Compared to relative strategies, where returns and success are measured by the performance of the fund versus a benchmark, absolute return strategies should firstly be judged by the sign in front of the fund performance statistics (+/-), and secondly by their ability to achieve a predefined target return.
A few examples of descriptions from marketing materials illustrate the wide range of interpretations circulating in the market:
We believe that definition b is the most sensible, covering the objective of achieving capital preservation in the short to medium term, while giving the investment manager scope to take the risks required to deliver additional returns. Strategies which promise to achieve returns above the risk free rate, while guaranteeing capital protection over the short term cannot work. Strategies which only aim to avoid capital losses in the long run are simply traditional, relative approaches with a different name.a) Absolute return strategies aim to deliver a specified target return above the risk free rate, while protecting against capital losses in any short sub period.
b) Absolute return strategies aim to deliver a specified target return above the risk free rate, while protecting against capital losses, over the short to medium term.
c) Target returns above risk free rate are to be achieved in the long term. Short to medium term negative returns can occur.
Once the approach has been identified, how should it be implemented to deliver the promised results?
A multi-strategy approach, which combines different sources of performance generation, driven by different risk factors, results in a portfolio with low directional risk. Performance opportunities should be identified through a consistent focus on fundamentals and valuation.
Analysis based on historical risk and return measures is often based on unrealistic hypothesis and cannot deliver absolute returns on a sustainable basis. A multi-strategy approach can adapt to the different market conditions.
Market conditions and opportunities change over time, and managers must have the flexibility to increase risk when the market compensates generously for it, and reduce it when valuations are stretched and the market does not offer adequate compensation for the risk you are taking.
A successful absolute return strategy requires alpha generation, portfolio construction and risk management. A balanced combination of quantitative risk measurements, a stop loss approach and common sense creates a robust risk management framework.
Technical quantitative measures like value-at-risk (VAR) and standard deviation are useful, but must be used in a pragmatic way: blindly relying on such measures can be dangerous, as they are calculated based on assumptions that usually do not hold up in periods of high market stress.
Enzo Puntillo is fund manager at Julius Baer Absolute Return Emerging Bond fund. The views expressed here are his own.