The absolute return or simply return is a measure of the gain or loss on an investment portfolio expressed as a percentage of invested capital. The adjective "absolute" is used to stress the distinction with the
relative return measures often used by long-only
stock funds that are not allowed to take part in
short selling.
The
hedge fund
A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction, and risk management techniques in an attempt to improve performance, such as ...
business is defined by absolute returns. Unlike traditional asset managers, who try to track and outperform a benchmark (a reference index such as the
Dow Jones and
S&P 500
The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices. As of ...
), hedge fund managers employ different strategies in order to produce a positive return regardless of the direction and the fluctuations of capital markets. This is one reason why hedge funds are referred to as
alternative investment
An alternative investment, also known as an alternative asset or alternative investment fund (AIF), is an investment in any asset class excluding stocks, bonds, and cash. The term is a relatively loose one and includes tangible assets such as ...
vehicles (see
hedge fund
A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction, and risk management techniques in an attempt to improve performance, such as ...
s for more details).
Absolute return managers tend to be characterised by their use of short selling,
leverage and high turnover in their portfolios.
Benchmark
Although absolute return funds are sometimes considered not to have a benchmark, there is a common one: the funds should do better than short-dated government bonds (e.g.
T-bills
United States Treasury securities, also called Treasuries or Treasurys, are government debt instruments issued by the United States Department of the Treasury to finance government spending as an alternative to taxation. Since 2012, U.S. gov ...
in the United States). For example, if such "cash" instruments yield 15%, and the fund returns 5% in that same time period, the fund would be under performing the benchmark. In the case where the cash rate is close to zero, such as the early 2010s decade, this makes little difference.
Short selling
Suppose that a manager thinks the share price of company A will go down. Then he can borrow 1000 shares of company A from his
prime broker and sell them for (say) 10 USD per share. The immediate gain for the manager is
USD. If (say) after a week the share price of company A drops to 9.5 then the manager buys 1000 shares, paying
USD, and gives the shares back to his prime broker. He thus ends up earning a return of
. If his prime broker asked a 2% interest rate for borrowing the shares then the net gain of the manager is
.
Leverage
Sometimes a strategy gives a positive return albeit a very small one. Therefore, a manager can use leverage to magnify his return. For example, a long-short manager can deposit 100M with his
prime broker in order to buy 200M of shares and simultaneously sell another 200M of shares, which gives a leverage ratio of
. As another example, a manager can borrow money from a country at an interest rate of 2% and reinvest the amount in another country that pays 4%, thus earning the spread
(this is called
carry trade). If the manager has a leverage ratio of (say) 5 then his return is not 2% but
.
However, leverage also amplifies losses: if a manager has a market loss of 3% in his portfolio and a leverage of 4 then his total losses are
. Therefore, even small market losses can be disastrous when there is a huge leverage. According to the
OECD
The Organisation for Economic Co-operation and Development (OECD; french: Organisation de coopération et de développement économiques, ''OCDE'') is an intergovernmental organisation with 38 member countries, founded in 1961 to stimulate ...
, prior to the 2007 crisis, hedge funds in 2007 had an average leverage of 3 whilst investment banks had a leverage above 30. With a leverage of 30, a market loss of 3.3% wipes out the entire portfolio whilst a leverage of 3 gives a total loss of 10%.
High turnover
Some absolute-return managers are very active with their portfolios, buying and selling shares more frequently than normal investors, because they focus on short-term investment opportunities lasting less than 90 days. Turnover is the rate at which managers rebalance their portfolios, and among other things it depends on the hedge fund's size: in 2008 hedge funds with less than 15M USD in AUM (
assets under management) had a 46.9% turnover per month whilst funds with over 250M USD in AUM had only 9.8%.
Research Reports – Hedge Fund Reports – eVestment
. Hedgefund.net. Retrieved on 2013-10-23.
See also
* Alpha
Alpha (uppercase , lowercase ; grc, ἄλφα, ''álpha'', or ell, άλφα, álfa) is the first letter of the Greek alphabet. In the system of Greek numerals, it has a value of one. Alpha is derived from the Phoenician letter aleph , whi ...
and beta
Beta (, ; uppercase , lowercase , or cursive ; grc, βῆτα, bē̂ta or ell, βήτα, víta) is the second letter of the Greek alphabet. In the system of Greek numerals, it has a value of 2. In Modern Greek, it represents the voiced labiod ...
References
{{Hedge funds
Investment