Measuring investment return
It seems easy. You buy a share for £100 in January and in December you sell it for £110. You now have your original £100 and an additional £10. Your return on your investment was 10%.
Yes? Sort of.
Let’s say the share you bought was in a company that is a member of the FTSE 100, the index of the UK’s largest hundred listed companies. Now let’s also say that in the same year that your share returned 10%, the FTSE 100 Index rose 15%.
In these circumstances, your absolute return was 10%. But relative to the peer group of similar investments, as represented by the FTSE 100, your share underperformedUnderperformanceAchievement of a lower investment return than a benchmark or other measure (e.g. competitor portfolios) against which that return is being compared (As opposed to outperformance). by 5%.
Is this result good or bad? On the one hand, you made a reasonable return. On the other hand, taking more or less the same level of risk, you might have done better.
Let’s look at an opposite example: you buy a share in a FTSE 100 company for £100 in January and in December it is worth only £95. Over the same period, the FTSE 100 falls 10%.
Is this result good or bad? You have not lost as much as you might have. Relative to comparable investments, you outperformed. But your absolute return is negative. You have lost money.
What is an absolute return?
An absolute return is the measure of the return on your investment regardless of the context or any alternatives. It measures the actual amount you made or lost.
A fund targeting an absolute return will seek to provide investors with a profit over a given period, usually between one and three years.
An absolute return fund, therefore, is generally suited to an investor whose main aim is to make positive returns, rather than to track or perform better than a given market or type of asset.
An absolute return – or the right return?
Any sensible investor will wish to make a profit over time. But there still remains the question of how much profit for how much risk?
One solution is to use a ‘benchmarkBenchmarkAn index or other market measurement which is used by a fund manager as a yardstick to assess the risk and performance of a portfolio.’ as a point of reference. This will be useful where a fund invests in a defined category of assets, such as UK shares. In this case, the FTSE 100 Index might be used as an indication for the scale of risk and returns you should expect.
Another reference point is the return on a cash deposit. After all, for many investors the choice will be between holding money on deposit and putting it to work in the market. The value of cash, however, is still vulnerable to inflation. For this reason, some absolute return funds will target a return exceeding the interest rate on a cash deposit plus the Retail Price IndexRetail Price Index (known as RPI)A monthly indication of the average price changes to a particular ‘basket’ of consumer goods, and used as a general indicator of price inflation..
What kind of fund can achieve absolute returns?
As we will see below, there are a number of ways in which fund managers seek absolute returns. Some of these techniques are subject to government regulation and are not allowed in some types of funds. However, it is possible to achieve absolute returns by investing in shares, bonds, currency or combinations of different types of assets.
How is an absolute return achieved?
It is not easy to go against a market. A seasoned, skilled manager can expect to outperform the market to a reasonable degree, winning more when the market is rising and losing less when it is falling. It is another thing to achieve a positive return in a negative market.
Funds seeking absolute returns will generally need to do more than buy and sell a broad range of stocks of a given type. There are a number of strategies which can be employed to increase the potential of a positive return. One is to reduce the fund to a small number of ‘high convictionHigh conviction stocksInvestments that a fund manager has high confidence will do well in the future.’ stocks. Another is to withdraw to the ‘safe haven’ of cash when markets are negative or when they have risen very rapidly.
Other techniques include the use of ‘shortingShort sellingThe sale of a security that is not yet owned, in the expectation that its price will fall so that it can be bought back at a later date.’, a means of profiting from an investment when its value falls. This can be a riskier strategy as negative movements cannot be carried as ‘paper losses’ but need to be met with cash payments at specified dates. However, in the right hands, it can be a useful way of generating positive returns in a falling market.
Absolute returns through multi-asset investing
An alternative strategy, one that entails less risk than shorting, but still offers a reasonable opportunity to increase capital value, is multi-asset investing. This works on two premises. The first is that, over the long term, the majority of returns is determined not by investment in specific stocks, but by the market or the type of asset. As an example, the key is not the decision between China Mobile and Vodafone, but between China and UK equities – or at the most basic level, the decision as to how much should be invested in cash, how much in bonds and how much in equities at any given time.
The second premise is that it is rare, but not unknown, for all markets – or all types of assets – to behave in the same way at the same time. In conditions in which higher risk assets, such as shares in small companies, are rising, it is likely that the value of lower risk assets, such as government bonds, will be falling. A multi-asset fund manager will take advantage of these variations at both a tactical and a strategic level to seek consistent absolute returns.
What are the risks of absolute returns?
Due to the variety of ways in which different managers seek absolute returns, there is no simple answer as to the levels of risk. Some techniques, such as short positions, can be higher risk when used aggressively, but can help to moderate risk when used at an appropriate level.
In assessing the likely risk of any particular fund, a number of factors should be taken into account. Does it invest in shares or bonds? The former is likely to be higher risk than the latter, but shares in large companies in developed markets may be lower risk than a high yield bond issued by a mid-sized company in an emerging market. In general, funds with more diversified investments will tend to be lower risk than those with a narrower remit.
DerivativesDerivativeA financial contract that derives its value from an underlying security, liability or index. Derivatives come in many varieties, including forwards, futures, options, warrants and swaps. can be used to increase risk or reduce it. Before making a decision, it is important to understand the aims of the fund, the types of derivatives it uses and the way it uses them.
Finally, don’t forget the obvious. How successful is the fund? How long has it been run by the present manager? A fund with a new manager, or with a history of volatile returns, is likely to warrant proportionately greater scrutiny. Most importantly of all, speak to your financial adviser to check it’s suitable for you.
This information sets out the basics of absolute return funds. It is not designed to be investment advice and should not be interpreted as such. Other factors will need to be taken into account before making an investment decision – your financial adviser can help you with this.