Exploring absolute return strategies

Absolute return strategies seek to provide positive returns regardless of how other asset classes are performing. Because of this, their returns can move independently of the major asset classes and they can therefore provide diversification benefits, helping to smooth out total portfolio returns.

In our second article we look at how absolute return strategies try to meet these objectives.

Absolute return: a recap

Absolute return strategies seek to provide investors with positive returns under all market conditions.

Whilst this implies anything above zero, they generally target a rate of return that is in excess of inflation or the return on cash deposits.

This is usually expressed as X plus Y%.

For example they might target an annual return that aims to provide 2% more than a 3-month deposit account.

  • However, and as we shall see, this does not mean they can be regarded as cash-like investments.

Because absolute return funds do not use traditional benchmarks, they are not tied to the kinds of assets they can invest in.

Keeping it simple

At the highest level, absolute return funds can be thought of as multi-asset strategies (those that invest across a range of investments) but with the freedom to pursue a wider range of investment opportunities with fewer restrictions.

For example, a traditional multi-asset strategy will have a benchmark and investment policy that:

  • set out the types of assets in which it can invest
  • provide an outline of the proportions these assets should be held in to meet a customer’s long-term financial objectives
  • have limits on the minimum and maximum amount of each asset that the fund manager can invest in.

So a benchmark that comprises 60% UK bonds and 40% UK equities tells the fund manager they can only invest in these two asset classes and tells them the relative proportions they should hold them in. They are usually permitted to hold small amounts of cash, too, to help them buy and sell investments.

If it comes with investment restrictions of plus or minus 15% the manager has the freedom to invest up to 75% of the portfolio in bonds (but no less than 45%) and up to 55% in equities (but no less than 25%).

Absolute return funds have no such limits. They can invest 100% in equities or 0% in equities (or bonds, or any other assets) depending on where they see the best opportunities.

An alternative approach

This freedom can allow the fund managers to invest in a whole host of assets. Some of them will be used in traditional funds, and even those that aren’t you will probably have heard of. But they can also invest in assets that many would consider ‘exotic’.

These could include, but are not limited to:

  • commodities
  • currencies
  • private equity
  • patents and intellectual property
  • life insurance policies
  • fine art
  • wine
  • classic cars.

The long and short of investing

Absolute return funds have another trick up their sleeve. Traditional fund managers can only express a positive opinion. They invest in the stocks, shares, bonds, etc that their research identifies as having the potential to provide a positive return.

If their research identifies investments that do not have this potential (and might perform poorly) they simply avoid investing in them.

The buying and holding of investments in this way is often called holding “long” positions and the fund manager is said to be “long” that investment.

But where the research uncovers a company share that was likely to fall in value, is there a way for the manager to make a potential return from this?

The answer is: yes.

There are two common techniques they can employ.

  • The first is to do something called stocklending.
  • The second is to use a derivative.

As it is the opposite of holding a positive view, taking a negative position in an investment is commonly called “shorting” and the fund manager is said to be “short” an asset.

Stock lending

Although it’s called stocklending, for the absolute return manager this is actually borrowing the share from another investor for an agreed amount of time. Having borrowed it, the manager sells it expecting to be able to buy it back at some point in the future at a lower price.

That might sound like a strange thing to allow someone to do with something they’ve borrowed, but the investor lending out the stock receives a payment in return. This can either be a fixed amount or a percentage of the potential profits.

If the absolute return manager is correct and the price falls they make a profit from the difference between the lower price they paid to buy the stock back and the higher price at which they sold it (minus their trading costs and the payment for borrowing the stock).

But, if everything goes to plan, they can still make a return from a falling share price.

  • A traditional manager aims to buy low and sell high.
  • An absolute return manager aims to sell high and buy low.

They both have the same objective – to make a profit from buying and selling an investment – but absolute return managers reverse the process.

At this point you’re probably asking yourself: who would lend out stocks in this fashion? Generally, it is institutional pension funds as they do not need to sell investments at short notice to help them raise cash.

  • It is a way for them to boost their long-term returns from the payments they receive.
  • However, they run the risk that the borrower cannot buy the asset back when the time comes to return it, or the borrower goes out of business.

Heads I win, tails you lose

Absolute return managers use stock lending to take positions against individual stocks. For example, if they think the shares of Microware plc will rise in value but those of its competitor Lynxus plc will fall, they can take matching but opposing positions in the two companies by buying shares in Microware and borrowing-and-selling (shorting) Lynxus.

This is called pairing.

Shares in Microware rise in value while shares in Lynxus fall.

  • The manager gains from buying shares in Microware.
  • The manager buys back the shares in Lynxus at a lower price than they sold them for.
  • Win/win.

Shares in Microware rise and the shares in Lynxus rise due to optimism about the technology sector.

  • The manager gains from buying shares in Microware.
  • The manager buys back the shares in Lynxus at a higher price than they sold them for.
  • Win/lose.

Shares in both Microware and Lynxus fall.

  • The manager gains from buying shares in Microware.
  • The manager buys back the shares in Lynxus at a lower price than they sold them for.
  • Lose/win.

Shares in Lynxus rise but those in Microware fall.

  • The manager loses from buying shares in Microware.
  • The manager buys back the shares in Lynxus at a higher price than they sold them for.
  • Lose/lose.

In situations where one half of the equation is a “win” while the other half is a “loss”, your success is reliant on the losses being smaller than the gains.

  • If the price of Lynxus shares rise, they need to do so at a slower rate than shares in Microware.
  • If shares in Microware fall, they need to do so at a slower rate than Lynxus.

Borrower beware

Remember, the investor has only borrowed the stock and they have a contractual commitment to return it by the time specified.

So, if the value of the stock increases in the meantime the absolute return manager will make a loss. They have to:

  • buy the stock back at a higher price than they sold it for
  • pay their trading costs
  • make a payment to the stock’s owner.

Because this kind of strategy has a higher level of risk than traditional long-only investing, it is generally not allowed in funds marketed to retail investors.

But the absolute return manager can use a derivative to provide some level of insurance against the value of the borrowed stock rising.

This is called offsetting.

Offsetting: an example

Supposing, as an absolute return manager, you believe the shares of Acme Oil are going to fall in value. So you decide to take a short position in Acme Oil by borrowing the stock from another investor and selling it.

This kind of strategy has a higher level of risk.

However, you run the risk that some future political or economic event could lead to the entire oil and gas sector becoming attractive to investors and the shares of Acme Oil rising along with its peers.

  • For example if the US-China trade dispute is resolved and global growth recovers, there could be a greater demand for oil.
  • This could see oil prices rise and the value of shares in oil and gas companies increase across the board.

Whilst the relative performance of Acme Oil might not be as good as its peers (and therefore underperforms as you anticipated) the general euphoria for stocks in the sector could see the absolute value of its shares increase.

And this would mean having to buy the shares back at a higher price than you sold them for.

So to offset this risk, you could buy a derivative that gives you exposure to the entire oil and gas sector.

Thinking about your two positions, you win if the value of Acme Oil’s shares fall, and you win if the oil and gas sector rises.

Offsetting: the outcomes

With this in mind this is how your investments would behave in the four potential outcomes: Acme Oil falls but the oil and gas sector as a whole rises.

You buy the shares in Acme Oil back at a lower price and make a profit

Your derivative position in the oil and gas sector also pays out.

  • Win/Win.
  • Acme Oil falls, taking the entire oil and gas sector with it.
  • You buy the shares in Acme Oil back at a lower price and make a profit.
  • Your derivative position in the oil and gas sector fails and you have to pay out.
  • Win/Lose.

Acme Oil rises as a result of the entire sector rising.

  • You have to buy the shares in Acme Oil back at a higher price and make a loss.
  • However, your derivative position in the oil and gas sector pays out.
  • Lose/Win.

The oil and gas sector falls but Acme Oil rises.

  • Your derivative position in the oil and gas sector loses you money.
  • You also have to buy the shares in Acme Oil back at a higher price and make a loss.
  • Lose/Lose.

Again, in situations where one half of the equation is a “win” while the other half is a “loss”, your success is reliant on the losses being smaller than the gains.

  • If the price of Acme Oil shares rise, they need to do so at a slower rate than shares in the oil and gas sector as a whole.
  • If shares in companies in the oil and gas sector fall, they need to do so at a slower rate than Acme Oil.

Conclusion

Absolute return funds have the potential to smooth total portfolio performance by providing returns that are totally independent of traditional assets and strategies.

This is because they take a ‘no-holds-barred’ approach to seeking positive returns including non-traditional investments.

And not only can they take a positive view on, they can use strategies to take negative positions as well. However, the techniques they use to achieve these returns can be complex and come with higher risks.

But knowing what they do is not the same as understanding what they do.

Selecting the right absolute return fund requires a deep understanding of investments, investment strategies and the different risks involved.

It also requires an appreciation of how the positions these managers take have the potential to benefit, neutralise or increase the risks in your existing portfolio.

We recommend customers take professional investment advice before considering adding absolute return strategies to their portfolios.

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