An investment objective that aims to generate positive returns, regardless of the overall direction of markets/asset classes etc. Absolute Return is distinct from traditional fund managers, who benchmark their returns to an Index/Sector or even a Factor.
Absolute Return Use
Primarily the stated aim of Hedge Fund managers, a variety of strategies may be used, but all attempt to profit regardless of whether the prevailing trend is bullish or bearish. Benchmark targets, if they use them at all, tend to be cash or short dated bonds (3-month Gilts for example).
Absolute Return fund managers tend to be characterised by their use of short selling, leverage and high turnover in their portfolios.
- Short selling: selling shares that the fund does not own, expecting them to fall so they can be bought back at a cheaper price.This can generate big returns in a bear market but are risky and can lead to “short squeezes”, particularly when a large percentage of the outstanding shares are held by short sellers, potentially leading to large losses accruing very quickly, as traders are forced to buy back the shares.
- Leverage: borrowing money allows a fund to magnify their returns, by increasing their return on capital employed (as debt, or leverage does not count as part of the denominator in the return calculation).This can be achieved by the use of derivatives ((options, futures etc) and by the use of margin trading.
- High Turnover: absolute return funds tend to adopt a short-term investment strategy, buying and selling holdings very quickly. This increases their trading costs, but allows flexibility in their investment strategy, allowing them to adjust quickly to changes in the market environment.The increased costs are passed on to their investors, with Hedge Funds often levying fees of “Two and Twenty” (2% of assets under management and 20% of the profits over a pre-agreed target level) compared to c.1% per annum for traditional fund managers.
All of these can increase gains relative to benchmark indices, but timing and investment errors mean that losses too are increased, leading to high volatility in overall performance.