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Absolute Return Definition
An absolute return refers to appreciation or depreciation that an asset accrues over a given period of time. It is the evaluation of the performance of an asset in relation to how much gain or loss it has made and incurred over a period of time. An absolute rate is expressed as a percentage of the capital invested in the asset.
An absolute return should not be confused with a relative return, both terms are distinct terms with varying significance. While an absolute return is a measure of how well or badly an investment portfolio has performed, a relative return compares the performance of the portfolio to a market benchmark.
A Little More on What is Absolute Return
The absolute return of asset is the profits made or losses incurred by the asset over a given period of time. An absolute return is also known as the total return, it is a measure of the gain or loss that an investment portfolio or an asset experience over a period of time.
The absolute return of an asset can either be positive or negative. In some cases, market activities and trends might not affect the absolute return of an asset. The absolute return of an investment portfolio is not determined by the market benchmark, as seen in the case of a relative return.
Relative and Absolute Returns
A relative return of an asset is not the same as the absolute return, basically, absolute return measures the loss and gains accumulated by an asset or investment portfolio over a period of time without regard to the market benchmark or market trends. Relative return on the other hand, compares the performance of an asset in terms of losses and gains to the benchmark portfolio in the investment market.
When an investor makes decisions by comparing the performance of an investment portfolio to its peers or other portfolios in the market, this is a relative approach to investing.
Absolute return on the other hand, examines the performance of an asset or investment portfolio separate from its peers in the market.
History of Absolute Return Fund
The history of absolute return fund cannot be discussed without making reference to Alfred Winslow Jones. This is because the creation of absolute return funds is credited to him. The first absolute return fund was formed in New York in 1949 by Alfred Winslow Jones.
The absolute return approach to fund investment is based on measuring the gain or loss that an asset or investment portfolio accrue over a period of time. The creation of absolute return fund birthed the common and most effective investment products that are available today, these are hedge funds.
A hedge fund is an investment instrument or product realized from pooling a significant amount of capital from various investors with the goal of investing the pooled funds in assets or investment portfolios. Typically, a hedge fund is formed as a private limited partnership or limited liability company (LLC).
The funds raised in a hedge fund is operated by a hedge fund manager who specializes in investments characterised by complex portfolio-construction. However, diverse risk management strategies are employed by the hedge fund manager to earn active return or alpha from investors that are contributors to the hedge fund.
Example of Absolute Return
If a mutual fund company earns a 15% profit on the mutual fund investment for a given period of time, the absolute return of the fund is 15%. Compare this to relative return;
In the case a relative return, if the return of the market benchmark is 10% and the mutual fund realizes a return of 15%, the relative return would be 5%.
The absolute return gives no regard to the benchmark portfolio in the market.
Reference for “Absolute Return”
Academic Research on Absolute Return
Some properties of absolute return: An alternative measure of risk, Granger, C. W. J., & Ding, Z. (1995). Annales d’Economie et de Statistique, 67-91. This paper explains that the expected absolute return belongs to a class of risk measure derived by Luce from axioms. It considers the time series properties of theta and also the marginal distribution properties for several properties of theta. The paper also states that the moments of absolute returns, after removal of a few outliers suggest that an exponential distribution is appropriate.
The myth of the absolute–return investor, Waring, M. B., & Siegel, L. B. (2006). Financial Analysts Journal, 14-21. The objective of this article is to define absolute-return investing and determine whether it exists. It concludes that all investment returns consist of a beta part and an active alpha part. Therefore, all investing is relative-return investing in which active returns are earned relative to an appropriate benchmark or mix of benchmarks.
Absolute return portfolios, Valle, C. A., Meade, N., & Beasley, J. E. (2014). Omega, 45, 20-41. This paper focuses on the problem of selecting an absolute return portfolio which is a portfolio of assets designed to deliver a good return regardless of how the underlying market performs. The paper presents a three-stage mixed-integer zero-one program for the problem that explicitly considers transaction costs associated with trading.
A VaR Black–Litterman model for the construction of absolute return fund-of-funds, Lejeune, M. A. (2011). Quantitative Finance, 11(10), 1489-1501. The objective of this paper is to construct funds-of-funds that follow an absolute return strategy and meet the requirements imposed by the value-at-risk (VaR) market risk measure. It proposes the VaR Black-Litterman model which accounts for VaR and trading requirements. This model is in the form of a probabilistic integer, non-convex optimization problem.
The Hedge Fund “Industry” and Absolute Return Funds, Goldman, S. (1999). The Hedge Fund “Industry” and Absolute Return Funds. The Journal of Alternative Investments, 1(4), 11-27. This article reviews the hedge fund industry in general and one specific strategy, which is market neutral, is analyzed. It also examines the ability of various market neutral or absolute return funds to perform well in hostile market environments.