Positive performance in any market?

The primary goal of an absolute return strategy is to generate positive financial returns consistently, regardless of broader market trends. This differs from the majority of investment approaches, which focus on what is known as relative return, where a manager seeks to outperform a benchmark, such as a stock market index. 

Positive relative returns can still lose money

Based on this difference in aims, absolute return strategies allow the manager and therefore the investor to focus on the actual profit or loss of their investments. The more common relative return approach, by contrast, is deemed successful if it beats the benchmark. This may involve a negative return if the benchmark falls over the investment period. For example, if the stock market rises by ten per cent in a year and a manager posts a twelve per cent return, this is a positive relative return. If the market falls by ten per cent, however, and the manager posts just a five per cent drop, this is also a positive relative return, even though the investor has lost money.

While this explanation makes relative return sound riskier than absolute return, this isn't necessarily true. Why? Because the strategy that an absolute return manager pursues to achieve a positive return is often far riskier - and far harder to understand than the often more straightforward approach of a relative return manager.

The importance of uncorrelated returns

Investors often use absolute return strategies as diversifiers within a larger portfolio. On the theory that an investor should never put all their eggs in one basket, depending on the strategy pursued, an absolute return fund can provide returns that are largely uncorrelated with more traditional asset classes like stocks and bonds. This has been useful in recent years.

"When interest rates were low or negative, a fixed income absolute return fund could provide the return and uncorrelated results that investors were looking for," explains Reto Egli, Head of Fund Research at LGT. "This low correlation was especially useful when stocks and bonds were moving in tandem, rather than in opposite directions." For most of the past 20 years stock prices and bond prices tended to move in opposite directions which tends to stabilize traditional portfolios. But when central banks started raising interest rates to fight inflation in 2022, the prices of stocks and bonds fell simultaneously.

"Today," Egli continues, "interest rates have risen substantially, and investors have good chances again when it comes to finding positive returns from investing in bonds with managers pursuing relative return strategies. In this environment, absolute return funds aren't as appealing as in the previous zero-rate-environment," he says.

Some will 'go anywhere' for outperformance

Absolute return strategies encompass a wide variety of approaches. While some absolute return funds focus on equities and others specialise in bond investments, some absolute return managers have adopted a 'go anywhere' approach, which allows them to take positions on virtually any sort of trade they think will generate a positive return, whether stocks, bonds, derivatives, or other asset classes. All absolute return strategies have one thing in common: they rely heavily on the manager's skill. When the manager's calls are correct, returns can be substantial. However, when the manager is on the wrong side of a trade, the downside risk can be equally painful.

Not all absolute return funds adopt as wide a brief as the 'go anywhere' type. Most identify certain guardrails around the percentage of their funds that can be invested in one type of asset, a given industry, or a type of strategy. This is a typical risk management technique that helps investors to understand the range of activities that a fund manager will be using.

Active management

Absolute return funds are by definition actively managed, meaning that the decisions on what to buy are determined by a manager or management team. They may use fundamental analysis to identify mispriced assets, as well as quantitative models to find market trends. In equity absolute return funds, managers are likely to invest across industries, sectors, and geographies to spread risk and capture different return streams. They are also likely to use long (buy) and short (sell) positions to benefit from rising and falling stocks; this in turn makes the manager less reliant on overall market movements.

Return consistency

Fixed income absolute return funds are also diversified and focus on providing return consistency. To accomplish this goal, managers will diversify across different types of bonds: government, corporate, high-yield, or mortgage-backed securities, selected to generate income based on yield potential, credit quality, and duration. To mitigate risk, absolute return bond managers may also use risk management techniques like duration hedging, interest-rate swaps, and credit derivatives, depending on the mandate of the fund.

Other strategies use leverage and derivatives to target a certain level of return regardless of market conditions. This management approach offers the potential for more stable returns, with investors giving up some potential upside return for protection on the downside. But even this approach can be very difficult for the lay investor to understand, as it may involve a number of very complicated trading strategies that still have the potential to go wrong.

Select your manager with care

Absolute return funds are not right for every investor, and you need to take care when selecting a manager. The ability of managers to produce consistent and positive returns in all market conditions is not a given, and investors should remember that a positive absolute return should also be net of costs. This means that even if a manager produces an absolute return of say, five per cent, the investor will only receive five per cent minus the cost of producing that return. As ever, the devil is in the detail.