Targeting absolute returns

Targeting absolute returns

‘Absolute’ vs ‘relative’ returns – what’s the difference?

Each fund has its own investment objective, which outlines what the fund aims to achieve on behalf of its investors.

Some funds aim to beat a particular market benchmark. In other words, their objective is to achieve ‘relative’ returns. A fund that invests in UK company shares might logically aim to outperform an index of the UK stockmarket, like the FTSE 100, for example.

The investment objective of an absolute return fund will typically be to target a specific return, seeking to outperform either the interest rates on cash savings or the inflation rate, by a certain amount and over a given timeframe. For example, a fund might target total returns (income and growth of capital) of 2% above returns on cash over any three-year period.

Please note there is no guarantee the fund objective will be achieved.

How can they perform in all market conditions?

Over the short term, markets will often deviate from how we might expect them to perform over the long term. The period of uncertainty following an important political moment, such as the UK’s vote to leave the European Union, is a case in point.

The manager of a fund that targets absolute returns can hold a mix of different types of assets that will be expected to perform well under different circumstances. The manager can also hold the same type of assets but each with different characteristics to achieve a similar effect.

While it may be counterintuitive, there are also ways to make money when asset prices are falling. Fund managers can combine a traditional ‘long investing’ approach – buying assets that they believe will do well and rise in price – with other investment techniques.

The opposite of long investing – ‘short investing’ – allows a fund manager to make money from assets where they expect the price to fall. One way of taking a ‘short’ position is by selling borrowed assets and buying them back later, at a lower cost if their price has indeed fallen. Of course, if the price has risen contrary to expectations, the fund manager will lose money as the assets would have to be bought back at a higher price than they were initially sold for.

In practice, the more common approach to “short” an asset is through the use of derivatives. These are financial contracts whose value is derived from one or more underlying assets. These underlying assets will generally include bonds (loans to governments or companies paying a rate of interest), company shares and currencies.

Picking the right combination of investment tools and techniques can involve a high degree of expertise and skill. For this reason, the experience of fund managers and the team supporting them might be an important consideration for investors.

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How does M&G define ‘absolute returns’?

The notion of ‘absolute returns’ can mean different things to different people. Above all, it’s important to know that the returns you might receive from funds that target an ‘absolute return’ – as with any investment – are neither fixed nor guaranteed.

To make this absolutely clear, we think it makes sense to consider these funds as target absolute return funds.

At M&G, we define target absolute return funds as those that target (but do not guarantee) positive returns over a stated investment horizon up to a maximum of three years. In our view, they have two key features:

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Why does low volatility matter?

Volatility, being the extent to which asset prices rise and fall over a given period, can be especially uncomfortable for some investors. There are investors who rely on their investments to deliver consistent returns, as well as others who need to draw on them in the near future, for whom volatile markets could spell a financial shortfall.

Target absolute return funds attempt to deliver smoother returns for investors and, in this respect, can offer a less volatile investment proposition.

Investment returns profile graph

Source: M&G, for illustrative purposes only.

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What is the potential trade-off?

It is possible that targeting lower volatility might come at the expense of investment returns, depending on how the wider market fares.

During periods when the prices of assets deemed to carry greater investment risk, such as company shares, are rising, it is possible that a target absolute return fund could underperform funds that invest solely in company shares. This is because large exposure to more volatile assets is normally inconsistent with investment strategies that target an absolute return.

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Are absolute return funds right for me?

The suitability of any investment will always depend on your circumstances and attitude towards risk and return. If you’re at all unsure, please speak to a financial adviser.

Absolute return funds are typically suited to investors who are willing to sacrifice some potential upside, in the form of investment returns, in favour of limited potential downside, in the form of investment losses.

For investors who are looking to preserve their capital but would also like positive investment returns – but who do not want their investments to experience sharp falls – there has arguably never been a more challenging market environment. Assets traditionally viewed as low risk – such as cash or the government bonds (loans to governments) of the largest economies – today offer low returns.

It’s also important to note that absolute return investing might not be a suitable strategy for investors looking to achieve consistently positive returns over shorter timeframes. It is possible, even over the medium or long term, that returns may not be positive.

When you're deciding how to invest, always remember that the value and income from a fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.

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Pros and cons of absolute return funds

    Investment returns depend less on the overall market performing well
    In a falling market, when the value of higher risk assets is going down, these funds have the potential to hold up better
    They can therefore add diversification within a portfolio of investments
    Positive returns can never be guaranteed – and should not be relied upon
    In a rising market, when the value of higher risk assets is going up, these funds can underperform the overall market

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