A SIMPLE GUIDE TO DISPERSION AND CORRELATION€¦ · Occasionally, investors mistakenly regard...

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What is correlation? ‘Correlation’ is a measure of how much two variables, such as two stocks, match each other in the direction of their performance over a certain period of time. Correlation does not measure their level of performance, only the relationship between them. If two stocks have a correlation of +1, their performance has always moved in the same direction. If they have a correlation of -1, their performance has always moved in opposite directions. A figure near zero suggests a weak or non-existent relationship between the performance of the two stocks. Importantly different… Occasionally, investors mistakenly regard dispersion and correlation as the same thing. The chart below illustrates the difference between them. It uses an example of a stock and its index that match each other closely in direction. However, the size of return from the stock and its index differs. This shows that two variables can be closely correlated, but their returns are widely dispersed. What is dispersion? In simple terms, ‘dispersion’ is the difference between the best and worst performers in a group, or ‘index’, of securities*. This measure is particularly relevant when you are looking at fund managers who generate returns based on picking stocks (as opposed to making decisions based solely on macro economic factors). For them, the greater the dispersion, the higher the potential to gain meaningful returns above the average return of the index. Dispersion is typically measured as a standard deviation – in other words, by how much the return of each individual stock differs from the average return of the stocks in the index at a given point in time. The greater the average difference for each stock, the higher the measure of dispersion. A SIMPLE GUIDE TO DISPERSION AND CORRELATION People often use the terms ‘dispersion’ and ‘correlation’ when they study how the performance of one investment security moves in relation to another. Both terms can help you understand how fund managers seek to generate outperformance and to understand the benefits of building a diversified portfolio. This guide explains what dispersion and correlation can tell you. Chart 1: Close correlation, but wide dispersion Time Stock Index Dispersion Performance *In this guide the securities we focus on are company shares, known as ‘stocks’. But dispersion also applies to other securities, such as ‘bonds’.

Transcript of A SIMPLE GUIDE TO DISPERSION AND CORRELATION€¦ · Occasionally, investors mistakenly regard...

Page 1: A SIMPLE GUIDE TO DISPERSION AND CORRELATION€¦ · Occasionally, investors mistakenly regard dispersion and correlation as ... Equity = Euro Stoxx 50 Index, US Equity = S&P 500

What is correlation?‘Correlation’ is a measure of how much two variables, such as two stocks, match each other in the direction of their performance over a certain period of time. Correlation does not measure their level of performance, only the relationship between them. If two stocks have a correlation of +1, their performance has always moved in the same direction. If they have a correlation of -1, their performance has always moved in opposite directions. A figure near zero suggests a weak or non-existent relationship between the performance of the two stocks.

Importantly different…Occasionally, investors mistakenly regard dispersion and correlation as the same thing. The chart below illustrates the difference between them. It uses an example of a stock and its index that match each other closely in direction. However, the size of return from the stock and its index differs. This shows that two variables can be closely correlated, but their returns are widely dispersed.

What is dispersion?In simple terms, ‘dispersion’ is the difference between the best and worst performers in a group, or ‘index’, of securities*. This measure is particularly relevant when you are looking at fund managers who generate returns based on picking stocks (as opposed to making decisions based solely on macro economic factors). For them, the greater the dispersion, the higher the potential to gain meaningful returns above the average return of the index.

Dispersion is typically measured as a standard deviation – in other words, by how much the return of each individual stock differs from the average return of the stocks in the index at a given point in time. The greater the average difference for each stock, the higher the measure of dispersion.

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A SIMPLE GUIDE TO DISPERSION AND CORRELATION

People often use the terms ‘dispersion’ and ‘correlation’ when they study how the performance of one investment security moves in relation to another. Both terms can help you understand how fund managers seek to generate outperformance and to understand the benefits of building a diversified portfolio. This guide explains what dispersion and correlation can tell you.

Chart 1: Close correlation, but wide dispersion

Time

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*In this guide the securities we focus on are company shares, known as ‘stocks’. But dispersion also applies to other securities, such as ‘bonds’.

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Why is ‘dispersion’ important to investors?

When seeking to invest in an asset class or region, investors have the option to invest in active or passive funds. In simple terms, a passive fund will seek to replicate the performance of the index of stocks while an active fund will seek to outperform the average of the index. ‘Active’ fund managers do this by increasing or decreasing their allocation to stocks in the index, based on which they think have the strongest prospects of outperforming.

Many of these active fund managers follow a ‘stock picking’ (also known as a ‘bottom-up’) approach. This means building their portfolio based on analysis of individual securities. They may also consider economic and asset allocation issues, known as ‘top-down’ factors, but these are not of primary importance for bottom-up managers.

Dispersion of returns from the stocks in the index is important to active fund managers. If there is a low dispersion of returns (see chart 2), then even by successfully identifying more of the winners, the manager can only generate limited levels of outperformance versus the index average. In contrast, in periods when there is a higher dispersion of returns (see chart 3), active fund managers have more opportunity to generate additional returns by identifying winners. Of course, there is also greater potential to underperform if they invest more in stocks that turn out to disappoint.

So stock dispersion is important when assessing the potential for outperforming a given index over a particular period of time (ie, when stock dispersion seems to be rising or falling). Leaving aside the debate on the benefits of active and passive funds, certain fund managers with proven stock-picking ability may be worth considering at times when stock markets exhibit higher levels of dispersion.

Chart 2: Low dispersion of returnsYou can see that the returns for all three stocks (black, red and yellow) tend to cluster around the blue line of the benchmark.

Why is ‘correlation’ important to investors?

Correlation is important in helping fund managers and investors to diversify. Diversification in this context means selecting a balance of investments that will perform differently over time. When fund managers allocate to certain stocks, they need to understand how these stocks are likely to behave given certain conditions in the markets in which they operate. For example, will two financial stocks behave in a similar way if an interest rate rise is announced, or is their performance likely to differ? In understanding the correlation between stocks, fund managers can seek to ensure that they are either exposed to certain economic or political changes or mitigate the risks of them.

In a similar way, investors can use correlation as a way of exploring the relationship between different asset classes. This can be useful if you are seeking to build a diversified portfolio. By investing in asset classes with different drivers, for example, equities, bonds, commercial property and alternative investments, you may be able to gain exposure to returns that are lowly correlated (a correlation close to zero) or always move in opposite directions (a correlation of -1). This means that if one asset class does badly, investors with a diversified portfolio may still see resilience in their overall returns, because performance from the other asset classes would be unaffected or move in the opposite direction. For example, chart 4 overleaf shows the performance of four asset classes over the past five years.

Chart 3: High dispersion of returnsYou can see that the returns for all three stocks tend to be well away from the benchmark.

A SIMPLE GUIDE TO DISPERSION AND CORRELATION

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European Equity 18.7%

US Equity 32.0%

Property 19.3%

Property 13.8%

High Yield Bonds 15.3%

US Equity 15.9%

European Equity 22.1%

US Equity 13.5%

European Equity 7.6%

US Equity 11.8%

High Yield Bonds 14.1%

Property 10.9%

European Equity 4.9%

US Equity 1.4%

European Equity 4.4%

Property 2.4%High Yield

Bonds 5.9%High Yield

Bonds 2.1%High Yield

Bonds -5.0%Property 2.2%

Source: Henderson Global Investors / Bloomberg, as at 31 December 2016. European Equity = Euro Stoxx 50 Index, US Equity = S&P 500 Index, Property = IPD UK Monthly Property Index, High Yield Bonds = iShares iBoxx $ High Yield Corporate Bond ETF. Total returns in local currency. Past performance is not a guide to future performance.

In addition to considering diversification when making asset class decisions, investors may also seek to allocate to certain funds based on the correlation of their returns. For example, if you want to hold two equity funds investing in Europe, you may choose two managers that have historically delivered lowly correlated returns. One could be a defensive manager running a portfolio of larger companies, and the other a manager running a concentrated portfolio of higher-risk smaller stocks. Building a portfolio of funds to suit your risk appetite is complex and therefore requires financial advice.

What to use and whenBoth ‘dispersion’ and ‘correlation’ are useful measures when assessing and allocating to stocks, funds and asset classes. They help build a rounded picture of how variables behave relative to one another, the potential effect of combining the two and possibilities for outperformance from stock-picking managers in certain conditions.

GlossaryActive investing: An investment approach where a fund manager actively takes

decisions about which and what proportion of investments to hold, often with a goal

of outperforming a specific index. It relies on a fund manager’s investment skill. The

opposite of passive investing.

Alternative investments: An investment that is not included among the traditional

asset classes of equities, bonds or cash. Alternative investments include property,

hedge funds, commodities, private equity and infrastructure.

Benchmark: A standard against which a portfolio’s performance can be measured.

For example, the performance of a UK equity fund may be benchmarked against a

market index such as the FTSE 100, which represents the 100 largest companies

listed on the London Stock Exchange. An index is often used as a benchmark.

Correlation: How far the movements of two variables (eg, equity or fund returns)

match each other in their direction. If variables have a correlation of +1, they move in

the same direction. If they have a correlation of -1, they move in opposite directions.

A figure near zero suggests a weak or non-existent relationship between the two

variables.

Dispersion: How much the returns of each variable (eg, stocks within a benchmark)

differ from the average return of the index.

Equity: A security representing ownership, typically listed on a stock exchange.

‘Equities’ as an asset class means investments in shares, as opposed to, for instance,

bonds. To have ‘equity’ in a company means to hold shares in that company and

therefore have part ownership.

Outperform: To deliver a return greater than that of a portfolio’s assigned

benchmark. Also often called excess return.

Passive investing: An investment approach that tracks an index. It is called passive

because it simply seeks to replicate the index. The opposite of active investing.

At a glance

3 Correlation measures direction, whereas dispersion measures difference

3 High stock dispersion typically provides a favourable environment for successful stock-picking fund managers

3 Investment skill, however, remains the key factor in generating outperformance

By speaking to a financial adviser, you can learn more about the importance of diversification.

Chart 4: Importance of diversificationThis shows the performance of four asset classes each calender year over the past five years. You can see the ups and downs of each asset class by following a particular colour trail.

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Other educational guides in this series include:

Important Information

Please read all scheme documents before investing. Before entering into an investment agreement in respect of an investment referred to in this document, you should consult your own professional and/or investment adviser. Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Tax assumptions and reliefs depend upon an investor’s particular circumstances and may change if those circumstances or the law change. If you invest through a third party provider you are advised to consult them directly as charges, performance and terms and conditions may differ materially. Nothing in this document is intended to or should be construed as advice. This document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment. Any investment application will be made solely on the basis of the information contained in the Prospectus (including all relevant covering documents), which will contain investment restrictions. This document is intended as a summary only and potential investors must read the prospectus, and where relevant, the key investor information document before investing. Issued in the UK by Henderson Global Investors. Henderson Global Investors is the name under which Henderson Global Investors Limited (reg. no. 906355), Henderson Fund Management Limited (reg. no. 2607112), Henderson Investment Funds Limited (reg. no. 2678531), Henderson Investment Management Limited (reg. no. 1795354), AlphaGen Capital Limited (reg. no. 962757), Henderson Equity Partners Limited (reg. no.2606646), Gartmore Investment Limited (reg. no. 1508030), (each incorporated and registered in England and Wales with registered office at 201 Bishopsgate, London EC2M 3AE) are authorised and regulated by the Financial Conduct Authority to provide investment products and services. Telephone calls may be recorded and monitored. Ref: 34U. H027701/0217

Contact usGeneral enquiries: 0800 832 832Email: [email protected]: henderson.com

ChargesPlease see HGi.co/charges for a simple guide to charges

A SIMPLE GUIDE TO CHARGES

Investment Management can appear a complex business. When you invest in a fund, we work hard behind the scenes to safely pool your money with that of other investors in the fund; we employ investment professionals to build and manage the portfolios, operations teams to administer the funds, and all transaction and regulatory expenses have to be met. All of this costs money, so this guide helps you to understand the charges and expenses incurred by funds.

The main fund charges

Entry charge One-off charge (we take this on the day you invest in the fund)

What is it?It's the maximum charge we can take from the money you use to invest in the fund.

What is it for?It covers the costs of setting up your account.

It may also cover payments to a financial adviser, if this has been agreed as part of the adviser fee.

How much?Typically anything from zero up to 5%.

ExampleIf you put £1,000 in a fund with an entry charge of 5%, the charge will be £50. This means £950 will be invested in the fund.

Ongoing charges figure (OCF) What is it?The OCF is a single figure that represents the charges you'll pay over a year for the length of time you hold your investment. It is usually stated as a percentage of the fund value.

What is it for?The OCF covers aspects of operating the fund each year. It includes fees paid for managing the fund such as the annual management charge and our administration and oversight tasks. See overleaf for more details.

How much?An OCF can typically range from 0.25% to 2.5% each year.

ExampleA fund with a constant value of £1,000 over a year and an OCF of 1.5% would have a charge of £15 in that year. Put another way, if the same fund achieved a return of 10% a year, the OCF would reduce the return to 8.5%. A breakdown of a typical Henderson OCF is shown overleaf.

Conditional charges Portfolio transaction costs

Some funds have conditional charges that are triggered when they meet specific predefined targets. The most common conditional charge is a performance fee – a fee that generally aims to reward good fund performance. So if the fund achieves a certain level of return, we can take part of that return as a fee for good performance. For further information please refer to our guide to absolute return funds at HGi.co/d33

All funds also incur various transaction costs. For example, when a fund buys or sells shares, this incurs broker commissions, transfer taxes and stamp duty, which the fund pays on each transaction. Transaction costs for Henderson funds are shown at HGi.co/by5r

Exit charge One-off charge (day fund is sold)

What is it?We may take an exit charge when you sell part or all of your holding in the fund. However, Henderson currently does not do so.

What is it for?It typically covers the costs if you sell your investment early.

Some funds may make a charge to deter excessive short term trading.

How much?Many funds such as Henderson's do not apply an exit charge.

If a fund applies a charge, the amount is often discretionary.

ExampleA fund that applies a 5% exit charge when it is sold at a value of £2,000 will make a charge of £100. This means the investor will receive £1,900.

The duration of the investment

Risk profilingPlease see HGi.co/riskprofiling for a simple guide to risk profiling

How can my attitude to risk be assessed?

A financial adviser or online tool can assist you in arriving at your ‘attitude to risk’ and then recommend the most appropriate investments to match your circumstances and needs. Typically categories of attitudes to risk can range from (1.) being the least risk to (10.) being highly adventurous (see example below).

Normally your attitude to risk will be assessed via a detailed questionnaire. Don’t forget that taking on more risk can lead to higher rewards but also potentially higher losses.

Risk vs reward

Before devising an investment strategy in order to reach your end investment goal, you must first establish how much risk you are willing to take. This can depend on:

· Your capacity to recover from losses should the markets fall during your investment period

· The length of time you wish to be invested

· Which investment products you should be invested in

· Whether cash is more suitable to you

· What other dependants you have relying on your investment goals i.e. family

Some investment products are more ‘risky’ or volatile but can offer greater returns over time, but the reverse is also true, you could potentially suffer greater losses. For example, shares are usually considered to be more risky compared to bonds. For the most part, the more risk you are prepared to take the greater the potential reward, but you must be aware of that before you or your adviser selects your investments.

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A SIMPLE GUIDE TO RISK PROFILING

Investors have a huge choice when it comes to deciding where to place their money. They must consider what their attitude to risk is and how they might want to diversify their investments. Risk profiled funds allow investors and advisers to match individual attitudes to risk to investment goals.

1. RISK AVERSE

2. VERY LOW RISK

3. LOW RISK

4. LOWEST MID RISK

5. LOW MID RISK6. HIGH MID RISK

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A TYPICAL ATTITUDE TO RISK SPECTRUM USED BY A FINANCIAL ADVISERINCREASING RISKS

Fund pricingPlease see HGi.co/fundpricing for a simple guide to fund pricing

A SIMPLE GUIDE TOFUND PRICING

A fund pools the money of lots of investors to buy a portfolio of assets. The price of these assets fluctuates and so does the size of the fund as investors buy and sell shares. So pricing the fund is complex and needs to be fair to both ongoing investors in the fund and those wishing to deal (buy or sell the fund). In this guide we explain what this means in practice.

How is the fund price calculated?The fund price takes into account the value of the fund’s assets, such as the shares, bonds and property it owns. Several factors contribute to the fund price:

· Spreads on underlying assets in the fund: When you buy an individual share or a bond you may notice there is one price for buying (the offer price) and a lower price if you want to sell (the bid price). This difference between the two prices is known as the spread. For widely traded assets the spread may be very small and for some very liquid assets there may be no spread at all, such as on cash. For other assets that are not widely traded, such as smaller-company shares, the spread could be large, say 3%. It’s larger because the broker who buys or sells the shares doesn’t want to sell you them too cheaply or pay you too much when buying them from you. The larger spread compensates the broker for the extra risk of dealing in smaller-company shares.

· Transaction costs: There are often external transaction costs for buying or selling assets, such as commissions, transfer fees and stamp duty. These costs can vary widely depending on the type of asset and where they are. For example, you need to pay 5% stamp duty land tax when buying UK commercial property above £250,000.

· Initial charge: This is applied by the fund manager when you buy into the fund. It covers the cost of setting up the investment, although fund managers often offer a partial or full discount on this charge, particularly if you invest through a cost-efficient platform.

The spread, transaction cost and initial charge mean there is essentially a buying price and a selling price for every fund, although the quoted price for the fund will depend on the pricing method.

Summary: what does the fund price include?

Underlying assets

The fund’s assets, such as the shares, bonds or property it owns

Spreads on underlying assets in the fund

The difference between the buying price (the offer price) and the selling price (the bid price)

Transaction costs

External transaction costs attached to buying/selling assets such as commissions, transfer fees and taxes

Initial charge The cost of setting up the investment applied by the fund manager

For information relating to charges please see our Simple Guide to Charges

VolatilityPlease see HGi.co/volatility for a simple guide to volatility

Can you measure it?

The most common measure of volatility is standard deviation. This measures how much the value of an investment moves away or deviates from its average value over a set period of time, i.e. how much it rises and falls. The more volatility, the higher the standard deviation.

The examples below show shares with lower and higher volatility. Share A has lower standard deviation (volatility) compared to share B which has higher standard deviation.

Forecast volatility attempts to use standard deviation to forecast future variation in returns. The higher a forecast volatility figure, the more an investment could move both up and down over time.

What is volatility?

Volatility is how sharply and how frequently a fund or share price moves up or down over a certain period of time (see example below).

What causes volatility?

Volatility can be triggered by any number of factors. The UK stock market, for example, can fluctuate because of various factors both home and away; the Eurozone debt crisis, the slowdown in the US and problems as far flung as China can all have a turbulent effect on markets. Periods of losses/downturns can be followed by upswings, also known as rallies, and vice versa. But this is the very nature of the stock market.

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A SIMPLE GUIDE TO VOLATILITY

Investors have much to think about when choosing and understanding investments; in particular, market volatility and the impact it can have on your investment. Extreme market volatility during the credit crunch demonstrated how markets can swing wildly. Understanding volatility is therefore, vital to the overall process of choosing the right investments, whether you decide to make your own investment decision or to consult a financial adviser. If you are unsure, we recommend consulting a financial adviser if you can.

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EquitiesPlease see HGi.co/equities for a simple guide to absolute return funds

In return, the shareholders become partial owners of the company, with their level of ownership dependent on how many shares they purchase. Shareholders have the potential to receive a share of the company’s profi ts and the right to vote on how that company is run. Their interests at the company are protected by a Board of Directors that they elect.

What affects the price of equities?Technically speaking, ‘equity’ is the value of a company’s assets, less the value of its liabilities. The value of those assets and liabilities is dictated by market forces i.e. the stock market. Share prices are constantly changing due to participants in the stock market making different assessments of the value of a company. If more investors want to buy a company’s equity than sell, then typically the price will increase. Similarly, if there are more sellers than buyers, then the price will typically go down.

(continued) (BGB 10pt)A SIMPLE GUIDE TO EQUITIES

Equities... shares... stocks – within the fi nancial markets they mean the same thing: company ownership. In this guide we refer to them as equities, and explore their structure, why their prices go up and down, and some of the key benefi ts and drawbacks to investing in the asset class. By speaking to a fi nancial adviser, you can discuss whether investing in equities may be right for you.

What are equities?A company may choose to raise money for a number of reasons. For example, it might want to expand its operations, invest in research and development, or reduce its level of debt. It may even be starting out and need money to form the initial business. A company can do this by splitting its ownership into ‘shares’ and selling these to ‘shareholders’. This is typically done via the stock market, where investors can buy and sell equities.

More investors predict improved prospects for a company = more buyers than sellers

VALUE INCREASES

More investors predict deteriorating prospects for a company = more sellers than buyers

VALUE DECREASES

BondsPlease see HGi.co/bonds for a simple guide to bonds

(continued) (BGB 10pt)A SIMPLE GUIDE TO BONDS

Bonds are debt securities issued by companies, governments and the like. For investors, they can provide a stream of returns. In this guide we explore their structure, why their prices go up and down, and some of the key benefits and drawbacks of investing in them. By speaking to a financial adviser, you can discuss whether investing in bonds is right for you.

What are bonds?A bond is an IOU, typically issued by a government or company (an ‘issuer’). When issued by a company, they are referred to as ‘corporate bonds’. By buying a bond you are lending the issuer money. Two things are specified at the outset: the agreed rate of interest that the issuer must pay you at regular intervals (the ‘coupon’), and the date at which the issuer must repay you the original amount loaned (the ‘principal’).

To illustrate this, let’s take a fictional bond issued by Enterprise Inc. Say you buy Enterprise Inc’s €100 five-year 5% coupon bond. This means you lend the company €100 and in exchange Enterprise Inc. will pay you an annual coupon of 5% (i.e. €5), and repay the principal after five years.

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What affects the price of bonds?

Bonds can be bought and sold in the marketplace. Their prices change constantly because people in the market make different assessments on two main factors: the likelihood that the issuer will repay its debts (‘credit risk’), and the effect of interest rates (‘interest rate risk’). We say more about these later.

If more investors want to buy a bond than sell, the price normally increases. Similarly, if there are more sellers than buyers, the price normally goes down. The rising or falling price affects the yield of the bond. Yield is a way of measuring the attractiveness of an individual bond. However, bonds are not always held until the principal is repaid - they can be bought and sold at any time until the principal is repaid - so there are many ways of calculating the yield. The most common is the ‘redemption yield’. This discounts the value of coupons received over time. It also adjusts for any difference in the price paid for the bond and the principal repaid at maturity.

However, one of the simplest is the ‘running yield’. Using the earlier example, imagine that after three years, Enterprise Inc’s five-year 5% coupon bond is worth €95 in the market, and another investor buys the bond from you. The coupon is still €5 – this never changes as it was agreed at the outset. The running yield would therefore be 5 ÷ 95 = 5.26%. Therefore, if bond prices fall, yields rise. If bond prices rise, yields fall.

BONDPRICE RISES

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GlossaryPlease see HGi.co/glossary for a glossary of financial terms used in this document.

Absolute returnPlease see HGI.co/absolutereturn for a simple guide to absolute return

that differs to a greater or lesser extent to the make-up of the index, but the fund will broadly rise and fall in line with that wider index. The drawback of this approach is that if the index is falling, the fund may do better than it on a ‘relative’ basis but still lose an investor money in ‘absolute’ terms.

An absolute return fund seeks to do things differently. Instead of being measured against an index, it aims to deliver positive returns regardless of whether equity markets are rising or falling. With this aim in mind, absolute return funds tend to be benchmarked against the return available from holding cash on deposit. See the chart below for an example.

How does absolute return investing differ from traditional investing?Traditional investment funds buy shares in companies that the fund manager believes will rise in value. Their success (or otherwise) is typically measured against an index of companies in the region where they invest, known as a ‘benchmark’.

For example a UK equities fund may be benchmarked against the FTSE All-Share Index or a European equities fund against the MSCI Europe Index. These funds are said to be managed on a ‘relative return’ basis, which means they aim to deliver returns above those of, or ‘relative to’, their benchmark. See the chart below for an example.

The manager of such a fund is likely to build a portfolio of companies

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A SIMPLE GUIDE TO ABSOLUTE RETURN FUNDS

Absolute return funds aim to deliver a positive (‘absolute’) return to investors regardless of whether the wider market in which they invest rises or falls. Please remember that absolute return funds do not guarantee positive returns. Performance will be impacted by market movements and the investment decisions made by the fund manager.

Absolute return investing can apply to many asset classes, but this guide focuses on funds invested in company shares (‘equities’). By speaking to a financial adviser, you can discuss whether investing in absolute return funds may be right for you.

Relative return example

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