Institutional portfolios seeking diversification are choosingAbsolute 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 presentsLong-OnlyAbsolute Return Funds (ARF), the latest entrant in the hedge fund-dominated alternative investment universe.

There is no standard definition forLong-OnlyARFs. Similarly, there is no internationally-accepted definition for hedge funds even though theyve 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 ofLong-OnlyARFs 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 betweenLong-OnlyARFs, Hedge Funds and Traditional Mutual Funds in Table 1.

ALong-OnlyAbsolute 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-OnlyARFs 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.

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

Leverage permitted, average 1.6:1 (assets + liabilities/NAV)

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

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

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

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-OnlyARFs, hedge funds and traditional mutual funds are clearly distinct from each other, as demonstrated in Table 1. However,Long-OnlyARFs more closely resemble hedge funds. Like hedge funds,Long-OnlyAbsolute 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.

A good chunk of the success ofLong-OnlyARFs is attributable to management expertise. Like hedge funds,Long-OnlyARFs are skills-based, employing the ingenuity of seasoned professionals to analyze securities and markets. Using superior knowledge, intuition and advanced and innovative techniques,Long-OnlyARF 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 ofLong-OnlyARF managers. The following excerpt of manager profiles fromLong-Only Absolute Return Fund Directory 2004, Asia-Pacific and Global Emerging Markets Edition, points to the exemplary performance ofLong-OnlyARFs.

Mr Wong has 21 years of experience, previously appointed Head of Citicorps fund management operations in Japan where he managed $2 bln in funds. During his five years there, Wongs 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 & Youngs 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 in Singapore.

The fee structure ofLong-OnlyARFs 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-OnlyARF 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. Its no surprise therefore that institutional investors are willing to increase the size of their commitments toLong-OnlyARFs once a managers 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. Whats more, the moral hazard associated with traditional fund managers is better contained forLong-OnlyARF managers, meaning they are less prone to taking unnecessary investment risks with other peoples money.

Another key characteristic shared byLong-OnlyARFs and hedge funds is flexibility.Long-OnlyARFs 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 thatLong-OnlyARFs 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 indices.

Flexibility in Allocation, Selection and Exposure

In contrast,Long-OnlyARFs are not beholden to any index benchmark and have no tracking error.Long-OnlyARFs are agile in terms of asset allocation, securities selection and exposure levels, including the use of leverage.Long-OnlyARF 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 funds 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 ofLong-OnlyARFs 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 factors.

Long-OnlyARFs 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-OnlyARFs 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 byLong-OnlyARFs 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, mostLong-OnlyARFs 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.

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 Feds 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 USAs 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: Were 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 is the most compelling reason for investors to holdLong-OnlyARFs 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-OnlyARFs 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 byLong-OnlyARFs 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 ofLong-OnlyARFs which characterize their general investment strategies. These will be highlighted in Part II of this article.