All things being equal, the ability within absolute return to be long or short in both duration and credit will produce greater returns than total return mandates over time. Too many mouths to feed Many fund-of-hedge-funds produce tremendous excess returns, but some have not.
All such vehicles represent substantial fee drains on several levels. If the return outcome, or expectation, is bank bills plus 2 per cent to 3 per cent or less, then the level of risk required to be taken at the coalface to produce such marginal net returns on the surface looks wrong. Selling your quoted fund-of-hedge fund shares can take time, or reduce your net sales proceeds, if there isn’t the interest on the other side.
Having an absolute return fund with full liquidity at net asset value with no penalty, paying lower total expense ratios but yet having access to instruments and trade types seen within a hedge fund makes the latter type preferable over time. It is this breadth of the investment opportunity set which differentiates successful absolute return investing from traditional formats, with guidelines and risk restrictions formulated to permit managers the maximum degree of freedom under rules that have been tried and tested in the European Union.
Some managers operate at fixed levels of value at risk – or VaR ; others at peak levels. The irony of fixed levels is that the manager is forced to take risk when mathematically it is low (a currency peg holds until it doesn’t) but is constrained when risk is seen to be high, where, say, a bond that falls dramatically in price is seen as high risk (the very time when risk return profile improves and value is being created).
Within the fixed income oriented absolute return product, most managers apply a range of sources of excess return:
• Rates, which includes duration, yield curve slope and shape, plus cross-market spreads
• Foreign exchange, including both systematic and discretionary strategies
• Emerging markets, comprising spreads within the hard-currency markets and local currency yields and their yield curves, as well as currencies
• Investment grade and high yield credit, both physical securities and credit derivatives, including short exposure using the latter.
• Convertible bonds, combined with equity and credit derivatives.
Further, some absolute return funds add equity strategies, notably long / short trades. It is important to understand the nature of returns likely to be generated by this approach – absolute return funds are not ‘deposit accounts’ nor unsecured creditors to banks, rather they are a product designed to generate a net 2-3 per cent over deposit rates over the course of an economic cycle.