Absolute Return Funds

Investors now have access to a range of more targeted absolute return strategies, with absolute return managers who can target skill-based returns (alpha) or market based returns (beta) or a combination of these sources of return.

Some characteristics that absolute return funds do have in common are a genuine ‘cash plus’ benchmark, specified volatility parameters and limited regulatory constraints. They usually charge high base fees (plus performance fees) and often involve the use of financial derivatives such as futures. 

Absolute Return Fund Benefits

• Diversification. Absolute return funds typically have low correlations with equity and bond investments and can reduce overall portfolio volatility. Technically the most attractive strategies are those with uncorrelated alpha.  

• Returns. Absolute return funds seek to generate positive (cash plus) returns across different market conditions. The impact on total portfolio return is driven by fund type, the correlation with other assets and the actual amount allocated. Typically absolute return funds would be expected to stabilise returns in falling markets (but may constrain returns when markets are rising sharply).

• Cash plus. Clients often identify more strongly with cash plus benchmarks rather than relative performance comparisons. It also provides a focus on avoiding negative returns.

• Efficiency. Absolute return funds are often able to balance their risks more efficiently than conventional long-only managers (including but not limited to their ability to short-sell). This means that the ‘truly’ smart managers have a better chance of converting skill into excess returns.

Absolute Return Fund Risks

• Finding Alpha. Alpha is hard to find and difficult to retain (it often fades over time). Investors should therefore only use alpha as a small component of total return. Manager selection is critical, given that the expected return across all alpha-seeking managers is negative (on after fees basis).

• Fee levels. Alpha-seeking absolute return strategies typically charge base fees of 1.5% to 2.5% plus performance fees of 20%. Some managers charge these performance fees on any net positive return (ie no hurdle rate). The risk here is that some absolute return managers achieving gross returns of 8% may not beat cash on a net of fees basis.

• Derivatives. Most absolute return funds use leverage in their portfolios, either as consequence of using futures (which are geared) or as a result of a conscious decision to leverage the portfolio.

• Relative performance. Most absolute return managers under perform traditional asset classes when share markets are rising strongly. This can sometimes test the patience of new investors into these sorts of strategies. Investors need to be realistic about what absolute return funds can and can’t achieve.