Absolute return funds: ESG's vital role

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Absolute return funds

Absolute return multi-managed funds are designed to protect capital during market downturns and manage risk optimally. These funds achieve this through an asymmetric investment return philosophy. While they might not capture all the upside in a rising market, their true value is demonstrated during market drawdowns, as they tend to decline less than the overall market.

Supporting asymmetry

The principle of asymmetry is pivotal in investment. An asymmetric investment return philosophy is an investment approach designed to capture more upside than downside. The goal is to participate in market gains while limiting losses during market downturns. Here are the key aspects:

1. Downside protection: The primary focus is on protecting capital during periods of market decline. This means implementing strategies that minimise losses when the market is falling.
   
2. Selective upside capture: While the approach aims to limit downside risk, it also seeks to capture some, but not necessarily all of the gains during rising markets. The objective is to achieve positive returns over time, even if these returns are not as high as those of a fully invested equity portfolio during bull markets.
   
3. Risk management: This philosophy heavily emphasises managing risk. It involves using various techniques such as diversification, hedging, and tactical asset allocation to reduce exposure to market volatility.
   
4. Smoother performance: By capturing more gains than losses over time, an asymmetric investment return strategy aims to provide a smoother performance profile with less volatility compared to traditional investment strategies that are fully exposed to market fluctuations.
   
5. Long-term objectives: The approach is often aligned with long-term investment goals, as it seeks to achieve steady growth while avoiding significant drawdowns that can derail long-term performance.
   

Effective capital protection during drawdowns allows investors to achieve similar or superior results compared to benchmarks without needing to capture every bit of the market's upside. In an absolute return portfolio, this asymmetry leads to lower drawdowns and reduced volatility, providing a smoother performance profile for investors.

Risk management and how ESG fits into the equation

Siphokazi Kayana and Charlene Ferns  27 Mar 2024

Linking drawdown management and upside capture with ESG

Asset managers factor ESG considerations into their investment processes, either to benefit from a return-enhancing opportunity or to mitigate risks in their funds. Both return-enhancing opportunities and risk mitigation fulfil the mandate for absolute return funds by capturing the upside and minimising the downside.

A risk mitigation approach: Managers that adopt a risk mitigation approach to ESG, consider ESG risks in the underlying counters in their portfolios, which may be detrimental to their overall portfolio return. They might choose to adjust their valuation methodology to consider the risk facing the share, constrain their position sizing, engage with company management to influence a positive outcome, or sell the share. This minimises downside capture. If the ESG risk materialises, the share price will decline. Asset managers who appropriately manage this risk will be able to limit their downside participation in the share.

A return-enhancing approach: Asset managers who view ESG through a return-enhancing lens will try to profit from ESG risks (for example, hedge funds can short the share) or, more appropriately for an absolute return framework, will look for ESG opportunities. For example, if a company incorporates socially and environmentally responsible behaviour, it can benefit in the long term from:

• Process efficiency that is less impacted by climate disruptions
  
• Reduced costs through efficient use of energy and raw materials
  
• Reduced penalty costs
  
• Brand recognition via community upliftment

This has the potential to positively impact a company’s share price and assists absolute return strategies with their upside capture mandate.

As more investors recognise the benefits of incorporating ESG factors, absolute return funds will continue to play a vital role in achieving long-term financial and environmental goals.