Investment Primer: Alternative – Absolute Return Composite

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Comprehensive guide to understanding, navigating, and evaluating Alternative: Absolute Return funds.

Last Revised: June 2025

Understanding the Absolute Return Mandate

The Alternative: Absolute Return composite includes strategies that aim to generate positive returns regardless of the direction of traditional equity and fixed income markets. These funds differ from conventional funds by focusing on delivering a positive result rather than outperforming a market benchmark. This section explains the core philosophy of absolute return investing and details the primary strategies within the composite.

The Core Philosophy: A Shift from Relative to Absolute

Traditional investment management is typically evaluated on relative performance. For example, if a market index falls 15% and a fund tracking it falls only 10%, the fund is considered to have “outperformed,” even though the investor lost money.

Absolute return investing breaks from this model. The objective is not to beat a benchmark but to achieve a positive return over a market cycle, often aiming to exceed a cash-equivalent rate like SOFR. The goal is a return greater than zero after fees, regardless of market conditions.

This means an absolute return strategy is not designed to be a portfolio’s primary growth engine during strong bull markets and will likely underperform traditional equity funds in those periods. In exchange for forgoing some upside, investors seek capital preservation during downturns, lower volatility, and a source of returns uncorrelated with traditional assets. The main benefit of an absolute return fund is its potential to provide stability and positive performance when other parts of a portfolio are struggling.

Deconstructing the Categories: A Deep Dive into Strategy

The Absolute Return composite is grouped into three categories, each with a different approach to achieving its objective.

Event-Driven Strategies

Event-driven strategies seek to profit from price movements related to specific corporate events, such as mergers, acquisitions, or bankruptcies. Managers focus on company-specific situations rather than broad market trends. Key sub-strategies include:

  • Merger Arbitrage: This involves capturing the “spread,” or the small price difference between a target company’s stock price and the acquisition price, after a merger is announced. The return depends on the deal’s successful completion, not the market’s direction.
  • Distressed Investing: This strategy focuses on the securities of companies in or near financial distress. Investors analyze these opportunities to identify undervalued assets that may recover if the company successfully reorganizes.
  • Special Situations: A broader category covering other corporate events like spin-offs, share buybacks, or liquidations where a specific catalyst is expected to affect a security’s price.

Managed Futures (CTAs)

Managed futures strategies, often run by Commodity Trading Advisors (CTAs), take long and short positions in futures contracts across global equities, bonds, currencies, and commodities. These strategies are typically systematic, using quantitative models to identify and follow price trends (momentum). Because they can profit from both rising and falling markets across diverse assets, their returns are often uncorrelated to traditional stock and bond portfolios.

Multi-Strategy

Multi-Strategy funds combine several distinct alternative strategies—such as event-driven, managed futures, and global macro—within a single portfolio. The goal is to provide diversification within the fund itself, as the underlying strategies often have low correlations to one another. This can lead to a smoother return stream compared to a single-strategy fund. However, evaluating these funds requires assessing both the underlying strategies and the manager’s skill in allocating capital between them.

A Practical Guide to Locating Funds in the ETF Action Database

A proper peer group is essential for any comparative analysis. The ETF Action classification system allows users to screen for and refine a list of Absolute Return funds.

Note: A good starting point for ETF research is exploring the Alternative Composite ETF Dashboard, which groups all alternative ETFs first by composite and then by category. ETF Composite Dashboards include basic reference data (ER, AUM, ADV) along with daily returns and flows updates, and provide hyperlinks to the ETF Database for deeper analysis.

Foundational Screening: Building the Initial Universe

The first step is to use the top-level classification filters to isolate all funds within the Absolute Return composite.

  • Step 1: Select the Database. Navigate to the ETF, Mutual Fund, or other desired database.
  • Step 2: Filter by Asset Class. Select Asset Class = Alternative to narrow the universe to non-traditional strategies.
  • Step 3: Filter by Composite. Select Composite = Absolute Return to isolate funds with this specific mandate.
  • Step 4: Filter by Category (Optional). To focus on a specific approach, select Category = Event Driven, Managed Futures, or Multi-Strategy.

Advanced Filtering: Screening for Outliers and Refining Peer Groups

After the foundational screen, the list can be refined by screening for outliers based on key data points. This helps create a more relevant group for comparison by removing funds that may be too small, expensive, or illiquid.

  • Brand (Issuer): Investors may prefer to stick with established fund providers. Screening by brand allows an analyst to focus on issuers with a long tenure and a demonstrated commitment to the alternative space.
  • Assets Under Management (AUM): AUM can indicate a fund’s stability and investor acceptance. Setting a minimum AUM threshold (e.g., >$100 million) can screen out smaller funds that may face viability risks. Persistent outflows can also be a red flag.
  • Expense Ratio: Absolute return strategies tend to have higher fees, but costs can vary. Screening by expense ratio can eliminate high-cost outliers, as fees are a direct hurdle to achieving positive returns.
  • Liquidity (ETFs only): For ETFs, liquidity is critical. Metrics like average daily trading volume and bid-ask spreads can be used to screen out illiquid funds, which can be difficult and costly to trade.

A Framework for Evaluating Absolute Return Funds

Evaluating Absolute Return funds requires a specialized approach. Traditional metrics, like comparison to the S&P 500, are inappropriate because the goal is not to capture market upside but to generate consistent, positive returns with low volatility and low correlation to traditional assets.

Quantitative Analysis: A Non-Traditional Toolkit

The quantitative evaluation of an absolute return fund should focus on the quality and characteristics of its performance, not just the raw return figure. All of the data points discussed in this section can be sourced directly from ETF Action’s databases and reporting tools.

Measuring Performance and Skill

Risk-adjusted metrics provide a more insightful view of performance than total return alone.

  • Risk-Adjusted Returns:
  • Sharpe Ratio: Measures return per unit of total risk (volatility). A higher Sharpe Ratio indicates better risk-adjusted performance and is a key metric for comparing strategies.
  • Sortino Ratio: A variation of the Sharpe Ratio that only considers downside volatility. It can be a more intuitive measure for strategies focused on capital preservation.
  • Information Ratio: Assesses the consistency of a manager’s excess returns over a benchmark (consider using a cash rate for these types of funds). A higher ratio suggests more consistent performance.

Deconstructing Risk and Diversification

The primary role of an absolute return fund is to be a diversifier. Analyzing its risk and correlation is therefore essential.

  • Volatility (Standard Deviation): Measures the dispersion of returns. A key objective is to deliver returns with significantly lower volatility than equity markets.
  • Maximum Drawdown: Captures the largest peak-to-trough decline a fund has experienced. It is a critical measure of downside risk and capital preservation.
  • Correlation and Beta (β): These are the definitive tests of a fund’s diversification benefit.
  • Correlation measures how a fund’s returns move in relation to another asset. A low or negative correlation to traditional assets is desirable.
  • Beta measures a fund’s sensitivity to market movements. A beta close to zero indicates low sensitivity and is a key feature of a good diversifier.

Understanding Fund Behavior in Market Cycles

Dynamic measures can provide a more granular view of performance patterns.

  • Upside/Downside Capture Ratios: Show the percentage of a benchmark’s gains or losses a fund captures. An ideal profile is low downside capture (protecting capital) and reasonable upside capture.
  • Batting Average: Measures the percentage of periods (e.g., months) in which the fund achieved a positive return. A high batting average demonstrates consistency.

A fund that is an effective diversifier will almost certainly lag equity markets during strong bull runs. The evaluation must be framed against the fund’s stated objective and its role as a portfolio stabilizer, not against a hot market.

Qualitative Analysis: Looking Beyond the Numbers

While the numbers show what a fund has done, they don’t explain how or why. This is especially true for absolute return funds. While some funds in this category track an index, these are rarely transparent, broad-market indexes. More often, they follow proprietary, rules-based methodologies that are not always transparent. Whether the fund is actively managed or follows a complex, in-house index, you are ultimately investing in a specific process. Looking under the hood is essential.

This requires getting comfortable with the people and the playbook behind the fund. Start with the basics: who is the portfolio manager or the index committee? What is their experience, especially through difficult market cycles? High turnover on a management team can be a red flag. It’s also worth checking the parent company. Does the firm have a solid, long-term commitment to alternative strategies, or a history of launching and closing funds when they’re no longer trendy?

Next, dig into the fund’s strategy or methodology. For an active fund, the manager should clearly explain their investment process. For an index-based fund, you need to understand the index construction rules. The explanation should match the fund’s actual performance and behavior. A fund claiming to be market-neutral shouldn’t have returns that move in lockstep with the S&P 500. Pay close attention to how risk is managed. A disciplined, repeatable process for managing risk is non-negotiable, especially when strategies involve derivatives or leverage.

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