Absolute Return

Absolute return is a financial term referring to the gain or loss that an asset or portfolio achieves over a given period, expressed in terms of its percentage return. Unlike relative return, which measures performance relative to a benchmark or index, absolute return focuses solely on the individual performance of the investment itself.

Concept and Importance

Definition and Calculation

Absolute return is calculated as the appreciation (or depreciation) in the value of an investment or portfolio over a certain period. It is typically expressed as a percentage. The formula for calculating absolute return is as follows:

[ \text{Absolute Return} = \left( \frac{\text{Ending Value} - \text{Beginning Value}}{\text{Beginning Value}} \right) \times 100\% ]

For example, if an investor starts with $100,000 and the portfolio grows to $120,000 after one year, the absolute return would be:

[ \text{Absolute Return} = \left( \frac{120,000 - 100,000}{100,000} \right) \times 100\% = 20\% ]

Importance in Investment Strategy

Absolute return strategies are important because they aim to provide positive returns regardless of market conditions. Investors employing such strategies seek to make money in both rising and falling markets, focusing on capital preservation and steady growth.

This type of strategy is particularly appealing during periods of market volatility or downturns, as it aims to deliver consistent results independent of market trends. Therefore, absolute return strategies can be an essential component of a diversified investment portfolio, providing a hedge against market risks.

Absolute Return Funds

Characteristics

Absolute return funds are investment funds managed with the goal of generating positive returns in any market environment. These funds often use various investment techniques, including long-short positions, derivatives, arbitrage, and leverage, to achieve their return objectives.

Types of Absolute Return Funds

  1. Hedge Funds: These are pooled investment funds that are more flexible than traditional mutual funds. They can use a wide range of strategies to achieve high absolute returns, such as long-short equity, market neutral, event-driven, global macro, and more.
  2. Absolute Return Mutual Funds: These funds aim to generate positive returns similar to hedge funds but are subject to regulations that generally make them less risky and lower returning than hedge funds.
  3. Managed Futures Funds: These invest in futures contracts and options on futures, employing strategies like trend following and systematic trading to achieve absolute returns.

Examples of Absolute Return Funds

  1. Bridgewater Associates: One of the largest hedge funds in the world, managed by Ray Dalio. Bridgewater Associates
  2. Two Sigma: A renowned fund that relies heavily on quantitative analysis and algorithms. Two Sigma
  3. AQR Capital Management: Known for its quantitative investment strategies aimed at absolute return. AQR Capital Management

Strategies for Achieving Absolute Return

Long-Short Equity

This strategy involves taking long positions in undervalued stocks while shorting overvalued stocks. The goal is to profit from the relative price movements of these securities, regardless of overall market trends.

Market Neutral

Market neutral strategies aim to exploit price inefficiencies between related financial instruments while maintaining a neutral exposure to the market. This is done by balancing long and short positions to mitigate market risk.

Global Macro

This approach involves taking positions based on macroeconomic trends and geopolitical events. Fund managers analyze global economic indicators and use various instruments, including currencies, commodities, and bonds, to achieve absolute returns.

Arbitrage

Arbitrage strategies seek to take advantage of price discrepancies between related instruments across different markets or within the same market. Common forms include merger arbitrage, convertible arbitrage, and statistical arbitrage.

Managed Futures

These strategies involve trading futures contracts based on systematic or discretionary methods. Managed futures funds often use trend-following models to capitalize on price movements in various asset classes, including commodities, currencies, and stock indices.

Event-Driven

Event-driven strategies capitalize on opportunities arising from corporate events such as mergers, acquisitions, bankruptcies, and restructurings. By identifying and investing in securities affected by these events, fund managers aim to generate absolute returns.

Benefits and Risks of Absolute Return Strategies

Benefits

  1. Diversification: Absolute return strategies often have low correlations with traditional asset classes like stocks and bonds, adding diversification to an investment portfolio.
  2. Capital Preservation: These strategies emphasize protecting capital and seek to generate positive returns in both bull and bear markets.
  3. Potential for Higher Returns: By employing various sophisticated techniques, absolute return funds have the potential to deliver higher returns compared to traditional investment strategies.

Risks

  1. Complexity: The strategies employed can be complex and may require a higher level of expertise and active management.
  2. Leverage Risk: Many absolute return funds use leverage, which can amplify both gains and losses.
  3. Market and Liquidity Risk: Despite aiming for positive returns in all conditions, absolute return funds are not immune to market and liquidity risks.
  4. Management Risk: The success of these funds heavily relies on the skill and experience of the fund managers. Poor decision-making can lead to significant losses.

Performance Measurement

Benchmarking

Unlike traditional funds, which are often benchmarked against indices like the S&P 500, absolute return funds do not have a standard benchmark since they aim to deliver positive returns regardless of market conditions. Performance is often assessed based on the fund’s ability to achieve its target return and manage risk.

Performance Metrics

  1. Sharpe Ratio: Measures risk-adjusted return by calculating the excess return per unit of risk (standard deviation).
  2. Sortino Ratio: Similar to the Sharpe Ratio but focuses only on downside risk by using the standard deviation of negative returns.
  3. Maximum Drawdown: The maximum observed loss from a peak to a trough, providing insight into the worst-case scenario for the investment.
  4. Alpha: Represents the excess return of the fund relative to its benchmark, adjusted for risk.

Conclusion

Absolute return is a compelling strategy for investors seeking to achieve consistent gains regardless of market conditions. By employing diverse and sophisticated techniques, absolute return funds aim to provide positive returns and capital preservation. However, they come with complexities and risks that require careful consideration and expert management. For those looking to diversify their portfolios and hedge against market volatility, absolute return strategies can offer valuable benefits.

For further information, investors can explore the following fund management companies that specialize in absolute return strategies: