Absolute Return Education Guide

8/3/2019 Absolute Return Education Guide

1/20

An introduction to:absolute return investing

Prepared for individual investors.


2/20

Introduction 3

What is absolute return? 4

What are absolute return funds? 6

What strategies do absolute return funds use? 8

The future - how might the absolute return 11sector develop?

How might absolute funds be used in a portfolio? 12

What should I consider when choosing an 14

absolute return fund?

Other frequently asked questions 16


3/20

The volatile nature o investment markets in recent

years, an increasing tendency or dierent asset classes

to behave similarly and the very low savings ratesoered by banks have proved an unsettling experience

or many people, encouraging them to seek out other

investment options. As such, absolute return investing

has been a logical next step and absolute return unds

have grown hugely in popularity.

This guide will discuss what absolute return investing

is, weighing up its attractions alongside the associated

risks beore outlining the dierent strategies used by

absolute return und managers. It will discuss howabsolute return unds might be used within a portolio

and address the various considerations investors

and their nancial advisers should bear in mind when

choosing a particular absolute return product.

Investors should be aware that the value o an absolute

return product and the income rom it may go down as

well as up and investors may not get back the amount

originally invested.

Introduction

3


4/20

4

In seeking to assess the perormance o a collective

und, such as an Open Ended Investment Company

(OEIC) or unit trust, the traditional approach has been

to measure it against an index o similar securities.

For example, a und that invests in large, blue-

chip UK stocks such as BP and Vodaone might be

benchmarked against the FTSE 100 Index while a

und that invests in smaller UK companies might be

benchmarked against the FTSE Small Cap Index. In this

way, an investor can judge whether a und manager is

adding value through their selection o stocks.

However, this approach ocusing as it does on so-called relative returns can have some unintended

consequences. At times when markets are alling,

a manager might technically be outperorming their

benchmark but still be losing money or investors. Over

the course o 2008, or example, the FTSE 100 Index

ell 28% in value*. A manager might still be considered

successul i their und had allen 25% in the same

period although, o course, their investors may noteel the same way. There is an investment saying, You

cant eat relative returns. The absolute return approach

to investing turns all this on its head. Historically used

or high net worth and institutional clients, the emphasis

What is absolute return?


5/20

5

LIBOR: Short or London interbank oered rate, this is the interest rate at which banks borrow rom each other and

is widely used as a benchmark or short-term interest rates.

OEIC: Short or open-ended investment company. An open-ended investment such as an OEIC or unit trust is

continually able to create new shares or units, usually to satisy demand rom buyers and sellers.

UCITS III: European legislation short or Undertaking or collective investments in transerable securities

which gives retail und groups the power to use a broader range o investment strategies, products and techniques

including the ability to synthetically short stocks than had previously been allowed.

KEY TERMS

or an absolute return manager is on wealth preservation. Instead

o a stockmarket index, the und and its manager will usually be

measured against cash or a cash-related benchmark such as

LIBOR and will aim to generate consistent returns in all market

conditions. The absolute return will not be guaranteed and the

time period over which managers aim to generate it will vary rom

und to und.

Absolute return strategies use techniques that are now permitted

within retail investment unds under European legislation known as

UCITS III.

*Source: Datastream, total return in sterling at 31/12/08.


6/20


7/20

7

income-based unds in 2004 but rom there the sector

has evolved into a more diversied grouping that

includes equity long/short and multi-asset unds. Now

the sector increasingly appears to be moving beyond

the UK and has seen the launch o European, Japanese

and North American long/short unds.

Absolute return unds are oten built out o und groups

existing hedge und strategies that were previously

unavailable to individual investors. Oten these hedge

unds will have lengthy track records and be run by

managers with extensive experience o the techniques

involved. As we will see later, risk control is a vitalcomponent o absolute return investing and so hedging

experience is arguably one o the rst things investors

should look or in an absolute return und manager.

Absolute return unds:

Theirobjectiveistogenerateaspecic

actual return

Managerswillinvestonlyinassetsbelievedtooffergenuine potential to increase return

Managersareconcernedwiththepotentialforlosing

money and will take measures to deal with this risk

Relative return unds:

Nospecictargetbeyondabenchmarksotheycould

lose money yet still achieve their objective

Managersmayholdstocksjustbecausetheyare

included in the unds benchmark

Managersmeasureriskrelativetoabenchmarkand

not to how much money could potentially be lost

Absolute return funds- some myths exploded

Absolute return funds are NOTguaranteed to deliver positive

returns each month BUT they do

have the potential to record fewernegative months

Absolute return funds are NOTimmune from market risk BUT

investors can expect volatility to belower than traditional funds

Absolute return funds are NOTa new way of investing BUT the

UCITS III legislation means they arenow available to individual investors

UCITS Absolute return funds areNOT hedge funds BUT they do

borrow techniques from them andthey are regulated funds


8/20

8

What strategiesdo absolute return

funds use?Absolute return unds have grown hugely in popularity as

investors look or ways to deal with the growing volatility in

global markets and also the increasing correlation between

dierent asset classes.

During the market rises o 2003 the correlation o assets such

as equities, property and even bonds increased. This high

level o correlation was then maintained during the market

crash o 2008.

These uncertain market conditions have led und groups

to develop more innovative products that look to reassure

investors by oering specic investment goals, such ascash or cash-plus targets, while at the same time aiming

to oer asset diversication and to preserve capital.

Strategies used by absolute return unds all into three

main categories equity, xed income and multi-asset.


9/20

9

Equity strategies

Equity absolute return strategies aim to make money

in all market conditions through the stock-picking skillo the unds manager. Absolute return unds maximise

the ability to deploy the managers skill by enabling

them to go short certain stocks or certain areas o the

market and thereby prot rom alling share prices*.

This is in addition to the more widespread practice o

long investing, where the manager looks to prot by

purchasing stocks that go up in value.

* The wider investment powers permitted under UCITSIII regulations allow unds to execute synthetic

shorting using Contracts or Dierence (CFDs).

These are cash settlement derivatives that enable the

manager to participate in a share price movement

without establishing a physical short position, hence

the term synthetic shorting.

Among the most common techniques

or equity-oriented absolute return undmanagers are:

Market neutral: Some equity absolute return managers

structure their portolios to be entirely market neutral,

which means they will have no sensitivity to market

risk technically they have a beta o 0 (see useul terms

opposite). I the market rises very strongly, this may

mean the und will lag, but it also means the und maydeliver a positive return even when markets are alling.

Market directional: In contrast, market directional unds

will take a view on the likely direction o markets, which

may mean a stronger return when markets rise or all,

but can create greater volatility in a portolio.

Pairs trading: In pairs trading, a manager will go long in

one stock and short in another within the same sector.

In this way, he is making a call on the direction o thestocks relative to each other rather than on the direction

o a stock in absolute terms. This ensures it is only the

superior qualities o one stock over another, rather than

market sentiment towards the sector as a whole, that

deliver returns.

Alpha: The return over and above a market or an index.

At a very simple level, it may be seen as outperormance.

Beta: The sensitivity o an investment to changes in the

level o the wider market. An index-tracking und will

thereore have a beta o 1.

Capitalisation: Total monetary worth o a company or

stock market. The market capitalisation o a company is

assessed by multiplying its share price by the number oshares in issue.

Correlation: The extent to which dierent types o

investment or example equities and bonds react

similarly to dierent economic and market conditions.

Diversication: Investing across a range o dierent

asset classes rather than, as it were, putting all your

eggs in one basket.

Volatility: The uncertainty inherent in returns rom an

investment and indicative o the extent to which that

investments returns have deviated around their average.

KEY TERMS


10/20

10

Market capitalisation:As with traditional equity unds, managers will have a

preerence or certain types o stock indeed, an equity absolute return strategy will

oten be built on the existing investment process o a manager. I they have previouslyavoured smaller companies and that is where their knowledge and expertise lies, they

will use the same process in their absolute return und. Smaller companies may oer

more scope or outperormance while larger stocks may oer less volatility.

Fixed income strategies

Fixed income strategies were among the rst absolute return unds onto the market.

These unds aim to generate alpha by going long and short in instruments such as

interest rate swaps, currencies and government bonds, but will generally hold a

portolio o short-dated bonds to preserve capital. These unds tend to have lower

volatility than other types o absolute return und. They will usually be benchmarked to

LIBOR, so returns can look anaemic when LIBOR rates are low.

Multi-asset strategies

Multi-asset strategies aim to blend a number o dierent lowly or non-correlated asset

classes with the aim o delivering absolute returns. A typical multi-asset und may

incorporate equities, xed income, commodities, currencies or derivatives strategies.

Most are unconstrained and will move to dierent areas o the market where they ndthe most compelling valuations. They will generally use index replication or synthetic

instruments rather than investing directly in securities, though some will use a multi-

manager approach.

Multi-manager unds could, or example, make use o investment trusts or exchange-

traded unds to access more esoteric asset classes, such as commodities, and tend

to be oered by larger groups that can call upon a broad range o expertise. The IMA

Absolute Return Sector now also contains some unds o unds that look to blend

together a number o portolios that are all trying to achieve absolute returns but indierent ways.


11/20

11

The future - howmight the absolute

return sector develop?The sector is becoming increasingly diverse ollowing

a rat o new launches in recent years. These launches

have been predominantly UK and international equity

long/short unds but there have also been a small

number o launches in the xed income sector though

these have generally been rom existing providers.

At present there are two main schools o thought on

investing in absolute return unds. The rst is to see

these unds as part o a wider alternatives portolio,

sitting alongside private equity or hedge unds and

separate rom the long-only part o an investors

portolio that will tend to be conned to assets such

as corporate bonds or equities.

The second is to see absolute return investing as simply

another way o running money. In this case, an investor

would have some o their portolio in the US, in Europe,

in the emerging markets and so on just as they would

with a long-only portolio. In this case, investors would

hold several absolute return unds.

The latter approach may sound some way o yet, but a

similar shit has been seen in the perception o the xedincome market over the past decade or so. At the turn

o this century, private investors would not generally

have held a portolio o bond unds but now this practice

is commonplace. As more companies launch more

international unds, the scope or investors to go down

this route will grow.

To date, the majority o und groups launching new

unds have existing expertise in running absolutereturn strategies either oshore or or private clients.

As such, most have an identiable track record and

robust process in place although history suggests less

experienced managers may enter the ray as the sectors

popularity grows.


12/20

12

Absolute returns may oer a dierent slant on investing but that does

not mean you can ignore the basics o good nancial planning. I you are

thinking about putting money into an absolute return und, you still need

to ask yoursel what you are trying to achieve just as you would with anyother investment.

Fundamental questions to address would thereore include:

Whatareyourinvestmentobjectives?Areyoulookingtogeneratecapital

growth,incomeorboth?

Howmuchriskdoyoufeelcomfortabletakingon?Doyouwanttoprotect

your money or can you stand to lose some o it in the hope o ultimately

makingagreaterreturn?

Whatsortoftimeframeareyoulookingat?Areyouinapositionto

leave your investment alone or the long term at the very least ve and

preferably10yearsormightyouneedaccesstoitatshortnotice?

How might absolutefunds be used in a

porfolio?

Core/satellite investing: This

investment approach involves

dividing an investors portolio into

a lower-risk core component, suchas a cautious or absolute return

und, and one or more higher-risk

investments the satellites.

KEY TERMS


13/20

13

The volatile nature o investment markets in recent

years means weighing up your thoughts to questions

such as these has arguably never been more important.

The rollercoaster ride oered by even supposedly less

risky assets such as bonds, twinned with the very low

savings rates available rom bank accounts, will have

encouraged many people to seek out other investment

options especially i they have a lower correlation with

other asset classes.

Absolute return unds now oer a wide range o

choice with regard to investment strategy, portolio

composition, risk-reward prole and even time horizon.As a result, they oer potential solutions to a number o

dierent investment needs.

At its most basic, an absolute return unds objective o

generating a tangible return, usually in excess o cash,

allows investors to tap into the power o compounding.

Compounding comes about when an investment

generates a return, which is then reinvested to help

generate urther returns and so on.

It is perhaps easiest to see how this would work within a

savings account and, in that context, you will probably

have come across the term compound interest but,

less obviously, compounding is also at the heart o equity

and bond investing (and, or that matter, house price

rises). Absolute return unds thereore allow investors to

access the power o compounding or a set risk prole.

As such, they could suit investors looking to achieveequity-like returns but with lower risk levels than equities

over a market cycle. They could also be appropriate

or equity investors willing to sacrice some return to

achieve steadier perormance, investors wanting to

preserve existing gains by reducing downside risk or

simply those looking or a core holding or their portolio,

ISA or sel-invested personal pension. Thus an absolute

return und could orm the core part o a core-satellite

investment approach the solid middle around which

investors and their advisers would then be able to

build some more risk, or example, through a smaller

companies or emerging markets investment.

On the other hand, absolute return unds can also be

helpul in diversiying a portolio. In addition to the risk

prole and potential annual return, a unds correlation

with other investments, the sector or asset class in

which it invests and the investment strategy itsel canbe diversiying actors. The lower correlation o absolute

return unds to equity and bond markets is thereore an

important consideration or investors and their advisers.

Another way investors and their advisers can use

absolute return within their portolios comes through

dierent unds having dierent investment timescales.

So while a more cautious und may have a shorter time

horizon, a riskier und may have a higher return targetand a longer-term time horizon. This means investors

should be able to track down a und that suits their

attitude to risk at a particular stage in their lie.

The act absolute return unds will tend to look to beat

savings accounts returns may even make them o

interest to more conservative investors. Nevertheless,

those investing with this in mind should note they will

have to remain in an absolute return und or a longerperiod than would be the case with traditional savings

options and that, i they were to take their money out

sooner, they risk losing some. While absolute return

unds may be used as an alternative to cash unds,

investors should be aware that they are not cash unds.


14/20

14

What should I considerwhen choosing an

absolute return fund?The extra techniques allowed by the UCITS III legislation

mean absolute return unds are more fexible and their

managers can move between dierent asset classes and

markets both with a view to looking to capture returnsand aiming to limit exposure to market alls. However,

while absolute return unds oer a bigger toolbox, in the

hands o the wrong manager or company those tools

can be dangerous.

Risk management is key and investors should thereore

ensure they are buying into a und and a company with

a good inrastructure with very clear compliance and

risk controls. Many absolute return unds aim to limittheir risk proles and keep them within tightly controlled

parameters through a method known as value at risk

or VaR, which measures the worst loss scenario that

could be expected under normal market conditions and

over a given period o time.

Furthermore, since short investing adds an extra layer

o complexity to the management o a portolio, it is

important that a und is underpinned by strong systems

and risk management techniques. A und manager whodoes not have the necessary systems or processes in

place may be unable to execute trades eectively or

could be taking risks o which they are not ully aware.

Historically absolute return unds have been seen as

an alternative asset class because they had lower

correlation with other investments but better risk

management. Risk management is vital in the absolute

return space because, i a manager is not careul, theycan take on ar more risk than with a long-only und.

The ability to leverage bets aggressively in absolute

return unds means the investment risk could be

magnied.


15/20

15

Naturally, protecting investors capital is a key objective

or absolute return unds but, ultimately, their managers

need to be going long on stocks that go up in value

and shorting stocks that go down in value. As such,investors and their advisers also need to be convinced

their manager has the ability and track record to do that

ideally, this would be someone who has experience o

running both long-only and absolute return portolios.

Put simply, proven stock-picking expertise is essential.

Investors and their advisers should be aware the

increased fexibility o any portolio using the wider

investment strategies allowed by UCITS III will notcover up any shortcomings in this area and may

even exacerbate them. In the end, the overriding

consideration when choosing an absolute return und

is to nd a manager, who has the experience, skill and

access to resources to maximise potential returns.

Questions investors and their advisers should ask about

an absolute return und and its manager:

Whatisthefundsvolatilitycomparedtothemarket?WhatisthefundsVaR?

Hasthefundmanagerusedarisingmarkettoachieve

performance?

Whatisthefundsbeta?

Howmanynegativemonthshasthemanagerhad

comparedtotheassociatedmarket?

Wherehavethefundsreturnscomefrom?

Whatisthemanagersexperience?


16/20

16

Other frequentlyasked questions

Can I lose money in an absolute return und?

Investors should never lose sight o the act that an absolute return is an objective not a promise.

There is a danger absolute return unds may be sold as investments that cannot lose money but this

is by no means the case. Most absolute return unds have the strategies and tools to enable them to

deliver positive returns in all market conditions, but these are only as good as the manager using them.

Are absolute return unds guaranteed?

Absolute return unds are neither guaranteed by the provider nor do they come with any guarantees

attached. As such, they are not appropriate or those who have no appetite or risk at all.

Do absolute return unds beat infation?

Absolute return unds should be in a position to beat infation and, depending on the level o infation,

may have an investment target that is infation-beating. That said, absolute return unds are unlikely to

be specically set up to beat infation.

Do absolute return unds have lock-in periods or investors?

No. Funds in the IMA Absolute Return sector are structured as OEICs or unit trusts and must, thereore

oer daily liquidity and the same access requirements or investors as any other open-ended und.


17/20

17

Is there a dierence between absolutereturn, total return and target return

unds?While these terms are oten used as i they are

interchangeable, there are actually subtle distinctions

between them. As discussed earlier, absolute return

unds aim to preserve capital and achieve consistent

and positive returns and are measured against an

absolute benchmark such as cash. The orerunners

and now essentially a subset o absolute return unds,

these portolios tend to be xed income-based and seta target o LIBOR, typically aiming to beat this by two

or three percentage points. For their part, total return

unds invest so their return comes rom a combination

o income and capital growth and will oten have an

index or peer group benchmark. Absolute return, targetreturn and total return unds can all all in value.

Are absolute return unds a type ohedge und?

The converse is more accurate. Many hedge unds use

an absolute return process with the aim o preserving

capital and generating positive returns. Both types o

und may use the similar investment tools and strategies,such as shorting, to achieve these objectives.

Should I ignore long-only unds in avouro absolute return unds?

With their ability to go both long and short on stocks,

absolute return unds operate very dierent strategies

to long-only unds and so returns are likely to vary

considerably. Investors and their advisers should bearin mind that, while a und that takes both long and short

positions should not see the same level o decline as

a long-only und in a alling stock market, equally it is

unlikely to achieve the same degree o capital growth in

a ast-rising market.

?

??

?


18/20

This document is issued by Cazenove Capital

Management which is the name under which Cazenove

Capital Management Limited and Cazenove Investment

Fund Management Limited both o 12 Moorgate,

London, EC2R 6DA and authorised and regulated by

the Financial Services Authority provide investment

products and services.

The contents o this document are based upon sources

o inormation believed to be reliable. However, save

to the extent required by applicable law or regulations,

no guarantee, warranty or representation (express or

implied) is given as to its accuracy or completeness

and Cazenove Capital Management, its directors,

ocers and employees do not accept any liability

or responsibility in respect o the inormation or anyrecommendations expressed herein, which, moreover,

are subject to change without notice.

Nothing in this document should be deemed to

constitute the provision o nancial, investment or other

proessional advice in any way.

Investors should remember that past perormance

is not a guide to uture perormance. The value o an

investment and the income rom it may go down aswell as up and investors may not get back the amount

originally invested.

The levels and bases o, and relies rom, taxation may

change. Investors should obtain proessional advice on

taxation where appropriate beore proceeding with any

investment.

The preceding descriptions are intended to provide

a summary only o the main risks associated withinvestments in absolute return unds.

18

Important information


19/20

Notes

C11041_Absolute_return_Education Guide


20/20

www.cazenovecapital.com

For more inormation please contact your nancial adviser.

I you do not have a nancial adviser please visit: www.unbiased.co.uk

Absolute Return Education Guide

Documents

Transcript of Absolute Return Education Guide