Issue: September/October 2005
Future Growth

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 and/or hedging.
  • 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 fund managers.
  • Leverage – the fund manager borrows or gears the assets of the fund to increase the size of the investment portfolio and potentially earn greater returns.

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 investments, and
  • 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 past decade.

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 (market) risks.

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, and
  • The potential for returns in rising and falling markets.

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