It is a category of mutual funds that does not consider relative return at all
While considering an investment, return is an important aspect. Its easy to assess return for fixed-income investments as there is a fixed rate. But its difficult to judge the performance of investments where return is uncertain.
Investment managers manage portfolios in two basic ways: on the basis of absolute return or on relative return.
Absolute return shows the gains or losses of a particular investment. Lets say your large-cap equity mutual fund scheme, which you have held for a year, has delivered 10% profit. This is your absolute return. But this number is not enough to judge whether your investment has done well or not. There are many similar schemes out there and you will know your schemes standing only when you compare it with others.
You can also compare with the benchmark index that the mutual fund scheme uses. As soon as you get into this kind of comparison, it means you are talking about relative return. Mutual funds are structured for relative return and compare performance either against a peer group of similar funds or against the stated benchmark. This makes it easier for the investor to assess performance.
There is, however, a category of mutual funds that does not consider relative return at all. Absolute return funds aim to achieve a defined level of positive return by using varied investment techniques. Hedge funds are one such category. A hedge fund can use various types of securities and assets to achieve a positive return. For example, in the same hedge fund, the fund manager may be able to buy equity, debt and currency as assets. Moreover, she may be able to invest in derivatives and indulge in both buying and short selling. Unlike mutual funds, hedge funds are typically not dependent on any trend in a particular asset class and often make returns by going against a trend or predicting the turn of a trend in advance. Thanks to the complicated strategies they use, it is difficult to compare the return of one hedge fund with another, and by design they become absolute return funds.
There are simpler forms of absolute return funds wherein the mandate specifies only one asset, for example, equity or fixed income. But within that asset, it can use multiple strategies to achieve return. Again, using multiple strategies makes comparison difficult, even with a benchmark. Typically, benchmarks are indices that are designed to give positive return only when asset prices increase. Dynamic bond funds are an example of a simple absolute return fund. Such funds can invest across the spectrum of fixed income securitiesbe it long dated or money market securities, corporate or government bonds. Moreover, each fund manager uses a different mix of securities so comparing returns may not help. However, unlike hedge funds, which can invest anywhere and a target return is often preset, in dynamic bond funds, you can compare the fund management skills as the underlying universe of securities is limited and shared.
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