FOR PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY Guide to absolute return investing January 2018 September 2016
Page What is absolute return investing? 2 What are the main investment techniques? 4 What are the risk parameters and controls? 9 Conclusion: an investment style for all market conditions 11 Glossary of key terms 12
What is absolute return investing? Long-only funds Use the traditional way of investing where an asset, like a share or bond, is purchased and the return is simply dependent on how it performs over the period it is held. Seek relative outperformance of a benchmark, such as a stockmarket index or a given peer group. Absolute return investing aims to produce a positive return over time, regardless of the prevailing market conditions. Even when markets are falling sharply, an absolute return fund still has the potential to make money, although this is never guaranteed. Producing positive returns is the key objective for an absolute return fund. Investment gains can never be guaranteed, but by using a range of techniques not available to traditional fund managers, absolute return funds are capable of generating smoother returns throughout the market cycle. 2 GUIDE TO ABSOLUTE RETURN INVESTING
Absolute return funds are different to traditional investments because they: Aim to beat the long-term returns from cash, over time. Typically, the aim is to do so on a rolling 12 month basis, however, there is no guarantee this will be achieved over all periods. Seek consistently positive results by deploying techniques that are able to profit from both the ups and downs in markets and stock prices. Have a lower correlation to the pattern of returns from other asset classes. Are not benchmarked against a specific index/sector. However there are some risks to be aware of: Returns are not guaranteed. Can underperform long-only in rapidly rising markets. Both positive and negative market movements may affect the overall value of the fund. While conventional funds still have a fundamental role to play within a diversified portfolio, the potential of absolute return funds to generate positive returns regardless of market conditions means they could prove a popular choice for investors attempting to shield themselves from possible volatility. RISK Past performance is not a reliable indicator of current or future results. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time. 3
What are the main investment techniques? Absolute return fund managers can employ a number of techniques to try and make a profit for their fund. The most common are long investing, synthetic short investing, pair trades and holding cash. By combining a variety of approaches and having the freedom to hold high levels of cash, absolute return fund managers aim to make money and also reduce risk within their portfolios. The range of strategies can be applied to a number of different assets such as bonds, commodities and equities. Long investing This is the traditional form of investing. Shares are purchased in a company and the return will depend on how these shares perform. Managers will invest in shares they believe will do well, based on their own research. These holdings will be sold over time, hopefully at a profit though this cannot be guaranteed. Long investing: an example Following in-depth research, a manager likes the prospects for Company A and purchases 10,000 shares at 5 each for his fund ( 50,000). As the fund owns the stock, it has a long position of 10,000 shares. Over the next 12 months, the manager s positive view proves to be correct and Company A s share price rises by 20%. The manager now believes that the shares are over-valued and decides to sell them all. The manager receives 60,000 from the sale, realising an ultimate profit of 10,000 (or 20%) for the fund over the investment period. 4 GUIDE TO ABSOLUTE RETURN INVESTING
Traditional investing Generate returns from rising stock prices Avoid falling stocks Sell Long Buy Long Absolute return Falls rises Avoid Time Synthetic shorting Shorting allows a fund to benefit from falling share prices. When conducting research, managers will invariably identify stocks they believe will perform badly as well as those they believe will perform well. They can profit from this by predicting that the share prices of the unfavoured companies will fall, and trading accordingly by shorting the share. Actual shorting (selling a stock the fund doesn t own) is not permitted under UCITS legislation but synthetic shorting (where a derivative contract is used to deliver the same economic effect) is, by entering into what is known as a contract for difference (CFD). Contracts for difference (CFD) This is one of the most commonly used derivatives for these types of funds. It is an agreement between two investors. One will have a positive view on a stock and one will have a negative view. At the outset, they record the prevailing price of the stock, known as the trade price and agree to enter into a contract for a set period of time say three months. When the three months is over, the stock will be trading at a new price, known as the close-out price. If the price has risen, the investor with the negative view will have to pay the difference between the close-out price and the trade price to the investor who had the positive view, (whose expectations proved correct. Conversely, if the price has fallen, the positive investor will have to pay the difference to the negative investor. 5
CFDs are not only used for short contracts. They can also be used to gain long exposure to a favoured stock, as an alternative to buying the shares directly. Using CFDs, a fund manager could gain more exposure to the stock than he or she could by using a conventional buy and hold strategy. For example, say a fund manager with 100,000 available for investment has a positive view on a company. Rather than buy 100,000 worth of shares, he or she could use a proportion of that money as the collateral for a CFD, giving the fund exposure to the company equivalent of an investment of 100,000. The fund manager can then use the remaining capital to access other attractive opportunities, leveraging the fund s exposure to a wider range of prospects. Synthetic shorting: an example Investor A = The fund Investor B = The counterparty A CFD is entered into by two investors for 10,000 shares at a trade price of 2.00. Investor A believes the shares of a company will fall in value while Investor B believes they will rise. The contract specifies a term of six months and they agree to pay the difference to whoever is proved correct. In six months' time, the price of the stock has fallen to 1.65 a share. This is the close-out price. Investor A, who has taken the short position, has been proven correct. Investor B, who took the long position, has to pay the difference between the trade price and the close-out price which equals 35 pence on each share in the contract to Investor A, who makes a profit of 3,500. If the price had risen over the period, Investor B would have gained. Credit default swaps (CDS) Taking a short position on a bond is achieved in a different way to shares. In this scenario, fund managers use a derivative called a credit default swap (CDS). In effect, the managers are entering into an insurance policy. They pay the issuer of the CDS a premium and, if the underlying security goes into default, the CDS issuer will 6 GUIDE TO ABSOLUTE RETURN INVESTING
reimburse them with the value of the bond. If the managers do not hold the bond, they are effectively shorting the security as they will profit if it goes into default. If the price of the bond falls, the CDS rises in value and can be sold on or cancelled at a profit. Long/short investing Generate returns from falling stock prices Price Buy Sell Long Return Long Short Absolute return Falls rises Time Sell Short Close out Short Pair trades This is a technique that allows a fund manager to eliminate a high degree of market risk from a trade while harnessing the full range of his or her stock-picking skills. The trade aims to turn a profit through changes in the relative value of two securities. Two investments in separate companies in the same sector are combined one a traditional long position, the other a synthetic short. As opposite positions are being taken in companies within the same industry, systematic risk is largely eliminated, as the direction of the overall market is mostly irrelevant. Pair trades allow fund managers to express their views on individual companies. Their research of a sector may have led them to believe that one particular company will thrive while another will struggle. By buying the shares in the one they favour, and by synthetically shorting the shares of the one they dislike, they are seeking to exploit the difference in share price performance between the two companies. Even if the shares of both companies fall, the manager will still profit if their preferred stock falls by less than the unfavoured one. 7
This is a good demonstration of how an absolute return fund manager can make money in any environment: if a market is rising or falling, profits can still be made if the manager s stock pairing decisions are successful although profits cannot be guaranteed. Pair trade: an example A fund manager has been studying the mining sector and is enthusiastic about Miner A. He has also met with Miner B and was unimpressed and believes the company will underperform. He therefore takes a long position in Miner A and takes out a synthetic short on Miner B. The stockmarket performs poorly over the next nine months. The price of Miner A s shares fall by 5% while Miner B s shares drop by 15%. The fund manager closes both positions and profits by 10%. His loss of 5% on Miner A s shares is offset by a 15% profit made from the synthetic shorting of shares in Miner B. 8 GUIDE TO ABSOLUTE RETURN INVESTING
What are the risk parameters and controls? A fund that has long and short exposures of equal propotions in the same market should broadly be carrying no risk to the market at large. It is said to be market neutral and returns would come from the fund manager picking the right stocks. Market leverage UCITS funds are not permitted to borrow to finance investments. However, they can use derivatives to gain what is called market leverage. A derivative typically involves only a small initial payment for which the fund manager obtains the same exposure to a company as if buying or selling the physical shares. Therefore a fund can potentially have exposure to a portfolio of shares which is larger than the value of its net assets allowing a much wider set of opportunities than a traditional fund. This leverage could increase profits when a fund manager is successful, but conversely, increases the overall risk profile of the fund and could amplify any losses. Market leverage calculations Gross exposure The sum of the fund s long and short exposures as a percentage of net asset value (NAV). As derivatives allow the use of smaller amounts of capital to provide exposures, the long and short sides may each be worth more than 100% of the fund s assets. For example, if a fund is 110% long and 100% short, its gross exposure would be 150%. Net exposure The fund s long exposures minus the short exposures (both as a percentage of NAV). For example, if a fund is 110% long and 100% short, its net exposure would be 10%. Net exposure takes into account the benefits of offsetting long and short positions. 9
Value at risk (VaR) Absolute return funds which are UCITS-compliant are governed by rigorous controls which constantly measure the risk that all assets, including derivatives, introduce to the portfolio. The principal measure that managers use is called Value at risk ( VaR ). This monitors the downside risk of the portfolio given its market exposure and assesses the extent of losses that are likely in the event of any sharp market movement. 10 GUIDE TO ABSOLUTE RETURN INVESTING
Conclusion: an investment style for all market conditions Absolute return investing covers a wide range of investment styles, asset classes and levels of risk, with many having set limits on their long and short exposures. Some examples are: Equity-based investing. Lower-risk bond or cash investments. Attempting to reduce market risk by balancing long and short positions, known as market neutral. Some strategies follow the direction of a particular market, known as directional. RISK Past performance is not a reliable indicator of current or future results. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. There are no guarantees that a particular investment strategy will succeed. Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time. 11
Glossary of key terms Contracts for difference (CFD) Credit default swap (CDS) Default Derivatives Futures Gross exposure Market leverage Net exposure Long investment / long-only Options Pair trade Relative return fund Short investment / short-selling, or shorting Synthetic short UCITS A derivative that provides an efficient way to gain exposure to a security. CFDs allow investors to participate in the price movement of a stock without actually owning it. They can be used to gain either a long or a short exposure. A contract similar to an insurance policy that protects the purchaser against the risk of a bond issuer going into default. If a CDS is purchased by an investor who does not own the bond in question, they are looking to profit from any financial difficulties that the issuer may have. In effect, shorting the bond. When a bond issuer fails to make an interest payment on a bond or if it cannot pay back investors original capital it is said to be in default. A collective term for financial instruments which derive their value from an underlying security, such as individual shares or bonds, commodities or a collection of securities like a stock market index. Contracts to buy or sell an asset at a future date and at a fixed price, agreed upfront. The sum of the fund s long and short exposures (both as a percentage of net asset value (NAV). A situation where a fund has exposure to a portfolio of assets larger than the total value of its own net assets. Leverage can be achieved by purchasing derivatives, where an exposure can be bought for a fraction of the cost of physically buying the asset. The fund s long exposures minus the short exposures (both as a percentage of NAV). The traditional way of investing where an asset, like a share, is purchased and the return is simply dependent on how it performs over the period it is held for. The right but not the obligation to buy or sell an underlying asset at a certain date in the future. A trade that combines a long and short position in two stocks, normally within the same industry sector. The investor is making a judgement call that one company (which they have a long position in) will outperform the other (which they have a short position in). As both companies are in the same sector, market risk is largely eliminated. A fund which aims to outperform relative to a benchmark, such as a stock market index or a given peer group. Unlike absolute return funds, most traditional funds seek relative outperformance. Selling an asset you do not own with the aim of buying it later at a lower price to secure a profit. Physical short selling is not permitted within a UCITS fund. However, UCITS funds can achieve a similar effect through the use of synthetic shorts. A way to artificially short a security by entering into a CFD or CDS. These transactions are permissible within a UCITS regulated fund. Undertakings for Collective Investment in Transferrable Securities is a European Union directive providing a standard regulatory regime across the EU for funds sold to the public. 12 GUIDE TO ABSOLUTE RETURN INVESTING
Risk Warnings Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. You may not get back the amount originally invested. Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time. Investors in these funds should understand that the funds are guaranteed to produce a positive return and as absolute return products, performance may not move in line with general market trends or fully benefit from a positive market environment. The Manager employs a risk management process to oversee and manage derivative exposure within the Funds. Important information The information mentioned in this communication is for illustrative purposes only and should not be construed as investment advice or investment recommendation. In the EU, issued by BlackRock Investment Management (UK) Limited (authorised and regulated by the Financial Conduct Authority (FCA)). Registered office: 12 Throgmorton Avenue, London EC2N 2DL. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited. This material is for distribution to Professional Clients (as defined by the FCA Rules) and Qualified Investors and should not be relied upon by any other persons. Issued in the Netherlands by the Amsterdam branch office of BlackRock Investment Management (UK) Limited: Amstelplein 1, 1096 HA Amsterdam, Tel: 020-549 5200. For qualified investors in Switzerland, this material shall be exclusively made available to, and directed at, qualified investors as defined in the Swiss Collective Investment Schemes Act of 23 June 2006, as amended. Any research in this document has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy. This document is for information purposes only and does not constitute an offer or invitation to anyone to invest in any BlackRock funds and has not been prepared in connection with any such offer. 2018 BlackRock, Inc. All Rights reserved. BLACKROCK, BLACKROCK SOLUTIONS, ishares, BUILD ON BLACKROCK, SO WHAT DO I DO WITH MY MONEY and the stylized i logo are registered and unregistered trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners. FOR MORE INFORMATION: blackrock.com CD00026-EMEA-I-JAN-18-EN
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