Absolute return

For other uses, see Absolute return (disambiguation).

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 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:

• 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 to his prime broker and sell them for (say) 10 USD per share. The immediate gain for the manager is $1000\times 10=10,000$ USD. If (say) after a week the share price of company A drops to 95 then the manager buys 1000 shares, paying $1000\times 95=9,500$ USD, and gives the shares back to his prime broker. He thus ends up earning a return of $(10,000-9,500)/10,000=5\%$. If his prime broker asked a 2% interest rate for borrowing the shares then the net gain of the manager is $5\%-2\%=3\%$.

• Leverage

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 $(200M+200M)/100M=4$. 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 $4\%-2\%=2\%$ (this is called carry trade). If the manager has a leverage ratio of (say) 5 then his return is not $2\%$ but $5\times 2\%=10\%$.

However, leverage also amplifies losses: if a manager has a loss of $3\%$ and a leverage of 4 then his losses are $4\times 3\%=12\%$.

• High turnover

Absolute-return managers are very active with their portfolios because buy and sell shares more dynamically 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%.

See also

• Alternative Investment
• Hedge Funds
• Relative return
• Alpha and beta