Absolute return strategies
This article introduces absolute return strategies and how they might be used to add value or reduce overall risk levels in investment portfolios
What is “absolute return”?
In order to measure the success of an investment fund, asset or portfolio, the rate at which it grows or falls needs to be compared with a benchmark. For example, a portfolio that holds stocks included on the FTSE 100 index might use the FTSE 100 itself as the comparative benchmark. The idea being that if the FTSE 100 increases by, say, 1.0%, then the portfolio ought to match if not beat that performance. This is an example of “relative” performance.
Absolute return is performance that is designed to add value not in relative, but absolute terms. In other words, it is hoped that the value of the investment will increase over time regardless of what various other benchmarks or comparisons might be doing.
The nuance that has to be taken into account is the term “value”. If the economy is in deflation (falling prices), then the value of £1 (i.e. what it can buy) will rise over time. So if an investment holds its value compared to cash, then it can be said to have delivered greater value in real terms, i.e. the cash value of the fund can buy more over time.
It is for this reason that many absolute return funds use cash as their benchmark. If the fund’s equivalent value in cash increases over time (e.g. rising from £100 to £105), then it has delivered an absolute return i.e. it’s worth more.
A broad church
In simple terms then, the term “absolute return” just refers to how performance is measured; it gives little indication as to what sort of investments or assets could be included.
As one might conclude, the range of investments that can be considered to offer absolute return characteristics is very broad. If anything, the removal of a traditional relative benchmark relieves absolute return fund managers from the restrictions that such a benchmark might impose.
For example, a conventional long-only fund (one that buys and holds assets) that compares itself to the FTSE 100 would be expected to buy and hold stocks on the FTSE 100 index. This tends to restrict the level of risk taken by the fund as well as the potential returns.
With absolute return funds, the restrictions inherent with a relative benchmark are absent, so fund managers can go far beyond the simple approach of buying and holding different assets.
Here are some of the investment techniques and tools that a retail-focused investment fund cannot use, but which an absolute return fund potentially can.
Long / short
A “long” position simply means buying and holding an asset, an approach familiar to the majority of investors. This position is taken when an investor expects the value of the given asset to rise.
If the investor expects the asset to fall, then they might take a “short” position. This involves borrowing the asset (more accurately, renting it because nothing is free in investing). The investor then sells the asset and hopes that its value falls. If the investor is correct and the value does fall, then the investor can buy it back at a cheaper price. The investor would then make a profit from the difference between the lower price that they paid to buy the stock back and the higher price at which they sold it (minus the costs to “borrow” the stock in the first place).
This is as risky as it sounds. If the value of the stock rises then the investor incurs both the loss of the rising price of the asset as well as the cost to borrow the stock. What’s more, the investor doesn’t really own anything, it is a trade based on borrowed assets or “leverage” to use the financial parlance.
When the investor gets it right, it can be lucrative. This means that the investor can, in theory, make money when share prices are falling. And that’s why it is referred to as absolute return and not relative return.
That’s also why short-selling tends not to be included in retail funds because the risk level is high. But this risk level can be mitigated, for example by pairing a short position with a “long” (buy-and-hold) position.
Pairing and offsetting
For example, an investor might expect BP shares to fall in value. So the investor could take a short position on BP. However, in order to mitigate the risk of the entire oil & gas sector rising as a result of, say, oil prices rising everywhere, the investor could also take a long position on the entire UK oil & gas sector.
The theory here is that the investor will make money if BP’s share price falls relative to Shell and Tullow Oil, though some of those profits will be offset by a fall in the value of the long position on the oil & gas sector should it be pulled down by BP’s fall.
By the same token, should the entire oil & gas sector rise in value taking BP with it, then the investor’s long position on the sector is designed to reduce losses on the short position.
The theory would be predicated on the sector not rising as fast as BP might fall so the benefits of BP’s fall would outweigh the losses from the entire sector falling.
A similar position can be taken with currencies. For example, if the investor expects the Japanese yen to rise and the Korean won to fall, the investor could sell won and buy yen. But that would leave the investor vulnerable to severe losses if the currencies move in the opposite direction.
Instead, the investor might take two different positions using the dollar value as a base.
For example, the investor could take a long position on the yen versus the dollar i.e. expecting the yen to rise in value relative to the dollar. This would be done by buying a “call” or buy option which would make money if the value of the yen rose high enough against the dollar.
The second part of the position would be to go short on the won versus the dollar, i.e. expecting the won to fall in value relative to the dollar. This would be done by buying a “put” or sell option which would make money if the value of the won fell low enough against the dollar.
Once again, the investor would skew the relative values of the two options with the intention of making a net profit if the value of the yen rose relative to that of the won.
There are countless other technical tools that absolute return funds can use with the aim of generating returns that can involve greater levels of risk. So risk management is the next issue to consider.
What is “risk”?
An investment portfolio has an overall level of risk i.e. the vulnerability to rapid movements in price and potential loss of value. By using sophisticated modelling, fund managers endeavour to quantify what those levels of risk are for the entire range of investment opportunities.
The level of risk associated with holding cash might be similar to the level of inflation (currently around 2.4% in the UK as measured by the Consumer Price Index). The risk here, is that the spending power of cash is being eroded at 2.4% a year.
The level of risk associated with a bond issued by a small company in an unstable jurisdiction is very likely to be considerably higher, perhaps 20 or more times as high as the risk of loss for holding cash. This is because there is a higher risk that, for example, the company might go bust or be unable to make the payments due on the bonds that it has issued.
These are simplified examples designed to convey the principle. Much more precise and complex calculations can then be used when considering what level of overall risk is appropriate for given investors and their respective portfolios.
Why take more risk?
Because by taking more risk, an investor has the potential to make greater returns. So fund managers often have what is referred to as a risk budget.
This is more or less what it sounds like. Fund managers might want their overall portfolio to have an estimated total risk of losing no more than 5% of the given value in a year. So they might allocate, say, 1% of that risk budget to cash and government bonds, 2% to equity, 1% to property and the remaining 1% to absolute return.
The amount of money allocated to UK government bonds is likely to be much greater than that allocated to absolute return, for the simple reason that UK government bonds generally carry a lower risk-rating.
Applying this to absolute return opportunities
With the broad variety of tools and risk levels associated with absolute return investments, the principles of managing a risk budget are essential.
The first step is to determine the targeted rate of return. If we assume an example of cash plus 2.0% then we have to decide what measurement is going to be used for “cash”. One frequently used measurement is that of the London Interbank Offered Rate (LIBOR).
LIBOR is the rate of interest that banks charge when lending to another bank on a short-term basis, a process that is necessary in order to manage the flows of cash on a daily basis. It tends to be fairly low because the borrowers are relatively stable fellow-banks.
The amount will vary though, to reflect how long the loan is expected to last. Therefore, the overnight LIBOR in the UK is based on an annualised rate of just below 0.5% at the time of writing in late July 2018, while the 12-month rate is a little over 1.0%.
An absolute return portfolio manager looking to deliver ambitious returns might choose three-month LIBOR + 5%, while a more defensive manager might choose three-month LIBOR + 2%. The former would have to take greater risk in order to achieve the targeted returns.
Once the target returns and associated risk budget have been established, the fund manager will allocate risk across the investment opportunities with the intention of taking the level of risk necessary in order to try to generate the desired returns. In other words, different opportunities will be selected that, between them, have the appropriate balance of risk and return.
One further factor to take into account is that of correlation. If several investments are likely to behave in the same way i.e. that correlate, then that could create too much risk. That’s a complicated way of saying “don’t put all your eggs in one basket”.
For example, if a portfolio includes investments in housebuilders and mortgage sellers, then they could both be vulnerable to a downturn in the housing market.
Fund managers can use this to their advantage by deliberately choosing investments that offer the appropriate levels of risk and potential return, but which behave differently. That level of diversification can help to provide a lower overall level of risk.
For example, an existing portfolio might have a high allocation to, say, equity in large companies. That could make the portfolio vulnerable to a fall in the value of large companies. In order to counter that risk, investments that don’t behave the same way could be introduced to the portfolio. For instance, a short (as described above) could be strategically placed so that a broad fall in large companies’ values could be countered. Alternatively, different asset classes or instruments could be introduced such as commodities or derivatives that, on their own, carry high risk-ratings but when appropriately selected for a given portfolio could counter existing risk levels and reduce the overall risk within that portfolio.
As we can see, absolute return funds include a broad range of investment opportunities that tend to require an advanced understanding of investments, finance and risk management. However, if implemented by specialists as part of a long-term investment outlook (such as around 10 years), we believe that they can offer an attractive extension to a carefully managed portfolio.
It is important to remember that each investment opportunity should be assessed for suitability relative to an investor’s unique circumstances, attitude to risk and objectives. The examples expressed in this article do not represent investment advice from Lloyds Bank plc. We recommend investors seek professional investment advice before making any investment decisions.
Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at September 2018. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.
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