What Is Absolute Return Gap?
The Absolute Return Gap refers to the discrepancy between an investor's or fund manager's targeted absolute return and the actual absolute return achieved over a specific period. This concept is particularly relevant within the field of Investment Performance Analysis, where the primary goal of an Investment Strategy is to generate positive returns irrespective of market conditions. A positive Absolute Return Gap indicates that the actual returns fell short of the stated objective, while a negative gap suggests outperformance of the target. Understanding this gap is crucial for evaluating the effectiveness of strategies that prioritize positive returns above all else.
History and Origin
The concept underpinning the pursuit of absolute returns gained prominence with the advent of the first Hedge Fund. Alfred Winslow Jones is widely credited with establishing the first "hedged" fund in New York in 1949, aiming to minimize risk and generate positive returns regardless of market direction,6. Early absolute return approaches focused on generating gains independent of traditional market Benchmark indices. Over time, as these strategies evolved and became more sophisticated, often employing techniques like Short Selling, Arbitrage, Derivatives, and Leverage, investors began setting explicit positive return targets. The "gap" became a natural metric to measure the success, or shortfall, against these stated objectives. The rise of absolute return investing, particularly among institutional investors like pension funds, further solidified the focus on achieving specific, positive outcomes rather than merely outperforming an index5.
Key Takeaways
- The Absolute Return Gap measures the difference between an investment's target absolute return and its actual achieved absolute return.
- A positive gap indicates a shortfall in performance against the target, while a negative gap signifies exceeding the target.
- It is a key metric for assessing the success of strategies designed to deliver positive returns in all market conditions.
- The existence of an Absolute Return Gap highlights potential challenges in consistently achieving pre-defined return objectives, even for strategies that aim to be market-agnostic.
- This gap can influence investor confidence and future capital allocations to absolute return-oriented products.
Formula and Calculation
The formula for calculating the Absolute Return Gap is straightforward:
Where:
- Target Absolute Return refers to the specific percentage return an investment or fund aims to achieve over a defined period, independent of any Benchmark.
- Actual Absolute Return represents the realized percentage gain or loss of the investment over the same period, without comparison to a benchmark. This is also sometimes referred to as the total return.
For example, if a fund targets a 5% absolute return for the year and only achieves 3%, the Absolute Return Gap would be 2%.
Interpreting the Absolute Return Gap
Interpreting the Absolute Return Gap involves assessing not just the magnitude but also the consistency and reasons behind the discrepancy. A consistent positive Absolute Return Gap, where actual returns repeatedly fall below targets, suggests that the fund's Portfolio Management may be struggling to execute its strategy effectively, or that the targets themselves are overly ambitious. Conversely, a consistently negative gap indicates that the strategy is regularly exceeding its stated objectives.
For investors, a large positive Absolute Return Gap implies that an absolute return strategy is not delivering on its promise of generating consistent, positive returns. This can be particularly concerning for those seeking capital preservation or non-correlated performance. Fund managers often strive to minimize this gap, ideally achieving a zero or negative gap (meaning targets are met or exceeded) to demonstrate the efficacy of their approach, especially in periods of market Volatility.
Hypothetical Example
Consider an investor, Ms. Chen, who allocates funds to an absolute return Mutual Fund that aims to deliver an annual absolute return of 6%. At the end of the year, after accounting for all gains and losses from positions in Fixed Income, equities, and other instruments, the fund reports an actual Capital Appreciation of 4.5%.
To calculate the Absolute Return Gap:
Target Absolute Return = 6%
Actual Absolute Return = 4.5%
Absolute Return Gap = 6% - 4.5% = 1.5%
In this scenario, the fund has an Absolute Return Gap of 1.5%, indicating that it fell short of its stated annual target by that amount. Ms. Chen would need to evaluate if this 1.5% shortfall is acceptable given her investment goals and the overall market conditions during the period.
Practical Applications
The Absolute Return Gap is a practical concept primarily used in assessing investment vehicles, such as hedge funds and certain alternative mutual funds, that are explicitly managed with an absolute return mandate.
- Fund Selection and Evaluation: Investors, particularly institutional ones like pension funds, use the Absolute Return Gap to evaluate potential and existing allocations. A persistent gap can signal a need for re-evaluation of the fund manager or the strategy itself4,3.
- Performance Reporting: Fund managers often report the Absolute Return Gap to demonstrate how well they are meeting their stated objectives, providing transparency beyond traditional relative performance metrics.
- Risk Management: While absolute return strategies aim for lower Volatility, a significant Absolute Return Gap can highlight unforeseen risks or flawed assumptions in the strategy's construction.
- Asset Allocation Decisions: For Diversification purposes, investors seeking investments uncorrelated with broader markets scrutinize the Absolute Return Gap to ensure these strategies are indeed delivering on their promise of independent, positive returns.
Limitations and Criticisms
Despite its utility, the concept of the Absolute Return Gap and absolute return strategies themselves face limitations and criticisms. One primary critique is that achieving consistent positive absolute returns, regardless of market conditions, is exceptionally challenging and often not guaranteed. Research has shown that many absolute return funds, particularly bond-focused ones, have struggled to consistently meet their ambitious return objectives2. For example, a Morningstar analysis indicated that the average absolute return fund, over a five-year period, significantly underperformed its own return targets1.
Furthermore, the pursuit of absolute returns can sometimes lead to strategies that, while aiming for market neutrality, may still carry significant and sometimes opaque risks, especially through the use of complex Derivatives or high Leverage. Critics also point out that the fees associated with actively managed absolute return funds can be higher than those of traditional funds, making any shortfall in returns (a positive Absolute Return Gap) even more impactful on net investor returns.
Absolute Return Gap vs. Relative Return
The distinction between the Absolute Return Gap and Relative Return is fundamental in investment analysis.
Absolute Return Gap focuses on the difference between a pre-defined positive return target and the actual return achieved by an investment. The emphasis is on generating a positive return in itself, irrespective of how broader markets or specific benchmarks perform. The "gap" signifies a shortfall or outperformance against this internal, self-imposed goal.
Relative Return, on the other hand, measures an investment's performance compared to a specific benchmark, such as a stock market index (e.g., S&P 500) or a peer group. A fund is considered successful in relative return terms if it outperforms its benchmark, even if the absolute return is negative during a market downturn. For instance, if a fund loses 5% while its benchmark loses 10%, it has a positive relative return (outperformance of 5%) despite an absolute loss.
Confusion often arises because both metrics relate to investment performance. However, their goals are distinct: absolute return strategies aim for positive returns in all environments, while relative return strategies aim to beat a given standard. The Absolute Return Gap is a direct measure of how well an absolute return strategy fulfills its core promise.
FAQs
What does a positive Absolute Return Gap signify?
A positive Absolute Return Gap means that the actual return achieved by an investment or fund was less than its targeted absolute return. It indicates a shortfall in performance against the predetermined goal.
Can an Absolute Return Gap be negative?
Yes, an Absolute Return Gap can be negative. A negative gap signifies that the actual return surpassed the targeted absolute return, meaning the investment performed better than expected.
Why is the Absolute Return Gap important for investors?
It's important because it directly measures how well an investment strategy, particularly one focused on Absolute Return, delivers on its primary objective of generating positive returns regardless of market conditions. A persistent positive gap can erode investor confidence and impact long-term financial goals.
Do all investment funds have an Absolute Return Gap?
No, not all investment funds explicitly measure an Absolute Return Gap. This metric is primarily relevant for funds and strategies that have an explicit "absolute return" mandate, meaning they aim to achieve a specific positive return rather than simply outperforming a Benchmark. Traditional Mutual Funds, for example, typically focus on relative return against an index.
How can investors minimize their exposure to a large Absolute Return Gap?
Investors can minimize exposure by carefully researching funds with absolute return mandates, reviewing their historical performance against their stated targets, understanding the underlying Investment Strategy and associated risks, and considering proper Diversification across different investment types and approaches.