Absolute return funds aim to deliver returns in both rising and falling markets. To do this, they invest in a wide range of asset classes and employ various investment strategies.
As a result, the fund’s performance is often not tied to the performance of traditional asset classes such as shares, property or fixed interest.
Absolute return funds typically use more complex investment strategies than fund managers in traditional listed investment companies (LICs) and listed investment trusts (LITs).
These strategies often include using derivatives. Absolute return fund managers may also take ‘short’ positions or invest in exotic securities. Absolute return funds may also take a ‘fund of funds’ approach, where the manager invests in a number of other funds.
Underlying investments in absolute return funds may include bonds, currencies, derivatives, futures, metals, money markets, mortgages, options, real estate securities, swaps, stocks, warrants or other specialised financial instruments.
The type of returns received by investors varies depending on fund strategy, and may take the form of dividend or distribution income, capital appreciation or a combination of both.
Investment techniques commonly used by absolute return funds include:
- Leveraging, or borrowing against the assets of the fund to increase the size of the investment portfolio and potentially earning greater returns. While leverage can increase the potential of return, it can also expose the fund to greater losses.
- Hedging, or buying a futures contract, option or warrant to ‘lock in’ a price for a security now, which offsets the risk of loss from market fluctuations (increases and falls)?
- Arbitrage, which aims to profit from pricing inefficiencies or discrepancies in individual securities or a securities market. This technique may involve short selling and/or hedging.
- Low liquidity or distressed securities, which involves investing in securities of companies or government entities that are either in default or heading towards bankruptcy, on the assumption that restructuring or capital injections will increase the entity’s value.
- Short selling, which is the practice of borrowing a security that the manager believes is overvalued and subsequently selling it, with an obligation to purchase back the security (usually at a lower price) and return it at a later date. This technique is often used as part of a hedge or arbitrage strategy.