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Absolute returns

Absolute return strategies

In the run up to the Brexit vote investors ploughed £10 bn of new money into targeted absolute return funds. Over the same period a net £38 bn was taken out of the overall UK fund market*. So why is the absolute return approach so popular at the moment and what are the pros and cons compared to other investment strategies?

Absolute return strategies rose to popularity in the wake of the 2008 financial crisis as investment funds sought ways to make money in a bearish market. The term ‘absolute return’ covers a wide range of strategies but the principal aim is the same: to produce positive returns regardless of market conditions. This makes them particularly attractive in periods of slow growth, market volatility and (in theory at least) even recession.

While some predicted the popularity of absolute return funds would wane as markets stabilised, sluggish growth and a succession of market shocks, coupled with poor and even negative yields from traditional diversifying assets such as sovereign bonds, have seen them become the most popular form of investment in the UK, according to sales figures from the Investment Association . And with volatility in the markets looking set to continue as the UK extracts itself from the EU, this trend seems set to continue – asset managers including Barings, Kames Capital and Jupiter all launching new funds within a week of the Brexit vote.

The appeal of an investment approach which offers the potential for conservative long term growth under any market conditions is obvious, but how does an absolute return strategy seek to achieve its aims and do they actually work?

The ins and outs of an absolute return strategy

A key element of absolute return funds is their ability to ‘short’ investments.

Essentially, shorting can allow a fund to experience positive growth despite a falling market. This is achieved by a fund manager borrowing an asset (such as an equity, for example) from a third party. This will then be sold when the fund manager believes it has become overvalued, with the aim that it is then bought back when the price falls, resulting in a profit. The fund manager will then return the asset to the third party he borrowed it from. Thus, a profit is made by the fund manager even as the market falls. However, if the price of the asset borrowed goes up instead of down, losses can be substantial.

To mitigate this risk and maximise potential profits, many funds use a mixed approach. Some of these include:

Long short: A long short strategy enables a fund to both hold shares in the market (go long) and short the market (as described above). In theory this allows profits to be made whether the market is rising or falling. However, in practice it also means funds can make losses on both buying and selling shares.

Global macro: Long and short positions are held in a range of assets including equities, fixed income, currency and futures markets to reflect the fund manager’s convictions in terms of the macroeconomic (big picture) prospects for various countries and regions. Often assets will be balanced against each other in an attempt to reduce losses should these convictions prove wrong.

Market neutral: These funds aim for zero net-exposure, that is, the fund’s short and long investments have equal market value. Often pair trading is used, whereby equal amounts are invested in two different stocks. The overall aim is to reduce risk compared to a traditional long investment approach.

Beyond the individual fund strategy, investors can try to mitigate risk by using an absolute return as part of a broader portfolio, which might include multiple absolute return strategies along with more traditional investments.

Too good to be true?

On the face of it, choosing an investment approach that offers the potential for steady growth seems obvious. In reality the complex nature of absolute return funds means that investors should tread carefully.

Perhaps the biggest issue for investors when looking at absolute return strategies – other than there being, in reality, no guarantee of a positive return - is that there is no clear definition of what absolute return is. Funds are spread over many different sectors, with each one adopting a different approach and a different mix of assets, which may include multi-asset, currency, bonds and equities. Some funds marketed as being based on absolute return strategies even use derivatives, which have the potential to make a disproportionate loss in the wrong circumstances. Unless the fund is very clearly defined and you do careful research, it may not be entirely clear what you are investing in and the risk could be greater than using a more traditional investment approach.

Consequently, your individual circumstances will dictate the investment approach that’s right for you and professional investment advice is of paramount importance when considering a strategy of this nature.

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. The value of investments may fall as well as rise. Any views expressed by Lloyds Bank Private Banking are our current in house views as at 10th July 2016 and should not be relied upon as fact and could be proved wrong. Views expressed are not intended to provide legal, tax or financial advice.

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