Absolute return investing aims to achieve positive returns regardless of market conditions. This is different from traditional investing which focuses on outperforming benchmarks. Absolute return strategies utilize a wide range of assets and derivatives to profit from both rising and falling markets. Popular absolute return strategies include market neutral, arbitrage, short selling and global macro. The key benefit of absolute return investing is providing steady returns and downside protection during market downturns. However, the returns tend to be lower than equity indexes during bull markets. Absolute return funds typically target returns of 6-8% above the risk-free rate over a market cycle. Individual investors can gain exposure through hedge funds, mutual funds and ETFs that employ absolute return strategies.
Market neutral strategy can exploit mispricing and achieve positive absolute returns
A market neutral absolute return strategy attempts to eliminate market risk by taking offsetting long and short positions. For example, a long-short equity fund would go long undervalued stocks while shorting overvalued stocks. The fund aims to capture the performance spread while remaining neutral to market moves. This strategy relies on the fund manager’s stock picking skill to identify mispricings. Advanced quantitative techniques are often employed for stock selection and portfolio construction. Market neutral funds posted modest positive returns during the 2008 financial crisis when equity markets experienced huge losses, demonstrating the effectiveness of this absolute return strategy.
Arbitrage strategies profit from price discrepancies
Arbitrage aims to lock in risk-free profits from temporary price discrepancies between related assets. A simple example is futures arbitrage which exploits the difference between futures prices and spot prices. As the futures contract approaches expiration, its price will converge toward the spot price due to arbitrage trading. Hedge funds employ more complex arbitrage strategies across global equity, fixed income and currency markets. However, arbitrage opportunities are being diminished by technology and efficiency. The profitable opportunities tend to be small and sporadic, requiring substantial capital and low leverage.
Short selling provides positive returns in falling markets
Short selling involves borrowing then selling securities in anticipation of buying them back later at lower prices. Short sellers profit when the security price declines. They may short individual stocks, industries, countries, or even entire markets if the analysis suggests overvaluation and impending downturns. Short selling hedge funds provided strong positive returns during the bursting of the dotcom bubble and 2008 financial crisis. However, short selling is risky due to the possibility of unlimited losses if the security keeps rising. Prudent risk management through diversification, portfolio construction and exposure limits are crucial.
Global macro strategies benefit from big economic trends
Global macro hedge funds base their investment decisions on macroeconomic events and trends such as interest rates, currencies, inflation and GDP growth. By having a global scope across numerous markets, they are able to shift capital to opportunities arising from major economic or political changes. However, successfully implementing global macro strategies requires a deep understanding of economics as well as flexibility to position for unpredictable events.
Absolute return investing aims to provide positive returns regardless of market conditions. It utilizes strategies like market neutral, arbitrage, short selling and global macro. The key benefit is downside protection and steady returns during market downturns. But the tradeoff is lower returns than equity indexes during bull markets.