An investment approach with absolute merit

Although the absolute return approach to investing has been severely tested, it remains a good investment option in the hands of competent managers who apply a well-considered investment process throughout.

The popularity of absolute return investing increased significantly in 2002 and 2003 towards the end of the last equity bear market. Investors, disillusioned with the negative performances of traditional balanced funds, began searching for alternatives that “promised” to satisfy one of their principal requirements – capital protection.

This was understandable given that numerous studies in the ever-growing field of behavioural finance have shown that the average investor is “loss averse”, as opposed to “risk averse”.

Beyond market-related benchmarks

Absolute return investing differs from traditional relative return investing in that it is concerned with the absolute return of a particular asset which is not compared to any traditional capital market benchmark.

This disregard for market-related benchmarks is driven by the belief that they are ultimately irrelevant to the aspirations of most investors. Absolute return investing is about delivering a cash-plus or inflation-plus return over the medium to long term, with low short-term volatility. It is as much about managing risk as it is about delivering returns.

Challenging period

The later part of 2007 and 2008 proved to be a particularly challenging period for most absolute return managers and a number of them failed to deliver on one of their stated “promises” – that of capital protection.

This should not be interpreted as the failure of the absolute return investment approach. While the approach was severely tested, it remains unbroken in the hands of skilful managers with appropriate judgement of downside risk and who continue to apply a rigorous and well-thought through investment process.

As bear markets tend to crystallise investors’ objectives more acutely than bull markets, it was little wonder that absolute return investing received so much attention during 2009 and into 2010.

Given the dispersion of returns among funds in this category as detailed in the chart, how can relatively uninformed investors select an appropriate fund when they all “promise” the attractive proposition of asymmetric returns?

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Annual returns achieved by funds registered in the ASISA Targeted & Absolute Return category. Each bar represents the range of returns achieved by funds in this category in each of the calendar years, with the various colours depicting one of the four quartiles.

Assessing strategies

The last two to three years have provided an ideal environment for assessment of the merits and pitfalls of the various absolute return strategies and the individual managers that employ them. It also facilitated important insights into how the various strategies perform during the different stages of the capital market cycle.

The absolute return investment approach has merit and, in fact, offers exciting opportunities if a multi-strategy investment approach is adopted, in which capital is allocated to various underlying strategies and managers with a risk management mindset, taking into account client-specific objectives, return and risk characteristics of each underlying strategy and behaviour of individual strategies relative to each other.