A “concrete” measure of absolute returns?

Back in October 2008, just as hedge funds were about to experience the completion of their worst year ever, we likened the creation of the moniker “absolute returns” to George W. Bush’s premature declaration of “Mission Accomplished” in Iraq.  What are “absolute returns” anyway?  Returns that are positive every month?  Every quarter?  How about every year?  Does the hedge fund industry’s -20% return in 2008 mean that hedge funds failed in their aim of producing absolute returns?

As we later observed, 2008 was actually the best year of relative returns in the history of the hedge fund industry.  No matter, critics argue: hedge funds provided the promise of absolute returns are there was a big fat minus sign in front of 2008’s results.  Relative returns are a cop-out, some said.  What matters are absolute returns.

The absolute result of great relative returns didn’t reveal itself until last month when the HFRI Composite Index surpassed its all-time high thanks to its “relatively” modest negative results in 2008.  In other words, hedge funds produced absolute returns over the past 2.5 years.  Does that count?  (It should.)

Who knows.  “Absolute returns” were a hedge fund marketer’s best friend until 2008.  I know since  I was one (a hedge fund marketer, not a best friend, necessarily).  Today, mutual funds are wrapping themselves in the absolute return flag as they scramble for a way to move beyond the extreme volatility they have become known for in the past three years.

A paper by Deniz Tudor from San Francisco State University and Bolong Cao of Ohio University explores whether hedge funds actually do provide “absolute returns.”  This is a critical question given the penchant for hedge funds to liberally invoke this term in marketing presentations.  As Tudor and Cao warn us:

“…investors need to know whether the absolute return attribute in the hedge fund industry is actually “true” or merely a marketing gimmick…as more and more portfolio managers consider allocation to alternative investments such as hedge funds in their portfolio, they also need to know what kind of hedge fund managers are more likely to be producer of “true” absolute returns.”

They say that returns need not be 100% positive in order to be “absolute” – only that they be “asymmetric”.  Or, to borrow again from the hedge fund marketer’s lexicon, “equity like upside with a bond-like downside.”

Regular readers – and CAIA members – will recall that “Asymmetric Returns” was the name of a book by author and CAIA board member Alexander Ineichen.  According to Tudor and Cao, Ineichen’s passion for the concept of absolute returns wasn’t exactly shared by member of the academic community – perhaps because it’s notoriously difficult to define.

“Even though there have been numerous research papers written about hedge funds in recent years, the only literature directly addressing the absolute returns and the asymmetric returns of hedge funds are the two books written by Ineichen.”

The duo builds on one of Ineichen’s major themes: that infrequent, but dramatic stock market crashes destroy wealth through negative compounding.  Ergo, absolute return strategies increase long-term returns by essentially truncating the left tail of the traditional (stock market) return distribution.

But instead of looking at fund results as a set of discrete monthly returns, they examine them as a large series of interlaced holding period returns (HPR).  They say that such an approach “has several advantages” – chief among them the fact that a series of monthly returns “reflects the compounding effects of negative returns.”  Given that research shows serial correlation in hedge fund returns, the order of returns can be quite material.

Tudor and Cao then apply a simple set of rules to the resulting distribution of HPR.  If the 75th percentile of the HPR distribution of a fund is higher than that of stocks (S&P 500) and if the 50th percentile is higher than that of bonds (Barclays US Treasury bond index) AND the number of negative HPR is lower than that of bonds, then the fund is said to produce “absolute returns.”  Anything else does not deserve to be called “absolute returns” according to the authors.  The diagram below is a slightly reformatted version of one contained in their paper:

Only about 30% of hedge funds in the CISDM database qualify as “absolute return” using this definition.  They tended to use “options arbitrage,” “fixed income – MBS,” “global macro,” emerging markets (yes, emerging markets) and event driven strategies.  They also had a higher likelihood of using a high water mark and hurdle rate.  And surprisingly, they had a higher likelihood of actually calling themselves an “absolute return” fund.  In other words, they may- on average – stay true to their word.  Go figure…

Absolute Return is an ethereal concept – one caught between the aspiration of fund managers and the pragmatism of investors.  So we guess it’s no surprise that despite the ubiquity of the term, there is a dearth of research on the topic.  This study constitutes a rare attempt to provide a “hard” definition, or as Tudor and Cao write:

“…our classification scheme assigns the description “equity-like returns on the upside and much more bond-like volatility on the downside” a concrete measure.”

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