THE term absolute return has been associated, and sometimes even used synonymously with, hedge funds. But strictly speaking, not all absolute return funds are hedge funds. Absolute return funds differ from conventional unit trusts, or relative return funds, in their return and risk characteristics.
A relative return fund has a return objective that is relative to a market benchmark. The aim of the fund manager is to outperform the benchmark.
Put in another way, if an investor believes that the Japanese stock market is rising, he could either invest in the Nikkei index or a Japan equity fund.
He would choose a fund if he believes that the fund manager is likely to provide him with a return higher than the index. And significantly higher returns are indeed possible with skilled managers. However, out-performance can still result in negative returns if a market declines.
In contrast, absolute return funds do not employ market benchmarks. Some funds have a “benchmark” stated in their prospectus but these are not market benchmarks, like the Nikkei or the S&P 500. These so-called “benchmarks” are actually target returns – the return hurdles the fund managers seek to beat.
Absolute return funds also differ from relative return ones in their risk characteristics. For relative return managers, risk management is relative to a benchmark. A risk neutral portfolio would be made up of the constituent benchmark stocks and their respective weights. Investors, however, pay fund managers to take risk to capture the premium in that asset class so most deviate from the benchmark and this deviation is called “tracking risk”.
For the absolute return manager, the risk neutral position is to hold cash. Absolute return managers define their risk as “total risk”. The risk they seek to manage is the loss of capital.
Who decides how much cash to hold?
The idea that the risk-neutral position of relative return managers is the market benchmark, and not cash, is perhaps slightly discomforting to some investors. A little bit of history is perhaps helpful at this point.
Absolute returns funds are actually nothing new. When asset management services first emerged in the US and Europe, the focus was on absolute returns and managers were given more or less a free hand. The poor performance in general, however, led to regulators stepping in to protect investors. They introduced benchmarks and mandates were clearly defined.
If a fund manager was entrusted to invest in German equities that was all he was legally allowed to do. For him to hold cash was to breach his fiduciary duty. The decision of whether to hold cash or to stay invested was handed to the investor. The investor himself was considered the best judge of the risks he could afford to take.
And here we find another difference between absolute and relative return funds – liquidity. With relative return funds, investors are able to sell their units any day they wish.
This is necessary if it is the investor who decides when and how much cash to hold. Absolute return funds frequently tie up investors for a period of time or place restrictions on redemptions. In the retail market however, absolute returns are usually liquid, and redemptions can be made any day.
High degree of specialisation
The catalyst for the re-emergence of absolute return funds was the long bear market in equities following the Internet bubble. The problem with an extremely large decline in value is that it affects the rate at which capital compounds and long-term return assumptions need to be adjusted. Risk perceptions changed and capital preservation, i.e. holding cash, was given more prominence.
Absolute return managers today are, however, highly specialised compared with in the past. Specialisation takes many forms and strategies include long-short, global macro, convertible arbitrage, event driven and relative value. There are, however, also absolute return funds that, like conventional unit trusts, are based on fundamental analysis.
Keep your portfolios diversified
So where do absolute return funds fit in a portfolio? Absolute return funds are usually considered more risky as they frequently employ leverage.
However, absolute return funds also often have lower correlation to traditional asset classes and may reduce overall unnecessary risk in a portfolio. Investing intelligently is partly about building more efficient portfolios from which you can get more potential return for the same risk or the same return for lower risk.
l UOB-OSK Asset Management Sdn Bhd is a foreign fund management company in Malaysia established in 1997 under a joint venture between OSK Holdings Bhd and UOB Asset Management Ltd.