfolio.
If you have an investment portfolio of long-only funds (funds that invest in stocks anticipating them to rise in value) then in theory an absolute return fund offers good diversity because it will exhibit low correlation with other parts of your portfolio.
Although absolute return funds are a useful addition to a diversified portfolio, because returns will not be strongly correlated with other elements, they should not be viewed as vehicles to invest all your money in.
Despite the fact that the funds can invest long and short and can by definition provide positive returns even if the stock market falls, the success of the fund depends very much on the fund manager making right decisions more often than wrong ones.
Given the complicated nature of some of these funds, ensuring the company investing your money has the competency to manage money in this way must be seen as a priority. You have to take a long hard look at the experience and resources a fund provider has to succeed in this specific area. Ideally you want an absolute return fund that is not just focused on equities but also bonds, currencies, commodities, property etc. As a consequence of the complexity of such strategies good risk management is essential. There needs to be a team of people to establish the strategy and a team of people to stress test it to identify hidden risks. For example, what would happen if interest rates rose unexpectedly?
Absolute return funds are frequently referred to as retail hedge funds, but this does not necessarily mean they are risky in structure. The outcome for your money will be skill based so you need to look even more closely at the management resources behind the fund. It is better to rely on funds that have been established for some time and can demonstrate an appropriate track record.
Absolute return funds are frequently referred to as retail hedge funds, but does this mean they are risky in structure? There is something of a misconception that hedge funds are high risk (only some are). In fact ‘hedging your bets’ which is what an absolute return fund tries to do, is about reducing volatility and providing smoother returns. You may not get all of the upside if the stock market soars, but then you may lose nothing (or actually gain) if the market plummets.
One of the criticisms often levelled at absolute return funds is that they are loaded with charges. I would disagree that all absolute return funds are excessively expensive – you pay for what you get. Charges are higher because you need more people and resources to run these funds and they also tend to trade more which means higher costs again. Charges only become an issue if performance consistently fails to deliver the correct level of return.
So my overall verdict is as follows: I believe absolute return funds serve as a useful diversifier in a broader investment portfolio, bringing a new dynamic in that returns are less influenced by market direction. At a time when global financial markets are in turmoil such funds would appear to offer some respite.