Absolute Return

What exactly is Absolute Return?

Absolute return is the calculated return generated on an asset over a specified period of time. This metric considers the percentage increase or decrease in the value of an asset, such as a stock or a mutual fund, over a particular period.

Absolute return, as opposed to relative return, focuses on the return of a given asset rather than comparing it to any other statistic or benchmark.

How does Absolute Return function?

The amount of money earned by an investment is known as its absolute return. The absolute return, also known as the total return, assesses an asset's or portfolio's gain or loss regardless of any benchmark or other criterion. Returns can be positive or negative and are not always tied to market activity.

How to measure success in Absolute Return Investing?

It is simpler to determine whether an absolute return fund outperforms standard benchmarks. Investors may be disappointed during strong equity bull markets because these relatively conservative strategies lag behind their stock fund counterparts. Fortunately, there are two commonly used indicators that, when used together, can give insight into absolute return performance. They are:

• Standard Deviation: It assesses the variability or volatility of a financial asset or portfolio's performance. The standard deviation of an absolute return fund is often much lower than that of any large stock market index, at least 50% lower. All else being equal, adding a low-volatility investment to a portfolio reduces overall portfolio volatility.
• Sharpe Ratio: This ratio calculates the additional return per unit of risk incurred, as defined by standard deviation. A greater Sharpe ratio indicates improved risk-adjusted performance.

The overall aim of adding an absolute return fund to a portfolio is to increase the portfolio's risk-adjusted return by attaining a higher incremental return from a less volatile mix of investments.

What are its benefits?

Absolute return funds adopt a completely different strategy. Absolute return funds, which avoid traditional benchmarks in favor of continuously positive performance and lower volatility, can provide several potential benefits when added to a broadly diversified portfolio. Some such advantages include the following:

• Lowering overall portfolio volatility
• Limiting losses in bear markets
• Increasing the diversity of investment returns
• Providing significant diversification potential
• Increasing a portfolio's risk-adjusted return

Absolute return techniques can be thought of as the most influential or dominant asset of your portfolio, which can significantly alter the overall output. Unlike other portfolio managers, absolute return managers focus on what may go wrong in financial markets and manage risk accordingly.

What are the major Absolute Return Strategies that exist?

Absolute Return Strategies differ greatly. However, here are some common strategies:

• Long-Short Equity Strategies: These are highly liquid strategies that combine 'long' and 'short' holdings for balanced performance, minimizing the overall risk by distributing among various assets. Some examples are short-bias equity, market-neutral equity, long-bias equity, and paired trade portfolios.
• Relative Value Strategies: These are techniques that seek to capitalize on perceived pricing/valuation disparities between specific securities. The manager takes a 'long' position in a security that appears to be 'undervalued' and a 'short' position in a security that appears to be 'overvalued'. Stock market neutral and fixed interest relative value strategies are two examples.
• Event-Driven Strategies: These strategies entail the manager assessing how company-specific events, including mergers, bankruptcies, and restructurings, are likely to unfold. Depending on the conditions, management may take a "long" position in one of such firms and a "short" position in another. Merger arbitrage and distressed debt are two examples.
• Global Macro Strategies: These strategies involve the manager's assessment of global economies and financial market movements. They are sometimes impacted by the qualitative judgments of the management. In other cases, quantitative models are the primary driving force behind the plan.
• Managed Futures Funds: These strategies frequently make use of algorithmic and technical models that focus on futures and other highly liquid instrument patterns. The majority of commodities funds fall into this group.
• Multi-Strategy Funds: These funds employ several of the strategies discussed above. They attempt to deliver consistent returns with low volatility by diversifying over various absolute return methods and asset classes. They are often managed by a single manager, allowing for a single, cost-effective entry point to absolute returns.
• Funds of Hedge Funds (FOHFs): These strategies typically invest in 30 to 70 distinct underlying alternative strategies. What distinguishes them from multi-strategies funds is that each underlying alternative strategy is normally managed by a separate manager.

What is the distinction between absolute and annualized returns?

Absolute return measures an investment's performance regardless of time. It is represented as a percentage of Indian rupees. On the other hand, the annualized return is the average return on investment over one year time. It is expressed as a percentage.

Absolute returns are simple to compute. The return on investment is computed using the beginning or original investment and the final value. On the other hand, the annualized return is somewhat difficult to calculate. In this case, one needs to first increase the absolute return by one. The annualized multiplier is then determined by taking the n^th root of the number (where n denotes the time period) and subtracting one. In other words, it illustrates the return on investment over one year time.

It is simple to compute absolute return, but comparing the absolute return from two investments becomes difficult. Because the period of the return is constantly being determined, it makes comparison somewhat difficult. In contrast, one may easily compare the annualized returns of two investments and choose the one with the higher annualized return.

Let us consider a three-year investment of INR 1,000. After three years, the investment had grown to INR 1500. The absolute return on this investment is 50%, while the annualized return is 14.47%. This indicates that the investment increased by 14.47% each year for three years.

Absolute and Relative Returns

Generally, a mutual fund seeks to beat its competitors, fund category, and market. This form of fund management is referred to as a relative return investment approach. The success of an asset is typically measured by comparing it to a preset benchmark, industry norm, or overall market performance.

As an investment vehicle, an absolute return fund seeks to achieve positive returns by employing investment management strategies that differ from typical mutual funds. Absolute return investment tactics include short selling, futures, options, derivatives, arbitrage, leverage, and unconventional assets. Absolute returns are examined in isolation from any other performance metric, and thus only investment gains or losses are analyzed.

Is CAGR a better metric than absolute return?

When investors are willing to take on additional risk in exchange for the possibility of gaining a lot of money, they should consider a technique known as "absolute returns". CAGR (compound annual growth rate), on the other hand, typically performs based on the length of time that an investment is held. This clarifies and refines the image of the investment's potential for growth that this statistic paints. The following is the usual formula for calculating CAGR:

CAGR (%) = Absolute Returns / Duration of Investment (years)

While selecting investments, faster and, higher returns can be considered.

Why are absolute returns not a more accurate measure of mutual fund performance than total return?

Let us first grasp how an equity mutual fund works before delving into the mechanics of the Total Returns and Absolute Returns computations. A mutual fund makes equity investments on behalf of its unit holders. Any dividends declared by the corporation are paid to the mutual fund. Second, any gains realized by the mutual fund from the sale of shares are returned to the fund. Finally, as shares grow, the fund's NAV (Net Asset Value) also rises. As a result, when we compute a mutual fund's returns as the point-to-point NAV, we consider dividends paid, gains (booked), and notional profits (not booked).

The question of measuring mutual fund performance versus the index now arises. When considering absolute returns, this is where the dichotomy originates. An equities mutual fund's absolute point-to-point returns take dividends and price appreciation into account. However, in the case of indexes, such as the Nifty and Sensex, point-to-point returns only capture price movement and not dividends received by index stocks. As a result, index returns may be overstated. Therefore, the equity fund's outperformance relative to the index tends to exaggerate the amount of the index's dividend yield. Total Returns Index solves the problem by combining dividend yield and index returns to provide a more trustworthy picture.

The Bottom Line

Absolute return analysis should be employed only by those willing to take measured risks in quest of short-term and long-term rewards. It's simple to calculate and worries only a bit about market conditions. Absolute returns are the foundation of a dynamic risk management strategy.