I am constantly surprised at how often the words ‘unconstrained’ and ‘absolute return’ are used interchangeably, as if they mean the same thing. Yet they are entirely different. One is a style of investing; the other is an outcome.
Unconstrained is a style of investing; it is the direct opposite of ‘benchmark aware’ or an indexed investment. Unconstrained portfolio managers are not held to a benchmark; instead they are free to pursue their best ideas, often across a variety of asset classes, security types, and sectors (commonly referred to as a ‘Multi-sector’ approach).
By contrast, absolute return is a potential outcome. An absolute return portfolio manager seeks to deliver positive (‘absolute’) returns in all market environments. In order to do this, absolute return managers, like equity hedge funds, employ a variety of techniques, including long/short positions, flexible duration exposure, sector rotation, and security and portfolio-level hedges. Contrast absolute return with total return. Managers seeking to maximize total return often bear more risk and, in return, may experience periods of negative return when rates are rising or spreads are widening. (A third potential outcome is income, which in today’s market usually requires adding additional risk, such as credit, duration, or liquidity risk.)
Along the spectrum of outcomes, one could also plot volatility (as measured by standard deviation) – a true absolute return fund should have a meaningfully lower volatility than one that reaches for total return. Similarly, potential drawdown increases along this spectrum. By definition, an investor in an absolute return portfolio expects to experience limited drawdown. Higher drawdown potential is consistent with greater risk.
Why are these terms so often confused? Probably because unconstrained investing has become the new, ‘hot’ fixed income style. Why? What’s the problem with benchmark investing? Most fixed income indices are constructed using a series of rules (ratings, domicile, currency, sector, etc.) that are applied to the existing stock of fixed income securities. These rules result in fixed income indices that, as we say, reward bad behavior. As issuers issue more and more bonds that meet these rules, their securities come to dominate the respective index. Adherence to an index means an investment that is weighted towards large debt issuers. Unconstrained managers are able to move away from these indices and to weight their portfolios towards issuers and security types that may be under-(or over-)valued or overlooked.
Absolute return investments have also become the darling of the fixed income world. Why? Most benchmarks, by definition, represent long-only portfolios with embedded duration. As investors have become concerned about the impact of rising rates on their fixed income portfolios, they see absolute return investments as solutions that might help insulate their portfolios and dampen volatility. The ability to deliver absolute returns is dependent on the ability to use a broad, unconstrained opportunity set, including shorts and hedges. For true absolute return managers, the benchmark is not a portfolio of fixed income, but instead, a risk-free investment – cash.
So all absolute return funds are unconstrained. But not all unconstrained funds are absolute return.