What Is an Absolute Return Strategy?

An absolute return strategy focuses on generating positive returns over a specific timeframe, irrespective of broader market movements. This approach aims to deliver consistent gains for investors, even when traditional markets experience downturns or volatility.

Understanding Absolute Return

An absolute return strategy aims to achieve positive returns over a defined period, regardless of market direction or economic cycles. Unlike traditional investment methods that measure success by outperforming a benchmark index, absolute return strategies are not constrained by such comparisons. Their objective is to deliver a gain, aiming to be profitable whether the market is rising, falling, or flat. This distinguishes them from “relative return” strategies, which aim to outperform a specific market index, like the S&P 500.

Relative return strategies are evaluated by their performance against a benchmark; for instance, a fund might aim to exceed the S&P 500’s return. A relative return fund could still experience losses if the benchmark declines, even if it loses less. In contrast, an absolute return strategy measures success by its ability to generate a positive return above zero, independent of market trends.

The core principle involves aiming for consistent positive returns over time. While a positive return is the goal, such returns are not guaranteed. The success of these strategies depends on the fund manager’s ability to navigate various market conditions and implement diverse investment techniques. Investors often seek this approach to diversify portfolios and potentially reduce exposure to market fluctuations.

Common Approaches to Absolute Return

Absolute return strategies employ various methodologies and techniques to generate positive returns. These approaches often involve complex instruments and active management to capitalize on diverse market opportunities.

Long/short equity

Long/short equity involves managers taking both long and short positions in stocks. They buy stocks expected to increase in value (long positions) and sell borrowed stocks they expect to fall (short positions). This strategy aims to profit from both upward and downward price movements, helping mitigate overall market risk. A long-short equity fund seeks to minimize market exposure while profiting from gains in long positions and declines in short positions.

Market neutral strategies

Market neutral strategies are a refined form of long/short investing, designed to eliminate overall market risk. They create portfolios where the total value of long and short positions is approximately equal, often in closely related securities. The objective is to profit from mispricings between these securities, regardless of broader market direction. This approach seeks to generate positive returns with low correlation to traditional market movements.

Arbitrage strategies

Arbitrage strategies exploit pricing differences or inefficiencies across various markets or securities. Examples include merger arbitrage, which profits from announced mergers by buying shares of the target company and sometimes shorting the acquiring company. Convertible bond arbitrage exploits pricing discrepancies between convertible bonds and their underlying common stocks. Statistical arbitrage uses quantitative models to identify temporary mispricings in securities, often by taking offsetting long and short positions.

Global macro strategies

Global macro strategies involve investment decisions based on broad economic trends, geopolitical events, and macroeconomic factors. Managers take positions in a wide range of asset classes, including currencies, commodities, interest rates, and equities, across different countries. They may use both long and short positions to express views on how global events impact financial markets.

Event-driven strategies

Event-driven strategies capitalize on specific corporate events expected to unlock value. These events include mergers, acquisitions, bankruptcies, reorganizations, spin-offs, or tender offers. Investors research the potential outcomes of these events, aiming to profit from price adjustments as events unfold.

Distinctive Features of Absolute Return Strategies

Absolute return strategies possess unique characteristics that differentiate them from conventional investment approaches. These features are integral to generating positive returns across varying market conditions.

Low correlation to traditional markets

A notable feature is their low correlation to traditional markets. These strategies aim for returns not directly tied to major stock or bond indices. This low correlation means absolute return funds might perform differently from the broader market, offering diversification benefits when traditional asset classes decline.

Risk management

Risk management is a hallmark of these strategies. Absolute return managers employ robust frameworks to protect capital and achieve consistent positive returns. This involves techniques such as diversification across different investment strategies, strict position sizing, and implementing stop-loss mechanisms. The focus is on minimizing downside risk and preserving capital.

Use of derivatives and leverage

Derivatives and leverage are common in absolute return strategies. Derivatives, such as options and futures, can enhance returns or hedge against market risks. Leverage, which involves borrowing capital to increase potential returns, may also be employed, though it amplifies both potential gains and losses. These tools offer flexibility and potential for higher returns, but also introduce complexity and risk.

Fee structures

Absolute return strategies often feature different fee structures than traditional mutual funds. A common structure, particularly for hedge funds, is the “2 and 20” model. This involves an annual management fee of about 2% of assets under management, plus a performance fee of 20% of any profits generated above a certain hurdle rate. These fees are generally higher and less transparent than those in standard investment vehicles.

Liquidity considerations

Liquidity is important, as some absolute return strategies may have varying levels. Certain funds might impose lock-up periods, restricting investors from withdrawing capital for a specified duration. Others may have redemption restrictions, limiting how frequently or how much an investor can withdraw. These measures manage the liquidity of underlying investments, which can include less liquid assets like private equity.

Evaluating Absolute Return Performance

Evaluating absolute return strategies requires different metrics than traditional investments. Traditional benchmarks are often irrelevant because these strategies do not aim to outperform a specific index. Instead, performance assessment focuses on their ability to deliver consistent positive outcomes.

Consistency of positive returns

A primary measure of success is the consistency of positive returns over time. The objective is to generate gains regardless of market conditions, so consistent achievement is a direct indicator of effectiveness. This means assessing whether the strategy reliably produces positive results over several months, quarters, or years.

Risk-adjusted returns

Risk-adjusted returns are a crucial aspect of evaluation. Metrics like the Sharpe Ratio and Sortino Ratio assess returns in relation to risk. The Sharpe Ratio measures return earned per unit of total risk (volatility), indicating how well an investment’s return compensates for risk. The Sortino Ratio focuses on downside risk, measuring returns against harmful volatility only.

Downside protection

Downside protection is a key measure of an absolute return strategy’s effectiveness. This refers to the strategy’s ability to preserve capital and minimize losses during market downturns. A successful absolute return strategy should demonstrate resilience in negative market environments, shielding investors from significant drawdowns.

Lower volatility

While the goal is positive returns, lower volatility in returns is a desired characteristic. A strategy that generates consistent positive returns with minimal swings in value is preferred, offering greater predictability and stability. This emphasis on smoother performance contributes to the appeal of absolute return strategies.