Absolute return investing is not a magical mystery tour, but reliant on exceptional fund manager skill. According to Jesse Livermore’s book “How to Trade in Stocks”, published in 1940: “The average man does not wish to be told that it is a bull or a bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He doesn’t even wish to have to think.”
Absolute return funds profess not to have benchmarks and work on the premise that retail fund managers can deliver hedge fund-like positive returns in all market conditions. Investors have fallen in love with these wonder funds, but is their nature truly understood?There does not seem to be a clear and consistent definition of absolute return funds. These funds have their own Investment Management Association (IMA) sector defined as containing “funds managed with the aim of delivering absolute (more than zero) returns in any market conditions”. The IMA does not vet these funds, and the fund manager decides if the fund is to be labelled absolute return.
The association also states that: “Performance comparisons are inappropriate due to the diverse nature of the objectives of the funds populating this sector, including differing benchmarks, risk characteristics and timeframes for delivering performance.” Funds in this sector include emerging market bond funds, global equity, British equity and more. Bizarrely, more than 25% of these funds have a benchmark, despite describing themselves as absolute return.
However, if a fund has no benchmark, how can you measure success? Understanding how returns are achieved is essential to understanding the importance of benchmarking. This in turn helps us recognise the real value of absolute return funds versus their relative return cousins.
In the 1960s, William Sharpe, later to become a Nobel laureate, showed how the total return on any portfolio consists of a risk-free part (cash), a market part he called “beta”, and a stock-specific or manager-specific part that is uncorrelated with the market called “alpha”. Fund managers, whatever their approach, have a “normal” or “home” portfolio. Whether they have single factor (for example, British large cap growth) or multi-factor (for example, equity and bond) portfolios, they know how the portfolio will perform. Beta explains how much of a fund’s returns come from that “home” (market exposure) and is relatively easy, and cheap, to achieve.
Alpha comes from techniques such as market timing or selecting for/against securities and is more difficult to produce than beta. Managers pledging to produce alpha have to add returns above what is expected from cash and beta exposure. If you assume markets are inefficient to a degree, then the conditions for positiveexpected values for alpha are possible. Alpha is what investors pay an annual management fee for, but do not always achieve.
Returns from portfolios with an absolute return remit can still be broken down into cash, beta and alpha. If managers expect returns to come from beta exposure – and at least one academic study has demonstrated that hedge funds return more from beta than they do from alpha – then investors could get much of that return far cheaper by buying index funds and market-replicating derivatives.
This is surprising as hedge fund managers are perceived to be more skilled than their retail cousins. However, if absolute return managers suggest their expected returns derive from alpha, then by definition the fund is not absolute return but relative return – that is what alpha is. No fund can be accurately called absolute return if by definition its returns are the product of both alpha and beta.
Absolute return funds have relatively short histories, but are essentially copycat hedge funds. Hedge funds’ “home portfolio” return is often targeted against cash and absolute return funds will often quote target returns in terms of the London Interbank Offered Rate (Libor). This may be seen by the uninitiated as something of a cop-out. Beating cash should be easy and with hefty performance fees to boot.
However, that target is used because the fund has no anticipated exposure to any particular market or investment style – in effect it produces a beta of zero. Alpha is the commodity being traded for higher charges, and the ability to short sell increases the opportunity to attract it. It has been demonstrated that long-short portfolios are more efficient than long-only, which makes sense – a skilful fund manager should amplify his or her returns given the opportunity to short.
A strategy that uses modern risk-control techniques to average out beta to zero while taking advantage of sell signals is known as “market neutral long-short” but that does not make it safe. Despite the increased opportunity, there is evidence that hedge fund managers are no more likely to produce alpha than “ordinary” managers. In relation to absolute return funds, like any other actively-managed fund, they rely on exceptional skill to produce exceptional returns.
Asset classes are typically defined as fully-diversified market segments or as sources of beta. An absolute return or hedge fund aspiring to zero beta is technically in the same asset class as cash. However, it does not make sense to list absolute return funds accordingly, as we know they can be volatile – they have cash-like beta and volatile alpha. The industry does not classify asset class by alpha – we classify funds according to their beta characteristics. Absolute return and hedge funds do not constitute a distinct asset class – simply a different way of getting alpha.
Absolute return is marShows the total return, bid-bid, of various indices and the IMA Absolute Return sector, from November 21, 2007 to November 21, 2008, rebased in pounds. Source: Financial Expressketed as a technique that delivers high positive returns regardless of market highs or lows and with little or no risk of negative returns, simply because the manager has a low net market exposure (low beta) and does not use a benchmark. This is dangerous. Any manager who adds value to a portfolio only does so by beating a benchmark or a collection of betas. Everyone is a relative return investor. It is just that some are better than others.