Issue: September/October 2005
Understanding Absolute Return Funds
What are Absolute Return Funds?
Absolute Return Funds (ARFs) can be described as
funds that focus on producing positive returns, without
investment exposure to market risk. In so doing,
ARFs provide diversification not otherwise available in
traditional investing, because returns have low correlations
to both the equity and bond markets.
What investment techniques do ARFs use?
- Short selling – the manager borrows a security
and subsequently sells the security with an obligation
to purchase back the security and return it at
a later date. This technique is utilised when the
manager believes the security to be overvalued.
This strategy may also be used as part of a hedge
or arbitrage strategy.
- Hedging – the manager invests in two or more
securities that are likely to move in opposition to
each other, thereby reducing risk.
- Arbitrage – the manager attempts to profit from
temporary pricing inefficiencies or discrepancies
in an individual share price on different securities
markets. This technique may involve short selling
- Low liquidity or distressed securities – the manager
attempts to earn returns through investments
in low liquidity or distressed securities
outside the investment mandates of traditional
- Leverage – the fund manager borrows or gears
the assets of the fund to increase the size of the
investment portfolio and potentially earn greater
What are the benefits of investing in ARFs?
In addition to diversification benefits, two additional
goals of ARFs are often to give investors:
- a better return outcome, given the risk, than traditional
- protection against negative market returns by
using hedging strategies.
Why should trustees invest in ARFs?
The evidence internationally is that by adding absolute
return funds to your portfolio the volatility of
portfolio returns can be reduced and there is potential
for higher long-term returns.
Many of the least volatile absolute return funds are
market-neutral funds, where the aim is to isolate and
maximise alpha (non-market sources of return) and
minimise beta (market sources of return). Market-neutral
investing is considered by many to be one of
the more significant investment innovations of the
What is the manner in which market-neutral strategies function?
- Identifying and exploiting pricing inefficiencies
between related assets,
- Buying relatively under-valued assets and selling
short relatively over-valued assets, and
- Balancing long and short exposures to systematic
What do Absolute Return Fund investors seek?
- Diversification into non-traditional financial instruments
and management techniques,
- An investment with low correlation to equities,
property, or fixed income,
- Returns generated from income and capital appreciation,
- The potential for returns in rising and falling
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