What are alternative strategy funds?

Ask ten different investment professionals and you will probably get ten different definitions. There is no standard or easy way to define them. The term ‘alternative strategy fund’ is used to describe an ever-growing number of investment vehicles, many of which have different objectives and investment styles.

For example, there is all the difference in the world between a conservatively run equity market neutral fund, on the one hand, and a leveraged merger-arbitrage fund on the other. These days, alternative funds are run from mainstream fund management houses as well as by small, specialist boutiques which have been specifically set up for this purpose.

Some alternative funds seek to leverage their returns. However, the amount of leverage used varies by strategy and indeed even by funds within the same strategy. Funds also have the ability to go short, meaning that they can make money when markets decline and when they go up. While not all alternative strategy funds necessarily use much leverage or go short, they all share one common characteristic: every fund is seeking to achieve what is known as an ‘absolute return’.

The term absolute return is used to contrast alternative strategy funds with mainstream investment products which are termed ‘long only’ in that they cannot go short and therefore bet on securities declining in value. Long only unit trust funds, for example, are to a certain extent correlated to the markets in which they operate. Long only investments like ordinary equity funds will tend to do well when the market in which they operate is rising and poorly when it is falling. In relative terms, a long only fund can even be considered to have had a good year when it has lost ten percent of its overall value if the index that it is benchmarked to has lost, say, 20 percent. Conversely, it might be considered to have done badly if it gained 10 percent in a year in which the index that it is benchmarked to had gained 20 percent.

The objective of alternative strategy funds is very different as it aims to make positive returns in all market conditions. An absolute return is a positive return. It is to do better than the risk-free rate of return such as wholesale cash deposits. An absolute return fund should be aiming to do at least as well as cash, irrespective of market conditions. This is achieved by shorting securities, as well as going long, and by exploiting arbitrage opportunities in markets. Alternative strategy funds are therefore able to preserve their investors’ capital by making a positive return – or at least losing considerably less money than long only funds when markets are performing poorly.

For further information, please contact Head of Institutional Business – Pieter Davis on pdavis@edge.co.za