Apr 24

Absolute return investing…a nice goal but disappointment is likely

Absolute return investing, according to many definitions, is about getting positive returns irrespective of the overlying “market” return of whatever asset class the investor is being exposed to. This essentially means that any “absolute” returning investment needs to employ strategies that are independent of market direction. For example, if the market (and it can be any market) is declining in value, the absolute return investment will need to have long exposures that still may move up (and they may include put options), or perhaps be trading in the direction of the down market by short selling that market…whether at a security level or market level (e.g. futures, CFDs, ETFs, or options).

OK…so that said, absolute return strategies must demonstrate skill in market timing…so they can profit in up and down markets. Much more easily said than done.

Like these first two paragraphs most discussion on absolute return investing just  focuses on achieving a positive return….but there is no mention of how much and what timeframe. Let’s face it, achieving a positive return is very very easy…just place your funds in a bank deposit, choose your term and voila…you have a government guaranteed “absolute return” for your chosen term!

So, what defines an absolute return fund in terms of required size of return and desirable timeframe? My personal belief based on discussions with advisers and investors suggests the required return is “equity-like” and the measured timeframe is 1 year…so each year, investors expect and want to see a positive return that is in the ballpark of cash plus 3 to 4% or perhaps a minimum of 10%pa. So today that means an annual return of around 7% to 10% each year…again much more easily said than done and I would suggest that the risk required to achieve this return goal is quite significant.

So I thought I’d have a look at hedge funds available in Australia (and reported to Morningstar) to see how they’ve actually performed in recent years. I thought I’d give them a helping hand by only looking at the last 5 years (i.e. very close to the bottom of the sharemarket) and there were only 51 strategies that had a 5 year track record…surely there’d be more but no. I chose hedge funds specifically because all other investment categories are “long only” meaning they can’t employ the above-mentioned strategies to profit in down markets.

Of those 51 hedge fund strategies, only 19 did not have a negative return over any 12 month rolling period in the last 5 years…to be honest I thought it would be lower so not a bad result. Of those 19, only 3 failed to have an average return above 7%pa…

…So my positively biased analysis has yielded 16 different hedge funds available in Australia that may meet the investor and adviser’s definition of an absolute return fund…and that’s out of many many more than 3,000 funds available in Australia…as a side note, I also wonder how they’ll go when Global Government Stimulus is no longer the norm and interest rates are much higher?…but I digress.

When you consider that a very high proportion of investors (& advisers) have an “absolute return” investment objective you have to wonder why there are so few investments that are designed to achieve it. The bottom line is that absolute return investing is incredibly difficult and achieved by very few. My personal thoughts and conclusion to absolute return investing…it’s fine to have positive returns year-in year-out as an objective or goal, but absolute returns should never be presented as an expectation as disappointment is inevitable. When aiming for “equity like” returns be prepared for the occasional negative year or two or three.

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