Absolute Return, Alpha or Something Else?

The Quest For Absolute Returns: Winning The Loser's Game, from the June 2012 edition of the Hedge Fund Journal (requires registration for a trial subscription), is the latest attempt to differentiate between Absolute Return and Alpha and how each is generated.  He recounts the Charles Ellis' reference to tennis matches in describing the differences.  Just as the highest levels of tennis is a Winner's Game (i.e. the winner being determined by the player who wins the most points), Alpha is generated by the managers who establish the most winning positions.  In contrast, Absolute Return is a Loser's Game, determined by the player making the fewest errors (losing positions).  The author describes the Absolute Return Manager as one who avoids cognitive errors and minimizes behavioral biases in his trading.

There are a lot of funds intending to generate Alpha calling themselves Absolute Return funds.  As this article notes, one very good way to distinguish them is to determine whether they make money by identifying winning trades, or avoiding losing trades.  Absolute Return funds put themselves in a position to avoid losing trades.

I have long maintained that Absolute Return strategies are not investment strategies in the traditional sense.  Absolute Return strategies are not compensated for exposures to risk factors that we normally associate with investment performance: inflation, credit, equity, economic growth, interest rates. m Indeed much of the trading that these funds do is designed specifically avoid these market related risks.  Instead, Absolute Return funds get compensated for performing a service for the market.  Some, such as the arbitrage strategies, provide liquidity to the market, driving price discovery between and across markets.  This is a dealer function, similar to the dealer described in the article.  The goal of these strategies is to be (nearly) net neutral to market forces, while awaiting the markets to reprice the positions to equilibrium.

The other group of strategies provides insurance to the markets.  The carry trade (borrowing short to lend long) is an example.  Others include the Macro strategies, the commodities funds, the short sellers, and the options traders.  They put on trades, often highly complex, to isolate a single element of risk for which they believe that they are compensated very handsomely.

Most of the strategies that I consider Absolute Return can not be executed in a mutual fund format, due to restrictions on concentration, short-selling, turnover, and a host of other techniques and vehicles.  The funds out there claiming the distinction are alpha generators.  They may be good at it, but calling a tail a leg does not make it one.