Absolute return

Short selling

Suppose that a manager thinks the share price of company A will go down. Then he can borrow 1000 shares of company A from his prime broker and sell them for (say) 10 USD per share. The immediate gain for the manager is ${\displaystyle 1000\times 10=10,000}$ USD. If (say) after a week the share price of company A drops to 9.5 then the manager buys 1000 shares, paying ${\displaystyle 1000\times 9.5=9,500}$ USD, and gives the shares back to his prime broker. He thus ends up earning a return of ${\displaystyle (10,000-9,500)/10,000=5\mathrm{\%}}$. If his prime broker asked a 2% interest rate for borrowing the shares then the net gain of the manager is ${\displaystyle 5\mathrm{\%}-2\mathrm{\%}=3\mathrm{\%}}$.

Leverage

Sometimes a strategy gives a positive return albeit a very small one. Therefore, a manager can use leverage to magnify his return. For example, a long-short manager can deposit 100M with his prime broker in order to buy 200M of shares and simultaneously sell another 200M of shares, which gives a leverage ratio of ${\displaystyle (200M+200M)/100M=4}$. As another example, a manager can borrow money from a country at an interest rate of 2% and reinvest the amount in another country that pays 4%, thus earning the spread ${\displaystyle 4\mathrm{\%}-2\mathrm{\%}=2\mathrm{\%}}$ (this is called carry trade). If the manager has a leverage ratio of (say) 5 then his return is not 2% but ${\displaystyle 5\times 2\mathrm{\%}=10\mathrm{\%}}$.

However, leverage also amplifies losses: if a manager has a market loss of 3% in his portfolio and a leverage of 4 then his total losses are ${\displaystyle 4\times 3\mathrm{\%}=12\mathrm{\%}}$. Therefore, even small market losses can be disastrous when there is a huge leverage. According to the OECD, prior to the 2007 crisis, hedge funds in 2007 had an average leverage of 3 whilst investment banks had a leverage above 30. With a leverage of 30, a market loss of 3.3% wipes out the entire portfolio whilst a leverage of 3 gives a total loss of 10%.

High turnover

Some absolute-return managers are very active with their portfolios, buying and selling shares more frequently than normal investors, because they focus on short-term investment opportunities lasting less than 90 days. Turnover is the rate at which managers rebalance their portfolios, and among other things it depends on the hedge fund's size: in 2008 hedge funds with less than 15M USD in AUM (assets under management) had a 46.9% turnover per month whilst funds with over 250M USD in AUM had only 9.8%.