Definition
Absolute return is an investment strategy that aims to earn a positive return regardless of the direction of financial markets. Unlike relative return, it does not compare the performance to a market index or benchmark. Absolute return focuses on actual gains or losses, not relative performance.
Key Takeaways
- Absolute Return refers to an investment strategy that is designed to achieve a return regardless of the direction of financial markets. This strategy seeks to produce positive returns irrespective of whether markets are rising or falling.
- Absolute Return differs from relative return because it is concerned with the return of a particular asset and does not compare it to any other measure or benchmark. It just seeks to make money under all conditions.
- Common absolute return strategies include arbitrage, long/short equity, fixed income arbitrage, global macro, and various types of derivative products. They are typically used by hedge funds and are known for their flexibility.
Importance
Absolute Return refers to the actual earnings or losses made by a financial asset or investment over a certain period of time.
It’s an important term in finance because it provides a clear and straightforward measure of an investment’s performance.
It varies from relative return, where the performance is compared to the market or a particular benchmark index.
By looking at absolute return, investors can truly comprehend the real amount of profit or loss made, without getting influenced by the market conditions.
Furthermore, this measurement may allow investors to effectively evaluate their portfolio’s risk-return tradeoff and make informed investment decisions.
Explanation
The purpose of Absolute Return is to attempt to generate positive returns irrespective of how the broader market is performing. Essentially, an absolute return approach seeks to produce consistent returns in both rising and falling markets.
It is commonly used in hedge funds that use the long-short equity strategy. These funds aim to deliver a positive return, no matter the direction of financial markets, by simultaneously buying securities that are expected to increase in value and selling short securities expected to decline.
This strategy is used by the investment managers, particularly those managing hedge funds, to not only preserve the principal investment but also to provide growth on their investors’ capital. Unlike relative return strategies, which compare performance to a specific market index or other benchmark, an absolute return strategy looks to avoid market volatility entirely, aiming to deliver positive returns even during market downturns.
This type of strategy is particularly preferred by investors seeking low correlation with traditional marketable securities.
Examples of Absolute Return
Hedge Funds: A common example of an absolute return strategy is a hedge fund. For example, a hedge fund may invest in a mix of assets like stocks, bonds, and commodities with the goal to generate a positive return regardless of how the overall market is performing. The managers of the fund might use various hedging strategies, like short selling or using derivatives, to protect the fund from market downturns and deliver an absolute return.
Managed Futures: This is another investment strategy that aims to generate absolute returns. Managed futures funds typically use a wide variety of financial instruments, including commodities, currencies, and interest rates, to generate positive returns in all market conditions. For example, if the managers anticipate a rise in oil prices, they may take long positions in oil futures. Conversely, if they forecast a decline in interest rates, they could sell interest rate futures.
Long/Short Equity Strategy: This strategy involves buying equities that are expected to increase in value and selling short equities that are expected to decrease in value. For example, an investor might buy shares of Company A because they believe its stock price will rise, while simultaneously selling short shares of Company B because they believe its stock price will fall. The goal is to generate positive returns regardless of the direction of the overall market. This dual approach aims to achieve an absolute return and is not tied to the performance of the broader market.
FAQs on Absolute Return
What is Absolute Return?
Absolute Return is a term used in the finance world to describe a strategy that aims to achieve positive returns regardless of the performance of financial markets. It is often used in the context of hedge funds.
How does Absolute Return differ from Relative Return?
Unlike Relative Return, which aims to produce returns relative to a specific market index or other benchmark, Absolute Return strategies seek to produce positive returns regardless of whether markets rise or fall.
What are the advantages of Absolute Return strategies?
Absolute Return strategies can offer diversification benefits and potentially lower risk compared to traditional investment strategies. They also have the potential to provide positive returns in both rising and falling markets.
What are the potential risks associated with Absolute Return strategies?
While Absolute Return strategies aim for positive returns in any market condition, they are not without risk. Market volatility, manager skill, and the use of leverage and derivatives can all impact returns and potentially lead to losses.
Who typically invests in Absolute Return strategies?
Absolute Return strategies often attract investors who want to diversify their portfolios, reduce potential investment risk, and seek positive returns regardless of market conditions. These can include individual investors, institutional investors, and hedge funds.
Related Entrepreneurship Terms
- Alpha
- Hedge Funds
- Capital Appreciation
- Investment Strategy
- Risk Management
Sources for More Information
- Investopedia – This financial education website can provide a comprehensive understanding of the term ‘Absolute Return’.
- Morningstar – This investment research firm often provides useful articles and definitions about diverse finance terms like ‘Absolute Return’.
- Corporate Finance Institute (CFI) – CFI offers free finance glossary that the user might find beneficial to learn about ‘Absolute Return’.
- J.P. Morgan – As a global leader in financial services, J.P. Morgan’s resources often feature information about various investment and financial terms such as ‘Absolute Return’.
