Institutional portfolios seeking diversification are choosing
Long-Only Absolute Return Funds, an actively managed
alternative proven to generate real returns independent from
any index benchmark.
The global second quarter bear market rally in major stock
markets brought back memories of the extraordinary returns
of the 1990s -- which evaporated with the internet implosion
and US financial scandals over the last few years. As a consequence
of these losses, institutional investors have been diversifying
from traditional mutual funds, which focus on beating an index
benchmark, to alternative investments, which promise capital
preservation and positive returns independent of market indices
and general market conditions. This article presents Long-Only
Absolute Return Funds (ARF), the latest entrant in the hedge
fund-dominated alternative investment universe.
There is no standard definition for Long-Only ARFs.
Similarly, there is no internationally-accepted definition
for hedge funds even though they've been around since 1949.
The absence of formal descriptions, however, is appropriate
given the numerous styles of alternative asset classes and
because alternatives can be rather obscure. Nevertheless,
a common understanding has emerged for hedge funds as several
similar definitions were jotted down over the years. In contrast,
it appears that the bulk of Long-Only ARFs have debuted
only within the past five years while the asset class itself
may be less than a decade old. Concrete definitions have therefore
not yet surfaced, so we will wager one now and clarify the
meaning by highlighting the key differences between Long-Only
ARFs, Hedge Funds and Traditional Mutual Funds in Table 1.
What is a Long-Only Absolute Return Fund?
A Long-Only Absolute Return Fund is a fund that takes
only long positions, seeks undervalued securities, and reduces
volatility and downside risk by holding cash, fixed income
or other basic asset classes. This fund may use options, futures
and other derivatives to reduce or "hedge" risk
and gain exposure for underlying physical investments but
not for speculative purposes. Exposure may also be gained
through investment funds that are not hedge funds. Long-Only
ARFs pursue strategies that it believes will result in positive
or "real" returns independent from any index benchmark
under all market conditions, in stark contrast to traditional
funds which pursue relative returns.
|Long-Only Absolute Return Funds
||Traditional Mutual Funds*
|Objective is consistent positive returns in all market conditions
||Objective is consistent positive returns in all market conditions
||Positive returns depend on rising markets, objective is relative return or out-performance of an index benchmark
|Flexible investment strategies including derivatives but no speculation
||Flexible investment strategies including derivatives
||Limited flexibility, generally must be fully invested
|Seldom invests in traditional or other Long-Only Absolute Return Funds
||Invests in other alternative funds only if Fund of Funds
||Seldom invests in other traditional funds
||Long and short selling allowed
|Leverage used sparingly
||Leverage permitted, average 1.6:1 (assets + liabilities/NAV)
||Leverage seldom used
|Mostly open-ended, available to a limited number of qualified institutional investors and selectively retail investors
||Mostly open-ended, available to a limited number of qualified institutional investors
||Generally open-ended, widely available to retail and institutional investors
|Typically large minimum investment
|| Typically large minimum investment
|| Relatively small minimum investment
|Shares or units subject to limited liquidity, normally bought and sold any business day and are required to meet a minimum holding period for redemption but rarely a lock up period
|| Shares or units subject to highly restricted liquidity, can be bought and sold any business day and are required to meet a minimum holding period for redemption but rarely a lock up period
|| Shares or units subject to daily liquidity and can be bought and sold any business day without any notice whatsoever
|Typically achieves consistent positive returns in all market conditions
|| Typically achieves consistent positive returns in all market conditions
|| Inconsistent returns, dependent on rising markets for positive returns
|| Actively managed
|| Actively managed
|Manager's capital often at risk
|| Manager's capital often at risk
|| Manager's capital not at risk
|Fees derived from management fee, manager awarded a percentage of profits
||Fees derived from management fee, manager awarded percentage of profits
||Fees from management fee, manager paid salary and bonus by company
|Highly skilled, experienced and knowledgeable managers
||Highly skilled, experienced and knowledgeable managers
||Generally less experienced and specialized managers
|Restricted from advertising and marketing
||Restricted from advertising and marketing
||Generally very actively advertised
|Tends to be registered investment
||Private investment, loosely regulated when offshore
||Registered investment (US SEC and other exchanges/authorities)
|Loosely correlated to major stock markets and traditional asset classes (diversification benefit)
||Loosely correlated to major stock markets and traditional asset classes (diversification benefit)
||Strong correlation to major stock markets and traditional asset classes (no diversification benefit)
|Table 1: Long-Only Absolute Return Funds, Hedge Funds and Traditional Mutual Funds* *Not including passively managed Index Funds or Tracker Funds
Long-Only ARFs, hedge funds and traditional mutual
funds are clearly distinct from each other, as demonstrated
in Table 1. However, Long-Only ARFs more closely resemble
hedge funds. Like hedge funds, Long-Only Absolute Return
Funds focus on making money, or at least preserving capital,
in both rising and falling markets. In order to achieve this
goal, the skill of a manager is crucial - just like it is
for a hedge fund.
Who Knows Best?
A good chunk of the success of Long-Only ARFs is
attributable to management expertise. Like hedge funds, Long-Only
ARFs are skills-based, employing the ingenuity of seasoned
professionals to analyze securities and markets. Using superior
knowledge, intuition and advanced and innovative techniques,
Long-Only ARF managers are able to pick winning securities
and build significant asset value.
Traditional fund managers typically do not have the impressive
real market experience and top-notch credentials of Long-Only
ARF managers. The following excerpt of manager profiles from
Long-Only Absolute Return Fund Directory 2004, Asia-Pacific
and Global Emerging Markets Edition, points to the exemplary
performance of Long-Only ARFs.
- Mr Wong has 21 years of experience, previously appointed
Head of Citicorp's fund management operations in Japan where
he managed $2 bln in funds. During his five years there,
Wong's listed flagship fund, the Nippon Fund, was ranked
1st and 2nd, among more than a hundred offshore funds.
- Howard began his career in the finance industry as a senior
financial analyst with Investec in South Africa 18 years
ago and then became part of Ernst & Young's Corporate
Finance team in Australia. Howard holds a Masters in Commerce,
is a Chartered Accountant and has successfully completed
the CFA examinations.
- Ms Low holds a CFA and has 18 years' Asian market experience.
Prior to joining in 1997, Ms Low was an analyst with Jardine
Fleming Securities and G K Goh Stockbrokers, and a top-rated
head of research at Baring Securities and UBS Securities
Rewarding Managers for Profitability
The fee structure of Long-Only ARFs has been borrowed
from hedge funds. It is incentive-based to encourage the highest
possible "real" returns and, at least in theory,
to boost allocations from institutions. During good years,
the vast majority of a managers' remuneration above a standard
management fee, which these days ranges from 1.5% to 2.0%,
is derived directly from performance fees. However, before
managers receive any performance-related reward, returns must
reach a "high water mark" and sometimes even a "hurdle
rate" or targeted minimum gross return. A performance
fee of 20% net of all other fees is the current market rate
attached to hitting a high watermark.
Long-Only ARF managers often take a personal financial
stake in the funds they manage. This practice also originates
from hedge funds and is intended to spur solid fund performance.
Although there are obvious limitations, it follows that the
more of his own cash a manager places in the fund he manages
the greater the chances for above-average returns. It's no
surprise therefore that institutional investors are willing
to increase the size of their commitments to Long-Only
ARFs once a manager's stake exceeds $1 mln. Conversely, traditional
fund managers lack performance incentives and accordingly
have nothing special to offer even the biggest index-riders
other than rock-bottom management fees, now 0.5% and falling.
What's more, the moral hazard associated with traditional
fund managers is better contained for Long-Only ARF
managers, meaning they are less prone to taking unnecessary
investment risks with other people's money.
Indexed Assets are Dull and Rigid
Another key characteristic shared by Long-Only ARFs
and hedge funds is flexibility. Long-Only ARFs can
pursue investment strategies that are much more flexible than
those of traditional funds even though they lack the ability
of hedge funds to exploit long and short positions for capital
gain. Traditional funds that are actively managed cannot make
the same bold investment and trading decisions that Long-Only
ARFs can. Plain-vanilla funds, for example, allocate investment
to just one asset class, usually equities, and are fully or
largely invested in heavily weighted components of a market
or sector index. Even so-called Asset Allocation Funds, also
known as Balanced Funds or Enhanced Index Funds, which are
a hybrid traditional fund, adhere to prescribed proportions
of equity, fixed income and cash, and are generally restricted
to investing in large cap securities belonging to one or more
Flexibility in Allocation, Selection and Exposure
In contrast, Long-Only ARFs are not beholden to any
index benchmark and have no tracking error. Long-Only
ARFs are agile in terms of asset allocation, securities selection
and exposure levels, including the use of leverage. Long-Only
ARF managers can invest in a virtually unlimited combination
of currencies, fixed income, equities and other asset classes
as long as this tactical mix complies with the fund's prospectus
and pertinent financial regulations. Like other "alpha"
strategies their performance is not determined by the strength
or weakness of the broad market. Instead, at least 50% of
the returns of Long-Only ARFs are explained by security
selection (similar to hedge funds), whereas "beta"
strategies of index-hugging traditional funds derive no more
than 20% of their returns from security selection, while the
balance is a function of macroeconomic and sector-related
Downside Protection for Consistent Returns
Long-Only ARFs safeguard the risk of capital loss
in flat or depressed markets by boosting cash holdings and
reducing exposure to securities that are highly correlated
to the broad market. Unlike traditional funds, Long-Only
ARFs can liquidate assets and exit markets at any time. This
reduction of positive systematic risk helps to preserve capital.
Downside protection also lowers fund volatility which helps
to ensure consistent positive returns. Conversely, traditional
mutual funds cannot provide any buffer against downside risk
or produce dependable income. Typically, cash and money market
instruments are held by indexed funds for technical reasons,
usually at levels below 10% of net asset value.
The one-two combination of flexibility and downside protection
delivered by Long-Only ARFs proved especially effective
throughout the global stock market claw-back from 2000 to
2002. While traditional funds lost a considerable percentage
of their value over three years, most Long-Only ARFs
managed to hang on to theirs and even earn "real"
returns. Little wonder that after enduring one of the deepest
market corrections on record, many investors not only possess
a renewed appreciation for the simple premise that markets
can fall as easily as they rise but are aggressively looking
beyond index investing.
Traditional Funds Are Not So Hot
Institutional investors are perceived to be increasingly
apprehensive about traditional funds. Extended economic frailties
in the US and other G7 nations and sky-high stock valuations
are part of the story. Traditional funds, which depend on
rising markets to make money, appear unlikely to generate
exceptional returns for the balance of this year unless concrete
evidence of a pending US economic recovery quickly materializes.
The fear is that the Fed's easing that has brought short-term
rates to levels last seen 50 years ago is not helping. Also
troubling is the US involvement in Iraq and other foreign
adventures, which could grab about $4 bln per month from US
taxpayers. The US budget deficit for fiscal 2003 is estimated
at a record $455 bln, with the supplemental budget adding
perhaps $50 bln, which could sooner than later impede the
USA's long-term strength.
Sure enough, investors are reassessing their historically
safe portfolio allocation strategies of buying index funds
to buy the broad market (the first passive fund dates from
1971), and buying actively managed Traditional Mutual Funds
that try to outperform an index benchmark have become less
compelling after billions worth of savings were wiped out
over the last three years. Pension funds in particular, whose
liabilities have eroded balance sheets, are making big changes.
Today, the future of traditional funds is in question, as
aptly revealed to Reuters by one fund manager on July 1: "We're
kind of at the trough in terms of the economic cycle and probably
likely to head into a multiyear upturn of some magnitude."
Most investors can no longer afford such wishful thinking,
which has always played a major role in the global market
for indexed funds, now estimated at a whopping $1.7 tln.
Diversification, the Way Forward
Diversification is the most compelling reason for investors
to hold Long-Only ARFs and other alternative investments.
According to Modern Portfolio Theory, investing in a group
of assets or asset classes that are not perfectly correlated
results in a portfolio that has less risk than the sum of
its component parts. In other words, a high level of diversification
reduces risk considerably, often without compromising overall
performance. Many institutions whose portfolios were until
recently concentrated in traditional funds agree that diversification
is the way forward.
Long-Only ARFs tend to be weakly correlated both from each
other and traditional funds across asset classes, sectors
and countries. The weaker the correlation the better the diversification
benefit for investors' portfolios. More specifically, the
extensive array of financial instruments bought and sold by
Long-Only ARFs has created several dissimilar portfolio structures
that have the potential to sharply reduce the risk of capital
loss. To make sense of it all, we have identified several
distinct styles of Long-Only ARFs which characterize their
general investment strategies. These will be highlighted in
Part II of this article.