Absolute Return Strategies: A Deep Dive

Published by admin on March 23, 2025March 23, 2025

What Are Absolute Return Strategies?

Absolute return strategies are designed to make money no matter what the market is doing. Unlike traditional investment strategies, which are often tied to a benchmark index (e.g., the S&P 500), absolute return strategies focus on generating positive returns independent of market direction. The aim is consistent, risk-adjusted returns through diversified methods, especially during volatile or bearish market conditions.

These strategies are highly attractive to sophisticated investors such as hedge funds, institutional investors, and high-net-worth individuals (HNWIs), who are looking for ways to protect their portfolios while generating solid returns in any market environment.

Here’s an in-depth breakdown of the various techniques used in absolute return strategies:

1. Long and Short Positions: Profiting from Rising and Falling Asset Prices

One of the core tactics in absolute return investing is the use of long and short positions to capitalize on both rising and falling asset prices. This technique allows investors to make profits regardless of whether the market is in a bull or bear phase.

Long Position:

A long position involves buying a security with the expectation that its price will rise. This is the traditional “buy low, sell high” approach.
In absolute return strategies, the goal is to identify undervalued assets with strong potential for growth and hold them until they reach their target value.

Short Position:

Short selling involves borrowing a security, selling it at the current market price, and then buying it back at a lower price in the future. Investors profit from the difference.
This position is taken when an investor expects an asset’s value to decline.
In absolute return strategies, short positions can hedge against market downturns or be used to profit from overvalued assets.

Example:
A hedge fund might take a long position in an undervalued technology stock while shorting a similar overvalued competitor. This strategy allows the fund to make a profit even if the overall tech sector experiences volatility.

2. Derivatives and Options Trading: Hedging Risks and Enhancing Returns

Derivatives are financial instruments whose value is derived from an underlying asset, such as stocks, bonds, or commodities. They allow investors to hedge risks, enhance returns, or take speculative positions without needing to own the underlying asset directly. In absolute return strategies, derivatives and options trading play a critical role.

Types of Derivatives:

Futures contracts: Agreements to buy or sell an asset at a future date at an agreed-upon price. These can be used to hedge against price movements in assets such as commodities or stocks.
Options contracts: These provide the right (but not the obligation) to buy (call options) or sell (put options) an asset at a specified price within a certain time frame.
Swaps: These involve the exchange of one type of cash flow for another, often used to hedge interest rate or currency risks.

Hedging with Options:

Investors use options to mitigate the risks of adverse price movements. For example, buying put options on a stock one holds can protect against declines in the stock’s value.
Options can also enhance returns by allowing investors to leverage smaller investments for higher gains.

Example:
A fund manager might use options to hedge a large equity position against potential downside risk or use options to speculate on future volatility in the market.

3. Arbitrage Opportunities: Exploiting Pricing Inefficiencies

Arbitrage refers to the practice of exploiting price discrepancies of an asset across different markets. Investors or traders simultaneously buy and sell the same asset in different markets to capture risk-free profits from the price differential.

Types of Arbitrage:

Spatial Arbitrage: Exploiting price differences between different geographical locations or markets. For example, buying a stock on one exchange where it’s undervalued and selling it on another where it’s overvalued.
Statistical Arbitrage: Using mathematical models to predict the price movements of assets and execute trades based on statistical anomalies.
Merger Arbitrage: This involves buying and selling stocks of companies involved in mergers or acquisitions. Traders may buy the target company’s stock and short the acquirer’s stock to capitalize on expected price movements during the deal.

Arbitrage opportunities are short-lived, as market inefficiencies tend to correct quickly, but absolute return investors often have the expertise and technology to act on them rapidly.

Example:
In a merger arbitrage situation, if Company A announces a buyout of Company B at $50 per share, but Company B’s stock is trading at $45 per share, an arbitrageur might buy Company B’s stock at the discounted price, expecting to sell it at the $50 acquisition price.

4. Global Macroeconomic Trends: Adjusting Positions Based on Economic and Geopolitical Factors

Absolute return strategies often take into account global macroeconomic trends, which include shifts in economic growth, inflation rates, interest rates, and geopolitical factors. Investors use this information to adjust their positions and capitalize on broader economic forces.

Key Macroeconomic Factors to Monitor:

Interest Rates: Changes in interest rates (set by central banks) affect the cost of borrowing and the attractiveness of certain investments. For example, rising interest rates can negatively impact high-growth stocks but benefit financial stocks.
Inflation: Inflation erodes purchasing power and can influence asset prices, particularly in the bond and real estate markets. Absolute return funds may position themselves in assets that benefit from rising inflation, such as commodities or inflation-protected securities.
Geopolitical Events: Wars, trade policies, and elections can create market volatility. Absolute return investors might shift their portfolios to hedge against geopolitical uncertainty or take advantage of opportunities presented by such events.

Example:
A global macro hedge fund might adjust its portfolio to favor emerging market equities if it anticipates stronger growth in these regions due to a new trade agreement or infrastructure project. Conversely, it might hedge its positions if it foresees geopolitical instability in a region, such as an oil-producing country experiencing unrest.

5. Alternative Asset Classes: Real Estate, Commodities, Private Equity, and More

Traditional asset classes like stocks and bonds are often the core of many investment portfolios. However, absolute return strategies often go beyond these conventional assets and tap into alternative asset classes that offer higher potential returns or additional diversification.

Types of Alternative Assets:

Real Estate: Real estate investments, particularly commercial properties, can provide stable cash flows and long-term appreciation. Hedge funds and absolute return strategies might invest in real estate or real estate investment trusts (REITs) to capture returns in an otherwise stable or low-growth environment.
Commodities: Commodities such as gold, oil, and agricultural products are often used to hedge against inflation or geopolitical risks. Hedge funds might take positions in commodity futures or physical commodities to diversify their portfolios.
Private Equity: Investment in private companies or startups can offer high returns, though it carries more risk and less liquidity. Absolute return funds may target specific sectors or companies they believe are undervalued or have growth potential.
Structured Products: These are pre-packaged investments that typically involve derivatives and offer exposure to a wide range of assets. They can be tailored to achieve specific return targets with limited downside risk.

Example:
A hedge fund may diversify its portfolio by investing in commodities like oil to hedge against inflation, real estate for steady cash flows, and private equity for long-term growth opportunities. This approach helps the fund deliver consistent returns regardless of market conditions.

Who Uses Absolute Return Strategies?

Hedge Funds: Absolute return strategies are a staple for many hedge funds, whose business models revolve around generating positive returns irrespective of the market’s direction.
Institutional Investors: Pension funds, endowments, and foundations use absolute return strategies to diversify their portfolios and protect against downside risk.
High-Net-Worth Individuals (HNWIs): Wealthy individuals, looking for both growth and protection, often employ absolute return strategies as part of a diversified investment portfolio to reduce risk and enhance returns.

Benefits of Absolute Return Strategies:

Diversification: By relying on a variety of asset classes and strategies, absolute return funds offer diversification, which can reduce portfolio volatility.
Downside Protection: These strategies can hedge against market downturns, which is especially appealing during periods of market stress.
Consistency: The goal of absolute return strategies is to generate consistent returns, offering an alternative to the volatility often associated with traditional stock market investments.

Risks of Absolute Return Strategies:

Limited Liquidity: Some of the assets and positions in absolute return strategies may have limited liquidity, making it difficult to exit quickly.

Complexity: These strategies often require specialized knowledge and expertise to execute successfully.

Higher Fees: Absolute return strategies can involve higher management fees due to the complexity and active management required.

Have Any Money Managers Delivered Positive Returns for the Last 10 Years?

While absolute return strategies promise stability, consistently delivering positive returns over a decade is challenging. However, some hedge funds and asset managers in the U.S. and Canada have outperformed markets using these tactics. Notable examples include:

U.S. Money Managers with Positive Absolute Returns

Bridgewater Associates – Known for its risk-parity strategy and macro-driven investments, Bridgewater has historically generated steady absolute returns.
AQR Capital Management – Implements quantitative and factor-based investing to achieve absolute return targets.
Man Group (U.K.-based but active in the U.S.) – Specializes in absolute return strategies using machine learning and quantitative modeling.

Canadian Money Managers with Positive Absolute Returns

CI Global Asset Management – Offers various absolute return funds designed for risk-adjusted performance.
Purpose Investments – Runs market-neutral and alternative strategy funds with consistent historical performance.
Fidelity Canada – Provides multi-asset and hedge-fund-style strategies targeting absolute returns.

That said, many absolute return funds have faced challenges in the past decade due to central bank policies, prolonged bull markets, and low-interest rates.

Are Absolute Return Strategies Worthwhile?

The effectiveness of absolute return strategies depends on an investor’s goals and risk tolerance. Here are key considerations:

Pros:

✅ Lower correlation with stock markets, reducing portfolio volatility.
✅ Potential downside protection during economic downturns and bear markets.
✅ Can serve as a hedge against market crashes and systemic risks.
✅ Access to diverse asset classes and investment techniques not available in traditional portfolios.

Cons:

❌ Higher fees compared to passive investments and traditional funds.
❌ Performance heavily depends on the fund manager’s skill and strategy execution.
❌ Strategies may underperform during long bull markets when broad indices are rising.

For investors seeking stable returns with reduced risk exposure, absolute return strategies can be a useful addition to a diversified portfolio. However, they require careful selection and due diligence.

Market-Neutral Funds in the U.S. and Canada

Market-neutral funds are a subset of absolute return strategies designed to generate returns independent of market direction. These funds aim to achieve near-zero correlation with stock indices by maintaining equal long and short positions.

Top Market-Neutral Funds in the U.S.

BlackRock Market Neutral Fund – Utilizes a systematic strategy to balance long and short positions.
AQR Equity Market Neutral Fund – Aims for stable returns by exploiting pricing inefficiencies.
JP Morgan Market Neutral Fund – Focuses on quantitative analysis to minimize systematic risk.

Top Market-Neutral Funds in Canada

Purpose Market Neutral Alternative Fund – Uses a blend of alternative strategies to hedge market risk.
CI Alternative Market Neutral Fund – Seeks to deliver steady returns through arbitrage and sector rotation.
NBI Market Neutral Fund – Implements sector-neutral positioning to achieve consistent absolute returns.

Market-neutral funds are particularly valuable for investors seeking low volatility and protection against major market swings.

Managed Mutual Funds in Canada That Include Absolute Return Strategies

Some major banks in Canada incorporate absolute return strategies within their managed mutual funds. These funds allocate a portion of their assets to hedge-fund-style investments, alternative asset classes, and tactical asset management strategies.

Canadian Bank Mutual Funds with Absolute Return Strategies:

RBC Alternative Absolute Return Fund – Aims to deliver positive returns with lower volatility.
TD Alternative Risk Reduction Pool – Integrates market-neutral and alternative strategies to enhance portfolio stability.
BMO Alternative Fund – Focuses on diversified absolute return investments to reduce market dependency.
Scotia Absolute Return Fund – Seeks to generate stable returns through global macro and tactical asset allocation strategies.
CIBC Alternative Investment Strategies Fund – Offers hedge-fund-like strategies with lower correlation to traditional markets.

These managed mutual funds provide an accessible way for retail investors to gain exposure to absolute return strategies without the complexities of direct hedge fund investments.

Can Investors Mimic Absolute Return Strategies Using Managed Funds?

Yes, but with limitations. Individual investors can attempt to replicate absolute return strategies through:

1. Allocating to Low-Correlation Assets

Gold, bonds, and alternative investments provide stability against equity market swings.
Real estate investment trusts (REITs) and commodities can offer non-correlated returns.

2. Using ETFs That Implement Hedge Fund-Like Strategies

IQ Hedge Multi-Strategy Tracker ETF (QAI) – Replicates hedge fund absolute return strategies.
AGFiQ U.S. Market Neutral Anti-Beta ETF (BTAL) – Aims to profit from low-beta stock outperformance.
Horizons Absolute Return Global Currency ETF (HARC-T) – Provides exposure to global currency arbitrage.

3. Investing in Structured Products and Derivatives

Structured notes with capital protection mechanisms.
Options and futures contracts for hedging and speculation.

4. Incorporating Options Trading for Downside Protection and Leverage

Covered call strategies to generate income.
Protective puts to hedge against market declines.

However, mimicking absolute return strategies requires active management, deep market knowledge, and risk control. Fully managed absolute return funds remain a more practical solution for most investors.

Final Thoughts

Absolute return strategies and market-neutral funds can be powerful tools for investors looking to reduce market dependence and enhance risk-adjusted returns. While some money managers have delivered consistent positive performance, selecting the right strategy requires thorough research. Investors can partially replicate these strategies through ETFs, alternative funds, and tactical asset allocation. However, fully managed funds provide a more efficient way to access these complex investment techniques.

Many major Canadian banks offer managed mutual funds that integrate absolute return strategies, making them accessible to a wider range of investors. Before investing, it is crucial to evaluate risk tolerance, fund performance history, and fee structures to ensure alignment with financial goals.

Want more AI-driven finance tips? Subscribe to our blog and stay ahead of the game!

Subscribe Now!

Disclaimer: This blog article is for informational purposes only and should not be considered financial advice. Everyone’s financial situation is unique. Always consult with a qualified financial advisor or planner to assess your individual circumstances before making financial decisions.

Absolute Return Strategies: A Deep Dive