On the face of it, the notion of an “absolute return fund” may seem a little strange. Aren’t funds supposed to deliver returns anyway? What other sorts of funds are there? Perhaps those offering “notional returns”, “fictional returns” or “equivocal returns”.
Yes, the language can be confusing, but the concept behind absolute return funds is quite simple.
Measuring value added
Conventional funds have measured their performance against either each other or against a benchmark such as a stock index. Absolute return funds, by contrast, set themselves a goal and seek to achieve it, regardless of what anyone else is doing.
Success or failure does not depend on comparisons with other players, but solely on the delivery, or not, of whatever return has been pledged.
In the examples just given, on 26 June 2019, that would work out at 4.75%, 6.5% and 4%, with the ECB rate being zero.
Why is it expressed in this way? Because the “plus” figure represents the value added that is delivered by the absolute return fund in question, given the investor could get the “cash” figure simply by putting their money in a bank.
The concept of absolute returns has been around since shortly after the war, and was adopted by the nascent hedge-fund industry. Indeed, absolute return funds and hedge funds are frequently spoken of in the same breath.
Bonuses paid while funds declined
But they are distinct, and we shall concentrate on the absolute return funds available to ordinary investors, rather than look at the more specialised and exclusive hedge-fund industry.
Some retail investors always sought absolute-return strategies, but the biggest lift to recruitment came with the financial crisis. As investors’ holdings were devastated by the events of 2008 and 2009, they were aghast to see, in many cases, their fund managers being paid generous bonuses.
The problem was that many investors had not fully taken on board how their managers were being remunerated. Yes, they had seen marketing material and billboards boasting that Fund X had outperformed most of its peers over a certain period or that Fund Y did better than a particular stock index last year.
But many had subconsciously assumed that “outperformance” applied only on the way up. Now, it became clear that it referred to any situation in which the fund in question did better than either the rest of the industry or the stock index.
Nor did they really see why their funds should be further diminished by having to pay bonuses to managers.
Hence the shift from the conventional “relative return” model to one of absolute returns. The fund either achieves its goal or does not, and the best absolute return funds will tie managers’ remuneration to the funds’ performance.
In this way, there is clear accountability and no room for hiding behind market conditions as an excuse for poor performance.
That, you may think, is quite a gamble for the managers concerned. Suppose another 2008-type crisis were to strike, or even a milder period of market turbulence? They would be held responsible for the absolute return fund’s performance despite being blameless as regards the cause of the problems.
Yes, it is a bold move to promise a particular return regardless of what happens in the rest of the market, but it is for this reason that absolute return funds employ a much wider range of assets and strategies than a traditional fund, to navigate market squalls and improve their chances of delivering their target returns.
These can include short selling, derivatives and the use of leverage. They can include also investment in unconventional assets such as real estate, commodities or loan notes. In this, absolute return funds and hedge funds are very similar.
If, post-crisis, absolute return is an idea whose time seems to have come, it is only fair to say that not everybody is a true believer. Writing in the UK financial magazine Money Week on 1 February this year, Max King described absolute return funds as “absolutely useless”.
He wrote: “Last year  provided an opportunity for these funds to prove themselves but, unfortunately, many have failed the test.”
More broadly, are we quite sure the conventional model of performance measurement against other managers or against benchmarks should be consigned to the dustbin of financial history? After all, it stimulates competition and what is so wrong in comparing how managers have performed in identical market conditions?
Finally, could it be that absolute-return strategies, while allowing for more flexible investment behaviour than conventional funds, come complete with their own inflexibilities, given the overriding need to make good on the pledged return?
All that said, there is something appealing about a clear commitment to a given performance figure. However, investors would be well-advised to check any fund’s record in achieving its goal before committing themselves.