Absolute return: why discipline matters in today’s market

Portfolio Manager Luke Newman argues why rising volatility and rational pricing are creating fertile ground for absolute return investors seeking genuine long and short opportunities.

After a decade defined by ultra low rates, markets have shifted decisively into a new regime. The cost of money is no longer close to zero; inflation, though moderating, remains a persistent variable; and correlations between equities and bonds have risen meaningfully. For absolute return investors, this is fertile ground.

Two features stand out for us. First, stock pricing dispersion – the spread of returns between winners and losers – has widened across regions and sectors, now comparable with 2009 (Exhibit 1). That creates room for genuine stock selection on both the long and short side, rather than the blunt force of beta (the markets) doing the work.

Source: FactSet, Morgan Stanley Alpha. * indicates the calendar-year dispersion for 2025 until 28th November 2025.
Past performance does not predict future returns.

In today’s more normalised interest rate environment, company fundamentals have regained primacy.

Second, volatility (and uncertainty – Exhibit 2) has moved higher and is less mono directional. While unnerving at an index level, that dynamism is a positive factor for absolute return investors, with the flexibility to take long positions in stocks where they see improving fundamentals at sensible valuations, and short positions where they see deteriorating fundamentals and stretched valuations.

Source: Ahir, H, N Bloom and D Furveri (2022), World Uncertainty Index, NBER Working Paper, at 30 September 2025.
Note: The index reflects the frequencies of the word ‘uncertainty’ (and its variants) in the Economist Intelligence Unit (EIU) quarterly country reports, rescaled by total word count and GDP weighted.

During what was a very long cycle of record-low interest rates, broad economic factors and market sentiment (‘macro’) consistently had a much stronger impact on asset prices and investment returns than the specific, bottom-up fundamentals of individual companies (‘micro’). This was a period where industry and sector correlations were high, and low quality growth prospered on the cheap cost of borrowing.

In today’s more normalised interest rate environment, company fundamentals have regained primacy. This means that cash generation, balance sheet strength, return on invested capital, and good management discipline, are being rewarded where they improve, and penalised where they slip.

This is a toolkit that absolute return managers rely on, with three primary attributes that can potentially resonate with investors:

1. Low beta, low correlation at an individual stock level: The potential to deliver positive absolute returns without leaning on macro factors helps when the performance of equities and fixed income become more synchronous.
2. Downside risk mitigation: The ability to reposition quickly – for example, by taking a larger exposure to short positions – can help to cushion drawdowns during sharp market sell offs.
3. Risk efficiency: Targeting equity like absolute returns, with historically much lower volatility, is a practical way to use risk budgets in periods of uncertainty.

Markets have felt like a ‘longs first’ hunting ground for much of the past decade or more, powered by secular growth prospects and ever-higher prices, particularly for a small sub-set of technology growth stocks. Now, we see opportunities on both the long and short side.

• Financials have seen years of capital restructuring and operational improvement. We are now at a point where lower interest rates and depressed valuations look like a tailwind for select companies with robust balance sheets.
• Aerospace and defence stocks in Europe have enjoyed a period of strong gains, reflective of heightened geopolitical uncertainty and renewed focus on domestic security needs. In our view, these industries still offer prospects for investors positioned for any short-term pullbacks in price.
• Duration sensitive assets such as utilities, real estate investment, and quality housebuilders, are likely beneficiaries of lower interest rates, with a focus on firms with strong balance sheets and well-structured debt, in areas with transparent regulatory frameworks.

The AI super-cycle has been profoundly impactful on investment markets, acting as the primary driver of equity market performance since 2023.

• Cost–price mismatches: Those companies facing cost inflation (rising wages, higher business rates, etc), with a diminishing ability to pass those costs on through higher prices. This includes hotels, leisure facilities, and select services with high fixed costs.
• US consumer names: Areas where pandemic stimulus and aggressive pricing structures temporarily boosted profits, where competition is growing, putting pressure on businesses to cut prices and offer promotions to defend their market share.
• Policy sensitivity: Positions with a greater exposure to budget uncertainty, tariff risks or procurement delays can work as effective tactical short positions when broader market risk factors dominate.

The AI super-cycle has been profoundly impactful on investment markets, acting as the primary driver of equity market performance since 2023. This is a serious conundrum for investors, given how crowded this area looks and the uncertain timescale for any return on investment.

We see more compelling opportunities in ‘AI adjacent’ areas – parts of the market that have either been overlooked, or associated services. This includes perceived ‘AI losers’ – high quality, data rich business-to-business providers that have been (in our view) harshly treated on fears that AI would undermine their business models.

We also see good prospects for those businesses that can benefit from greater integration of AI in assisting productivity, such as financial services, business services, and selected industrial support functions.

This intersects with another emerging theme – pockets of disinflation – where we see AI as acting as a potential ‘silent hand’, compressing costs in services, manufacturing, etc, which can potentially help to lower price pressures across the global economy.

In our view, the conditions now in place – wider stock dispersion, more rational pricing, and a healthier cost of capital – create an unusually constructive backdrop for absolute return investing. This is an environment that rewards selectivity, discipline, and flexibility rather than reliance on market direction. For investors seeking a diversifying source of returns, with the potential for downside resilience and efficient use of risk, absolute return strategies can potentially serve as a stable anchor in an increasingly unstable world. The regime has changed. The playbook should too.