Achieving positive returns regardless of market direction would seem to be a challenging objective. Absolute return funds aim to achieve positive returns in rising and falling markets by blending long and short positions on equities and, oftentimes, including bonds and cash in their portfolios for stability. Similar to hedge funds, this approach takes advantages of market moves in either direction and reduces its correlation to stock index performance. These funds must be actively managed by portfolio managers whose skill levels are likely to determine whether the fund’s objectives are achieved.
Absolute return portfolio managers utilise many of the same techniques as hedge fund managers who also focus on absolute returns. Most managed funds simply establish long positions in stocks or bonds and have a variable cash position depending on market conditions. Absolute return managers may apply multiple and untraditional methods to achieve their objectives.
Because they use several different investment techniques and a mix of securities, portfolio managers derive a total return from their activities through capital appreciation, short covering and dividend income. The total return this mix of investments generates is not likely to mirror the performance of the stock or bond indexes, which is why as stock or bond indexes decline, an absolute return fund may increase in value.
Fund managers are guided by fund objectives as to what investments and strategies they can use which might include equities, debt instruments, commodities, fixed yield investments, derivatives, stock swaps, and many other alternatives.
Absolute Return Funds can also adopt one of two structural approaches depending on the fund’s objectives. Most invest directly into the market while some adopt a funds within a fund approach where the investment portfolio consists of a variety of other funds.
As with any securities investment, there are associated risks with investing in absolute return funds. The level of risk is based on the fund manager’s objectives and investment strategy which can be range between very aggressive to conservative. Most fund managers employ hedging strategies in order to reduce overall risk, however, like in any investment, the higher amount of risk one is willing to assume, the higher the potential return.
Among the non-traditional techniques employed by absolute return fund managers:
Establish short positions: Instead of buying a long position in a stock, the fund manager will establish a short position by selling a stock. The securities are loaned to the manager who sells it and then, after it declines in value, it is purchased to cover the short.
Straddle the market: Similar to a hedging strategy where multiple securities are bought with the expectation they will move opposite each other. When one of the securities begins to run in the expected direction, the manager might sell the other securities.
Arbitrage strategy: fund managers can sometimes take advantage of temporary disparities between a securities price and the market’s pricing to reap quick profits.
Buying on margin: Some fund managers are allowed to buy positions on margin, meaning they can borrow funds to purchase stocks so they can achieve potentially higher returns. There only real cost is the interest owed on the borrowed funds.
Investors who seek total returns from both capital appreciation and income through a broadly diversified portfolio of traditional and non-traditional investments may find absolute return funds to be attractive. Investors should carefully review the fund product disclosure statement to see if its investment objectives and philosophy are suitable for their own financial objectives and risk tolerance.
Article provided by 2020 Funds Management, and investment manager for managed funds. This article provides information only and is not financial advice. It should not be taken as an endorsement or recommendation of any security or product.