Absolute return
Encyclopedia
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 equity
funds
, i.e. funds that are not allowed to take part in short selling
.
The hedge fund
business is defined by absolute returns. Unlike traditional asset managers, who try to track and outperform a benchmark (a reference index e.g. Dow Jones and S&P500), hedge fund managers employ different strategies in order to produce a positive return regardless of the direction and the fluctuations of capital markets. In fact, this is the reason why hedge funds are also called alternative investment vehicles (see Alternative Investment
and Hedge Funds for more details).
Some of the strategies used by absolute return managers are:
Suppose that a manager thinks the share price of company A will go down. Then he can borrow 1000 shares of company A to 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 95 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 
.
Sometimes a strategy gives a positive return but it is a very tiny 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 on 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
but 
.
However, leverage also amplifies losses: if a manager has a market loss of
in his portfolio and a leverage of 4 then his total losses are 
. Therefore, even small market losses are small can be disastrous when there is a huge leverage. According to the OECD, 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%.
Absolute-return managers are very active with their portfolios because they buy and sell shares more frequently than normal investors, which allows them to profit from short-term investment opportunities, typically lasting less than 90 days. The turnover is the rate at which managers rebalance their portfolios, and it strongly 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%.
Relative return
Relative return is a measure of the return of an investment portfolio relative to a theoretical passive reference portfolio or benchmark.In active portfolio management, the aim is to maximize the relative return...
measures often used by long-only equity
Equity (finance)
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
funds
Collective investment scheme
A collective investment scheme is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group...
, i.e. funds that are not allowed to take part in short selling
Short selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...
.
The hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
business is defined by absolute returns. Unlike traditional asset managers, who try to track and outperform a benchmark (a reference index e.g. Dow Jones and S&P500), hedge fund managers employ different strategies in order to produce a positive return regardless of the direction and the fluctuations of capital markets. In fact, this is the reason why hedge funds are also called alternative investment vehicles (see Alternative Investment
Alternative investment
An alternative investment is an investment product other than the traditional investments of stocks, bonds, cash, or property. The term is a relatively loose one and includes tangible assets such as art, wine, antiques, coins, or stamps and some financial assets such as commodities, private equity,...
and Hedge Funds for more details).
Some of the strategies used by absolute return managers are:
- Short sellingShort sellingIn finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...
Suppose that a manager thinks the share price of company A will go down. Then he can borrow 1000 shares of company A to 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 95 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 .- LeverageLeverage (finance)In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
Sometimes a strategy gives a positive return but it is a very tiny 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 on another country that pays 4%, thus earning the spread (this is called carry tradeCarry (investment)
The carry of an asset is the return obtained from holding it , or the cost of holding it .For instance, commodities are usually negative carry assets, as they incur storage costs or may suffer from depreciation, but in some circumstances, appropriately hedged commodities can be positive carry...
). If the manager has a leverage ratio of (say) 5 then his return is not
but .However, leverage also amplifies losses: if a manager has a market loss of
in his portfolio and a leverage of 4 then his total losses are . Therefore, even small market losses are small can be disastrous when there is a huge leverage. According to the OECD, 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 turnoverTurnover-Business:*Turnover is sometimes a synonym for revenue , especially in European and South African usage.Services sold by a company during a particular period of time....
Absolute-return managers are very active with their portfolios because they buy and sell shares more frequently than normal investors, which allows them to profit from short-term investment opportunities, typically lasting less than 90 days. The turnover is the rate at which managers rebalance their portfolios, and it strongly depends on the hedge fund's size: in 2008 hedge funds with less than 15M USD in AUM (Assets Under Management
Assets under management
Assets under management is a financial term used denote the market value of funds being managed by a financial instutition on behalf of its clients, investors, depositors, etc. This metric is a sign of size and success against competition...
) had a 46.9% turnover per month whilst funds with over 250M USD in AUM had only 9.8%.
See also
- Alternative InvestmentAlternative investmentAn alternative investment is an investment product other than the traditional investments of stocks, bonds, cash, or property. The term is a relatively loose one and includes tangible assets such as art, wine, antiques, coins, or stamps and some financial assets such as commodities, private equity,...
- Hedge Funds
- Relative returnRelative returnRelative return is a measure of the return of an investment portfolio relative to a theoretical passive reference portfolio or benchmark.In active portfolio management, the aim is to maximize the relative return...
- AlphaAlpha (investment)Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers' performances...
and beta