Absolute return: The search for positive returns in changing markets

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DB Advisors

Deutsche Bank Group

Absolute return: The search for positive

returns in changing markets

Tuesday, 7 June 2011

www.dbadvisors.com

Gordon Ross

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Deutsche Bank Group Gordon Ross

Topics for discussion

— What is absolute return?

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DB Advisors

DB Advisors Global Fixed Income Seminar 2011

What is absolute return?

— A fund or mandate whose strategy is to preserve capital and

consistently achieve positive returns

— Absolute returns:

–

Generally measured against cash

–

Can be measured against a ‘real’ return objective or against a nominal

return target

— Performance should be positive in all market environments

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Absolute return is not…

…the same as ‘total’ return

–

‘Total’ return performance is generally relative to a market benchmark

or against a universe of similar managers

–

‘Total’ return will give investors market returns plus a margin. Over a

cycle this can be negative

…necessarily a hedge or leveraged fund, but most hedge funds employ

absolute return strategies

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DB Advisors

Examples of absolute return strategies

Descriptions illustrate a wide range of strategies:

—

Absolute return strategies aim to deliver a specified target return above the

risk-free rate, while protecting against capital losses in any short sub-period

—

Absolute return strategies aim to deliver a specified target return above the

risk-free rate, while protecting against capital losses over the short- to

medium-term

—

Target returns above risk-free rate are to be achieved in the long-term.

Short- to medium-term negative returns can occur

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Characteristics of absolute return strategies

— A fund or mandate that separates ‘alpha’ from ‘beta’

— Uses well-diversified investments

— Ability to take long and short positions

— May be able to use limited leverage (UCITS 3 funds)

— Neutral cash position*

— Rigorous risk controls

— High level of transparency

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DB Advisors

Why are absolute return strategies needed?

— Interest rates (and short dated bond yields) are low

— Investors in cash/short bonds are looking for higher returns, without

taking substantial ‘beta’ risk

— Demand for solutions/strategies that work in all environments and

are not dependent on a single strategy

— Investment alternative if rates and yields start rising

— Used in asset allocation, absolute return strategies can dampen

overall risk

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Who uses absolute return strategies?

–

Pension funds

–

Central banks

–

Asset managers/allocators

–

Fund of fund managers

–

Private clients

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DB Advisors

Who manages absolute return strategies?

–

Traditional asset managers

–

Hedge funds

–

Proprietary trading desks

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Sources of alpha

–

Macro

–

Duration

–

Yield curve

–

Inflation breakeven

–

Country and credit spread

–

Micro

–

Investment-grade credit

–

High yield credit

–

Emerging markets

–

Currencies

–

Securitized assets

–

Equities

–

Commodities

Instruments

–

Up to 100% in physical cash plus

additional 100% in derivatives

(long or short) (UCITS 3 rule)

–

Long positions

–

Short positions

–

Futures

–

Forwards

–

Swaps

–

CDS (single name and index)

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DB Advisors

Types of absolute return strategies

—

Funds using all asset classes on an opportunistic basis

—

Pure fixed income related funds (no equities, commodities or convertibles)

—

Funds with measured risk goals, rather than return objectives

—

Directional strategies

—

Relative value strategies

—

Yield curve strategies

—

Sector strategies

—

Multi-strategy

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How do absolute return strategies achieve returns?

— Efficient use of capital

— Ability to identify multiple investment opportunities

— Identification of ‘alpha’ against ‘beta’

— Use of derivatives

— Focus on risk

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DB Advisors

What does an absolute return manager need?

— Investment process that has strong investment disciplines and

transparency

— Full spectrum of investment ideas – large team – resources

— Specialist investment skills – derivatives, risk

— Coverage of all areas of markets – government, credit, EM, FX

— Extensive research of key drivers

— Ability to design correct product

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What to look for in a absolute return manager

Checklist of manager attributes:

— Investment process

— Manager’s experience in both long and short strategies

— Manager’s performance/volatility track record

— Approach to leverage

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Performance of managers has varied

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Source: Bloomberg – June 2011. For illustrative purposes only. Past performance is no guarantee of future

results

Index=100 on 7/1/2008

Absolute return manager performance: July 2008 to May 2011

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How have absolute return strategies performed?

July 2008 to May 2011

— Many products have been shown to be beta products – no alpha

— A number of failing products relied too heavily on credit and

illiquid alpha sources

— Products relying on macro strategies have performed better, on

a relative basis

— Volatility has been major divider between some products

— Some products appear to be fatally damaged in recent history

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Dispersion increased during the crisis

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Source: Bloomberg – June 2010. For illustrative purposes only. Past performance is no guarantee of future results

Index=100 on 7/1/2008

Absolute return manager performance: July 2008 to Dec 2008

80.00 85.00 90.00 95.00 100.00 105.00 110.00 115.00 120.00 1/7/08 1/8/08 1/9/08 1/10/08 1/11/08 1/12/08

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How have absolute return strategies performed?

H2 2008

— With low yields some were tempted into illiquid sectors

— Credit crunch and redemptions illustrated failings of design

— Many adopted highly rated ABS/MBS

— Even rated funds performed no better

— Forced liquidations meant losses were locked in

— Assets fell by over 75% – some funds closed

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DB Advisors

Manager performance rebounded in 2009

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Index=100 on 12/31/2008

Absolute return manager performance: 2009

90.00 95.00 100.00 105.00 110.00 115.00 120.00 125.00 130.00 31/12/08 31/3/09 30/6/09 30/9/09 31/12/09

Manager A Manager B Manager C

Manager D Manager E Manager F

Manager G Manager H Manager I

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How have absolute return strategies performed?

2009

— Further fall in risk appetite in Q1 2009 showed credit funds

— Overall recovery in NAV’s / performance reflected asset class focus

— Recoveries proved that ‘concept’ is successful

— Investors become more focused on volatility and manager

disciplines

— Major differences are in the product designs

— Returns overall were positive

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2010 was a challenging year for managers

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Index=100 on 12/31/2009

Absolute return manager performance: 2010

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How have absolute return strategies performed?

2010

— 2010 has seen risk appetite decline and Euro deficit concerns

— Most funds have been affected

— NAV volatility has increased and become a focus

— Even well diversified products have been affected by asset class

contagion

— Will be interesting to see how performance develops

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DB Advisors

2011 continues to present challenges for managers

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Index=100 on 12/31/2010

Absolute return manager performance: Year-to-date May 2011

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Implications for absolute return strategies

— Absolute return strategies will become increasingly popular as

rates/yields rise

— Need to be very diligent in manager selection

— Ensure a multi-strategy, disciplined and transparent investment

approach

— Focus on volatility as well as returns

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DB Advisors

Contact

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DB Advisors

1 Appold Street, Broadgate

London, United Kingdom EC2A 2HE

www.dbadvisors.com

Gordon Ross

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