How absolute-return strategies can strengthen portfolios

As featured in the ASX Investor newsletter on August 13th 2019, written by Brendan O'Connor.  Brendan is chief executive officer of Regal Funds Management, the manager of the Regal Investment Fund (RF1), an ASX-listed investment trust that provides investors with exposure to a selection of alternative investment strategies that seek to produce attractive risk-adjusted returns over a period of more than five years with limited correlation to equity markets.

 

The features, benefit and risks of using hedge funds in challenging markets.

An absolute return investment strategy, as the name suggests, seeks to achieve positive returns regardless of the direction of capital markets. Because absolute returns have little correlation (relationship) to equity or fixed-income markets, these strategies can provide diversification benefits when added to a traditional portfolio. 

A portfolio that is diversified across assets and correlation can lead to improved risk-adjusted returns; that is, higher returns for a given level of risk or a lower level of risk for a given level of return. 

It is commonly accepted that there are four major traditional asset classes: cash, equities, fixed income and real estate. In recent years, alternative investment strategies have been gaining a lot of attention. These include a broad range of strategies that typically involve investment manager skills (rather than simply rising markets) in generating absolute returns that are not correlated to traditional financial assets through exposure to either:

  • A broader range of beta (infrastructure, private equity and debt, water, agriculture, commodities). (Beta is a measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors.)
  • Skill-based strategies trading traditional asset classes; for example, long-short or market neutral equities strategy. 

Common alternative investment strategies include private equity, venture capital, infrastructure and hedge funds. 

Hedge funds are a nonhomogenous and broad category of investment strategies and include macro-economic strategies, event strategies such as merger arbitrage, relative value strategies such as convertible bonds or volatility arbitrage, and equity strategies such as long-short and market neutral. 

Some long-short strategies can also be described as active extension strategies because by selling some investments short, the strategy receives cash, which is used to invest in addition to the investments made with the investor’s subscription capital. The outcome is a gross exposure to the market of, say, 200 per cent comprising 50 per cent short and 150 per cent long. The Regal Australian Small Companies Fund is a long-short or active extension fund, which allows it to benefit from both beta and alpha returns.

A market neutral fund has an equal exposure to short selling and long investments and seeks to generate absolute returns by profiting from the increase in the value of the fund’s investments and the fall in value of the fund’s short investments. Regal’s Tasman Market Neutral Fund seeks to generate “equity-like” returns with little correlation to equity markets. 

All hedge fund strategies seek to generate absolute returns and are differentiated from long-only strategies in three main ways:

  • Their ability to sell short.
  • Their ability to provide dynamically managed risk exposures.
  • Their ability to use leverage, which can magnify gains and losses. 

The idiosyncratic nature of hedge fund returns is the key reason these funds can provide a different risk-and-return profile to traditional long-only investment managers. It is this profile that can help diversify a traditional investment portfolio. However, each hedge fund manager has a unique investment process and trading skill in generating returns, which makes manager selection critical. 

How and why they are used 

Absolute return investment strategies or hedge funds can offer positive returns that are uncorrelated to traditional asset classes, and therefore provide two key benefits to investors:

  • The absolute return generated. 
  • The diversification provided, as the returns are unlikely to move in the same direction as traditional asset classes, measured through correlations. 

The ability to use leverage and invest short (profit from falling securities prices) helps explain why the median long-short manager has outperformed the median long-only manager over the past eight years. 

Modern Portfolio Theory was developed by Nobel Prize winner Harry Markowitz in 1952. This theory supports investing across multiple asset classes to enhance the risk-adjusted returns of an investment portfolio. A diversified investment portfolio is likely to produce returns with varied correlations and therefore lower risk.

It is commonly accepted, and a key tenant of investing, that higher returns are typically associated with higher risk. Risk can be measured in many ways. One common yardstick is the lower the volatility of returns, the lower the risk. Investors are motivated to seek to optimize their return for a given level of risk. The optimal return for a given level of risk was defined by Markowitz as the “efficient frontier”.

The graph below shows a theoretical efficient frontier representing all portfolios with the lowest risk (as measured by volatility) for a given level of return or, conversely, all portfolios with the highest return for a given level of risk. Combining alternative investments, including investments in hedge funds, with traditional investments can improve risk-adjusted returns.

Including absolute return strategies in a traditional investment portfolio that delivers positive returns that are uncorrelated to traditional asset classes, moves the efficient frontier so that:

  • The same return can be achieved with lower risk (A), or
  • A greater return can be achieved with the same risk (B). 


Risks associated with absolute return strategies

A skill-based investment strategy must invest in the talent or investment personnel that deliver the investment returns. Accordingly, absolute return investment strategies will typically attract higher management and performance fees than long-only managers and passive investment strategies. The higher fees reward portfolio managers who have delivered alpha: investment returns in excess of market returns. 

Such fees are justified if the manager can unequivocally demonstrate they have achieved investment returns greater than the market, after fees, over the medium term. 

For example, the Regal Australian Long Short Fund has generated above 7 per cent alpha since inception in August 2009. That is, it has made 16 per cent per annum post-management fees of 0.80 per cent and a performance fee of 15 per cent on returns greater than the market, compared to a 9 per cent return in the ASX 300 Accumulation Index over the same period. 

Another risk posed by absolute return investment strategies is that of over-diversification. That is, the tendency of an investor to blend too many different investment manager styles together to achieve diversification.

Investment manager selection is critical when building a diversified portfolio of absolute return strategies, as each manager typically has a unique or idiosyncratic way of generating returns that are uncorrelated to traditional asset classes. Allocating to several absolute return strategies, each with their own method of generating alpha, can erode the diversification benefits afforded by any one individual manager.

Conclusion

Absolute return investment strategies seek to generate what all investors want: positive returns regardless of the movement in traditional asset classes. A good absolute return manager will be able to demonstrate a track record of delivering alpha over the medium term. 

Further, the investment returns should be uncorrelated to, or regardless of, movements in traditional asset classes. Absolute return investment strategies can generate positive investment returns that are uncorrelated to movements in traditional asset classes and can improve the risk-return efficiency of a traditional investment portfolio. 

***************

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity of the RF1. Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on ASX (ASX: EQT). Information provided is of a general nature only and is accurate at time of publication. Read the PDS of RF1 before making any decision to invest in it.

For more 'insights' please visit our News page.  For an overview of our investment products please visit our Investments page.  Alternatively, if you would like to get in contact with us please complete our enquiry form and we will respond to you as soon as possible.