Meaning of Absolute Return: It refers to the return that an individual receives on an asset over a particular period. It calculates the depreciation or appreciation, expressed in the percentage achieved by an asset such as a mutual fund and stocks over a given interval. One should not confuse relative return with absolute return because the latter consider the returns on a specific asset without comparing it with any other benchmark or measure.
The hedge business is known for its absolute returns. The conventional security head is the one who outperforms and tracks a benchmark (or a reference index, e.g., S&P 500 and Dow Jones). One the other hand, the hedge fund handler makes use of different methods or strategies to generate a positive value of return regardless of the fluctuations and direction of the financial or capital market. It is the reason why hedge business is also known as an alternative investment tool.
The absolute return handler is known for their leverage, short selling and high yield in their portfolios.
How Does Absolute Return Works
The absolute return is also known as total return reflects the total amount of funds earned by an investment. It calculates the loss or profit that an asset or independent portfolio of any standard or benchmark undergoes. The output can be negative or positive and can be viewed uncorrelated with respect to other market activities.
Some Important Keywords:
Benchmark
Many consider that absolute return funds do not have a benchmark, but it is not true; it has a common one: these funds should perform better than the short-dated bonds of the government including the T-bills in the United States.
For example, if the returns on the fund are 5% and the cash tool generated is 15% over a period, then this reflects that the funds are performing less than the benchmark. In the situation where the rate of cash tends to zero (such as in the early decade- the 2010s), it creates little difference.
Short Selling
Suppose a condition that a manager believes the stock price of company X will decline. Then he can acquire 1000 shares of company X from his brokerage firm and sell them at 10 USD per share. In this case, the instant profit of the manager is 10* 1000 = 10,000 USD
If the stock price of firm X after a week declines to 9.5, then the manager purchases 1000 shares, spending 9.5* 1000 = 9500 USD, and returns the stocks to his brokerage firm.
Thus, the manager ends up making a return of 5% [(10,000- 9500)/10,000]. If the brokerage firm asks an interest rate of 2% for borrowing the stocks, then the total aggregate profit of the manager would be 3% (5%- 2%).
Leverage
Seldom, this approach gives a positive value of return, though a small. In such a case, a manager can make use of leverage to amplify his return.
For example, a manager (long-short) can deposit 100M in the brokerage firm to purchase 200M of stocks and concurrently sell another 200M of stocks; this makes the leverage ratio as 4 [( 200M + 200M)] / 100M.
Another example, a manager can also borrow money from a nation at a 2% rate of interest and reinvest the money in another country that offers a 4% rate. Thus, by making the spread earning as 2% (4%- 2%). It is known as the carry trade. If the leverage ratio of the manager is five, then the return is not 2%, but 2% * 5 = 10%.
High Turnover
Some absolute managers are quite engaged with their portfolios, selling and purchasing the stocks more often than an ordinary trader. The reason for this is they mainly direct on short-term opportunities in investment remaining less than 90 days.
Turnover is the amount at which the financial managers rescales their portfolios and other things. It depends on the hedge size of the fund.
In the year 2008, hedge funds having a size less than 15M in assets under management or AUM had a turnover of 46.9% per month. At the same time, funds over 250M USD had only 9.8% in AUM.
