What is an “Absolute Return Strategy”?
The return that an asset achieves over a specified period is called absolute return and is measured by the appreciation or depreciation in price expressed as a percentage. Unlike relative return, absolute return does not take into account the performance against a benchmark or an index – it is purely the amount of return that investment has earned over the period.
The main objective of absolute return strategies is to deliver positive outcomes regardless of the prevailing market conditions. They could use a range of non-traditional techniques such as arbitrage, short selling or using leverage, and can invest in complex instruments such as derivatives.
Key Learning Points
- Absolute return is measured purely on the performance of the investment concerned, where the relative return is measured against a particular benchmark.
- Portfolio managers aim to produce positive returns in all market environments and also reduce the overall risk in their portfolio.
- This is achieved through a number of sophisticated techniques like short selling and using complex instruments such as derivatives.
- Absolute return strategies are typically less correlated to the broader market (for example measured as the performance of the S&P 500 Index) and therefore could also work as a diversifier in a portfolio.
Key Features of Absolute Strategies
Absolute return strategies use an unconstrained approach to investing, meaning they have the flexibility to go where the manager sees potential opportunities in any given market. Therefore, these strategies are expected to be highly responsive to changing market climate and tilted toward more defensive segments such as government bonds or cash, or using hedging techniques to protect the portfolio should the manager anticipates a weaker market.
On the other hand, managers tend to attempt to capture most of the upside in stronger markets by having higher exposure to riskier assets such as equities or emerging markets debt. As a result, absolute strategies tend to have higher portfolio turnover.
However, the objective of absolute return strategies can be subjective and this is the reason why many portfolio managers set the objective to outperform cash deposits or some measure of inflation (for example the Consumer Price Index – CPI or the Retail Price Index – RPI) by a target percentage over a specified time frame.
Advantages and Disadvantages
The flexibility of the “go-to anywhere” approach is one of the main benefits of absolute return strategies. They can use complex products such as derivatives (for example options) for hedging purposes which can remove some of the market risks and make the portfolio more independent of the overall market. However, this may have an outsized impact on performance and, when the decisions are wrong, could lead to larger losses.
That said, absolute return funds are heavily reliant on their manager’s skill, and therefore getting the market timing or other aspects of the strategy wrong could hamper returns. Absolute return strategies may underperform during stronger markets, as they have to ensure that the portfolio is built with an emphasis on limiting the downside if markets were to sell off, while relative return funds may use their mandate to overweight riskier assets.