Absolute Return

The Investment Management Association only launched a dedicated grouping for absolute return funds in April 2008 and yet, by its second anniversary, the sector had attracted more than £11bn. However, the huge popularity of absolute return investing among UK retail investors does raise the question of how they and their advisers should go about assessing the performance and risk profile of these funds.

As with more ‘traditional’ long-only funds, the headline performance numbers do not tell the whole story and so it is vital to understand what is driving the underlying returns and how much risk is being taken to achieve them. Keeping an eye on these measures and how they change over time should offer a better insight into the nature of an absolute return fund and, importantly, how it is managed.

While some of these metrics are the same as the ones investors would use with long-only funds – for example, volatility and Sharpe ratios – others are very different. Indeed, one of the more common mistakes made by investors and their advisers is to compare the performance of absolute return funds to the equity markets.

Absolute return funds should not be seen as a way of replacing equity exposure within a portfolio but as a way of enhancing that portfolio’s overall risk/return characteristics. As such, absolute return funds should have a low correlation to equity markets, low volatility relative to equity markets and a low beta.

The Sharpe ratio is a particularly useful measure for absolute return funds because it reflects volatility and is compared to the risk-free rate. On the other hand, the information ratio, which is often used with long-only funds, is not helpful in the absolute return space because of its link with equity markets. Investors and their advisers should instead focus on a fund’s correlation with markets – over time, a correlation with equity returns that is close to zero would be indicative of a true absolute return strategy.

Gross exposure

The gross exposure of an absolute return portfolio can reveal the degree of risk that is being taken as it shows how much leverage is being used. It is important investors understand why this varies and they should be looking out for changes over time as well as gauging a particular manager’s approach to gross exposure.

At times of higher volatility, an absolute return fund manager can meet their return target with a lower gross exposure. Leaving it higher might mean the fund achieves greater returns but it could also mean the manager is taking more risk than is necessary to achieve the return target.

Another useful metric is net exposure, which shows how exposed a fund is to market movements, and changes over a period of time will once again tell more of a story than the level at any particular moment. Some fund managers will keep their net exposure within a tight band – for example, market-neutral funds would stay close to zero, with a view to only delivering stock-specific risk and returns without any market exposure. Other funds, meanwhile, may have the flexibility to move within a particular range, depending on their managers’ views.

A fund with a bottom-up investment process would typically have a net exposure that reflects the number of long positions held against the number of short ones. However, there could also be times where a fund’s net exposure level is significantly out of line with the manager’s market outlook and, here, they might use index futures to shift the net exposure up or down to reflect their degree of confidence in the direction of the market. Of course, the manager could simply increase individual stock positions but this brings its own risks. Not only do index futures allow the market exposure to be altered without excessive stock-specific risk, they are also very liquid.

Source of return

A final question for investors and their advisers to address is whether a fund is really generating absolute returns – and this is especially the case after equity markets have rallied. High net exposure may mean returns have actually come from beta or exposure to market risk, which is not what investors should expect from an absolute return fund. As an example –and all things being equal – if markets have rallied by 20%, a fund with net exposure of 100% that returns 15% is less impressive than a fund with net exposure of zero that returns 10%.

The real test of an absolute return manager is whether they do generate absolute returns across different market conditions. Therefore, while investors should not expect positive returns every month, it is important to assess whether a fund can deliver positive returns over time in different environments. An absolute return fund that is essentially tracking equity markets, for example, is not delivering the benefits it ought to as an effective diversifier to an investor’s overall portfolio.

The right absolute return strategies can benefit investors when used in portfolio construction but these funds should not be seen as a substitute for other asset classes. Equally, the investments selected should actually deliver absolute returns rather than mimicking another asset class. In the end – and as with long-only investments – the performance of absolute return funds must be assessed relative to the risks taken and using measures that are suitable for their unique nature.