How absolute return funds work
Learn about the features, benefits and risks of this style of managed fund.
There is more than one way to make money in the Australian sharemarket. Over the past five to 10 years, a number of boutique equity investment firms have emerged to offer investors access to so-called absolute return Australian equity funds.
They aim to generate positive returns over a set time, with little concern about how they perform against commonly used sharemarket indices, such as the S&P/ASX 200.
An absolute return approach may offer a way to invest in growth assets, whilst having a strong focus on preserving clients’ capital in times of market stress.
Absolute returns refers to a type of investment approach that aims to deliver positive returns over a full market cycle, with a very strong focus on preserving capital during market stress. Unlike traditional fund managers, these funds tend to have more flexible mandates, recognising that having fewer constraints provides more opportunities to generate returns and avoid large losses.
Many absolute return funds express their investment targets as aiming to outperform the Australian cash rate set by the Reserve Bank, or, in the case of Monash Investors, 12 to 15 per cent per annum after fees over a full investment cycle, while trying to avoid a negative return over any financial year.
In contrast, traditional fund managers tend to focus on beating a market index. Their portfolios tend to look very similar to the market because deviating too far away from their benchmarks could put their careers at risk over the long term.
Importantly, unlike the major benchmark tracking funds, which generally rise and fall in line with the overall sharemarket, an absolute return fund should behave very differently over the long term, offering lower drawdowns and lower volatility, which can lead to higher rates of compound returns.
Why absolute return investors care so much about avoiding large capital losses
It’s all about the maths. When an investor suffers a major loss of capital, it requires a much larger return to get back to breakeven, which can be very difficult to do. As we know, sharemarkets regularly have long periods where the losses can be large, causing unnecessary (and largely avoidable) stress for most investors.
How do absolute return managers achieve their objectives?
As soon as a fund manager expresses their objectives in absolute terms, they must adopt a different investment approach to traditional fund managers, who are always fully invested.
Features of absolute return investment funds include:
- Being able to “short” stocks the manager believes will fall in value, as well as being “long” in stocks they like.
- Having the flexibility to quickly adjust exposures to the overall market by moving to cash or using derivatives to protect clients’ wealth.
- Use gearing at certain times or can be “short” the market (which will make them money when the market falls).
- The ability to completely avoid sectors and stocks that make up a large portion of the overall sharemarket – for example, banks, materials and resources.
- Being able to invest in stocks that may not be part of an index or in stocks the research community does not generally cover – smaller capitalised stocks where growth rates might be higher.
- Adopting a more flexible approach to investing in companies. For example, taking the best from different types of investment styles, meaning that their fund’s performance will not be tied to how one style is performing at a point in the investment cycle.
Together, these attributes generally result in lower volatility outcomes, with lower drawdowns (smaller losses than the market). Lower volatility and smaller drawdowns in times of market stress can lead to higher rates of compound returns compared to commonly used market indices. That is, investors may achieve higher returns with lower risk.
Fees are an important consideration
Generally, the fees of absolute return managers are higher than the long-only and benchmark-aware fund managers. There are management and performance fees. The higher fees reflect more tools being used to manage the portfolios, and also because many managers that offer absolute return strategies cap the amount of money they manage; they know that if they get too large, their ability to outperform will be limited.
It is important for investors to understand how fees are calculated, whether there are high watermarks and hurdles in place for the performance fees and whether the return expectations (and track record) can justify the level of fees.
How investors should view absolute return funds
An absolute return approach is designed to suit investors who want access to growth assets but with less volatility than a traditional fund. Their more flexible approach can act as a complement to investors’ direct holdings.
ASX has more information on Absolute Return Funds.
ASIC’s Moneysmart website has a page on absolute return funds (Hedge funds) that has a good review of the risks and benefits. They characterise these funds and ‘complex products’ so due diligence before investing is very important.