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Introduction to Absolute Return

Asset prices were at, or close to, their all-time highs for much of 2018. During the last quarter of the year investors became nervous and these conditions can lead to more frequent fluctuations in the prices of investments. To investors, this equates to a greater level of risk.

At the same time, central banks in the US, UK and the European Union have announced that they will start to reverse the measures they took to boost their domestic economies in the wake of the great financial crisis of 2007/8. This includes withdrawing some of the money they injected into the financial system by selling the bonds they have bought. As more bonds come onto the market, the prices of bonds are likely to fall leading to negative capital returns.

Bonds are a key component in diversified portfolios as they behave differently to equities under the same economic conditions. So what can investors do when asset prices – especially share prices – are more volatile, and bonds are likely to produce negative returns? One tool that we believe can help diversify risk in some portfolios is the broad range of strategies referred to as “absolute return”.

In this, the first of an occasional series, we provide an overview of absolute return strategies and look at how they might be used to add value or reduce overall risk levels in investment portfolios.

What do we mean by absolute return?

To measure the success, or otherwise, of an investment fund, asset or portfolio, the rate at which its value grows or falls is often compared to a benchmark. This type of strategy is referred to as a relative return approach: performance is measured relative to something else.

Passive funds seek to match the performance of an index. Traditional active funds seek to produce returns that are better than their peers and/or the investment market as a whole.

  • For example, a fund that holds stocks included on the FTSE 100 index might use that index as the comparative benchmark.
  • If the FTSE 100 increases by 1.0%, then the portfolio is expected to match if not beat that performance.
  • But this approach can restrict the type of investments held, the level of risk that can be taken, and the potential long-term returns.

Absolute return strategies, seek to increase the value of the portfolio over time regardless of what various benchmarks or other comparisons might do.

  • Removing the limitations of a benchmark can provide managers with the freedom to use many kinds of investment to reach their goal.

Here we should consider what we mean by the term ‘value’. If prices in the economy are steadily falling (known as ‘deflation’) then the amount of goods and services that £1 can buy will increase and therefore the value of that pound will also increase.

  • If an investment holds its value when 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.
  • For this reason many absolute return funds use cash as their benchmark.
  • However, we should keep in mind that they are not cash funds.

A broad church

The terms “equities” and “bonds” provide us with a pretty good idea of the types of investments a fund will hold, and some idea of the relative levels of risks that come with that.  However, “Absolute return” is just a label that tells us how performance is measured; it gives no indication as to what sort of investments or assets its portfolio might include, nor the types or levels of risk that might entail.

In fact, the range of investments that can offer absolute return characteristics is very broad. As investors we need to investigate how each fund seeks to achieves its objectives, and be able to understand the risks these might bring.

A range of techniques

As well as investing in traditional assets such as equities, bonds and property, absolute return funds can also buy non-traditional assets and can make use of other investment techniques.

Alternative investments

Some of these investments you might be familiar with such as commodities, currencies, and private equity; some of them may seem more unusual like patents.

Derivatives

A derivative is a contract to buy or sell an asset – in this context an investment – at a pre-arranged price by or on a pre-arranged date.

The value of the contract is derived from the value of the underlying asset; hence the term derivative.

Examples of derivative include options, futures and swaps.

  • Options confer the right but not the obligation to buy or sell a specified number of assets (e.g. 100 shares) at a specified price on or by a future date.
  • Futures confer an obligation on both parties to exchange the cash value of a specified asset at a specified price on or by a future date.
  • Swaps enable contract holders to exchange incomes or debt payments.

Leverage

Sometimes an investment might provide a positive return but potentially a very small one. In such cases an absolute return manager can use a technique called leverage to magnify the return.

This basically means borrowing money from a bank to buy investments in the expectation that the returns will be greater than the costs and interest of the loan. Or borrowing money from a bank in a country with an interest rate on loans of 2%, for example, and investing that money in another country that pays 4% on deposits.

However, leverage can also amplify losses: not only does the manager lose on the investment they still owe the bank the original amount borrowed.

Even small losses have the potential to be disastrous where large amounts of borrowing are involved. And if the money has been borrowed to buy derivatives, the losses can be very significant.

Some absolute return funds focus on using only one of these strategies – such as a multi-asset approach, or a single asset class approach using derivatives or leverage to improve returns – while others will use any and all of these to meet its target returns.

Risk management

As we have seen, absolute return funds can use a number of techniques to meet their objectives. Some involve greater levels of risk than others and risk management is the next issue to consider.

What is risk?

When investing, there is always the fear that asset prices might fall significantly just as we are about to sell our holdings; potentially losing all our gains and possibly our initial investment, too.

So investments that vary rapidly and/or significantly in value are considered to be ‘riskier’ than those that do not.

The level of risk associated with holding cash might be similar to the level of inflation (currently around 2.1% in the UK as measured by the Consumer Price Index). The risk here is that the spending power of cash (its value) is being eroded by 2.1% a year.

The level of risk associated with a bond issued by a small company in a politically unstable jurisdiction is likely to be considerably higher than the risk of loss for holding cash, perhaps 20 or more times as high. This is because:

  • There is a higher risk the company might go bust
  • It could be nationalised
  • It could be prevented from making international payments
  • It might be unable to make payments due on the bonds that it has issued for other reasons.

These are simplified examples but they convey the principles. By using more precise and complex calculations, fund managers endeavour to quantify what those levels of risk are for the entire range of investment opportunities.

These can then be used to design portfolios that aim to match investors’ risk appetites.

Why take more risk?

By taking more risk, an investor has the potential to make greater returns. So fund managers often use what is referred to as a risk budget. This is the total acceptable portfolio level of risk which is to be allocated across different types of investment.

Suppose a fund manager wants the overall portfolio to have an estimated total risk of losing no more than 5% of its value in a year. The manager can be said to have a risk budget of 5%.

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 target rate of return, and this is generally relative to the return from holding cash. So one of the first things we need to decide is what measure we will use for ‘cash’. One frequently used measurement is the London Interbank Offered Rate (LIBOR).

This is the rate of interest banks charge each other on a short-term basis.

It tends to be fairly low because the borrowers are relatively stable fellow banks.

In mid-February 2019, three-month LIBOR was just under 1.0%.

An absolute return portfolio manager looking to deliver ambitious returns might choose three-month LIBOR plus 5%, while a more defensive manager might choose three-month LIBOR plus 2%. The former would have to take greater risks to achieve the targeted return.

Once the target returns and associated risk budget have been established, the fund manager will allocate that risk budget across the various investment opportunities. The aim is to maintain an appropriate balance of risk and return.

The long and short of investing

Traditional asset managers who buy and hold investments in their preferred company shares and bonds are said to be holding “long” positions.

But what if your research uncovered a company share that you thought was likely to fall in value? Is there a way in which you could potentially make a return from this?

The answer is: yes.

There are two common techniques that some asset managers can employ.

The first is to borrow the stock from another investor and to sell it in the expectation of being able to buy it back at a lower price on a future date and hand the share back to the original holder.

The second is to use a derivative which is akin to taking a bet against another investor.

Taking a negative position against an investment is commonly called “shorting”.

Diversification

Why use absolute return strategies?

One of the key principles of multi-asset investing is to select a range of assets that react in different ways to the same economic or political trigger.

Investments that move in exactly the same way and to the same extent are said to be “correlated” and their returns are said to move in “correlation” to each other.

  • For example house builders and mortgage arrangers would both be vulnerable to a downturn in the housing market.
  • Their performances are correlated to housing demand.

This could create too much risk in the portfolio. Fund managers use this level of knowledge to select investments that offer the appropriate levels of risk and potential return, but which behave differently.

A portfolio with a high allocation to shares in large companies is clearly vulnerable to a fall in their values. To counter that risk, investments that don’t behave in the same way could be introduced to the portfolio:

  • a ‘short’ could be employed via the purchase of an option (see above)
  • other asset classes such as commodities or derivatives could be introduced to increase diversification.
     

How can absolute return funds improve diversification?

Because absolute return strategies seek to provide positive returns regardless of how other investments move, they can be said to be uncorrelated to other investments and therefore provide the potential to improve diversification and reduce total portfolio risks.

Conclusion

Absolute return funds include a broad range of investment opportunities, some bearing more risk than others and some carrying considerable risk.

As investors we should be selective in the strategies we choose. Firstly they have to offer true diversification and not merely amplify existing risks, but we need to ensure that we understand the additional risks they might introduce.

This tends to require an advanced understanding of investments, finance and risk management. However, if implemented by specialist managers as part of a long-term investment outlook (such as around 10 years), we believe that their approach can offer diversification benefits to a carefully managed portfolio.

It is important to remember that each investment opportunity should be assessed for suitability relative to each 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.

Important Information

Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions. The forecast of future performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of investments, and the income from them, may fall as well as rise. No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this document or any opinions or projections expressed herein.

Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions. Any views expressed within this report are our in house views as at March 2019 and should not be relied upon as fact and could be proved wrong. The information contained in this document has been derived from sources which we consider to be reasonable and appropriate. This document may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) for any other purpose without prior written consent.

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