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November 10, 2011

Time to Get Off the Rollercoaster – A Look at Absolute Return Funds

Are you a part of the growing crowd of disenchanted investors that have recently taken a look back at their equity portfolio’s performance over the past 10 years only to be greatly disappointed in the overall lack of progress over…

Time to Get Off the Rollercoaster – A Look at Absolute Return Funds

Are you a part of the growing crowd of disenchanted investors that have recently taken a look back at their equity portfolio’s performance over the past 10 years only to be greatly disappointed in the overall lack of progress over that time? Many
investors are facing the hard reality that while they had some strong years during the last decade, the market declines of 2001-02 and 2008 likely muted any real successes they may have had along the way.

You see, most traditional mutual funds task the portfolio manager with outperforming a stock or bond benchmark such as the S&P 500 Index or Barclays Capital U.S. Aggregate Bond Index. The manager is usually constrained to invest only in the in a specific market like the US, a sector such as healthcare or utilities, or in an asset class such as small cap or fixed income.

These constraints are designed to benefit investors in that they discourage a money manager from taking a range of  unintended risks and bring the focus back to security selection. These constraints however can carry disadvantages as well. In a general market decline, when securities fall in price for systemic, rather than specific, reasons, there is little that a constrained manager can do to avoid a negative result. In fact, a manager may do what is considered a good job — by
outperforming the market benchmark — yet, during a bear market, the fund might post a significant decline for shareholders.

Flexibility

In contrast, an Absolute Return objective removes many constraints on managers and allows them to implement more strategies for addressing market volatility. Freedom from the constraints of a traditional benchmark means more than the ability to invest in a wider range of securities. It also gives absolute return strategies the capability to adjust dynamically
to changing market conditions.

They can move assets into the sectors and global markets that offer the best potential for achieving their return targets with low volatility because they are not limited to a narrow investment universe. They can also abandon less attractive sectors that are potentially too risky, or that may not help them reach their return targets within the specified time period of the strategy. In other words, as markets evolve, absolute return strategies can adapt with them. The goal is to make the strategies more resilient, more versatile in changing markets. This flexibility can help absolute return strategies as they seek to overcome the
short-term volatility risks that have posed problems for traditional strategies.

For example, a bond manager who can invest in either high-yield or mortgage-backed securities has a better opportunity to generate positive returns more consistently over time than a manager whose hands are tied. Similarly, in a strategy without asset class constraints, a manager can move money out of stocks and into bonds, or out of both stocks and bonds and into cash and alternative investments. In short, an absolute return manager is free to take risk only with investments considered likely to generate positive returns, and to avoid weaker investments.

Stability and Consistency

The old poker player adage, “Double up to catch up,” used to be heard only in the walls of casinos and back door card rooms.  Yet in recent times this saying has unfortunately crossed over into the vocabularies of many investors after the market’s precipitous declines from the heights of 2007 to the trough of 2009. These short term declines effectively
derailed much of the long term planning previously undertaken by investors both young and old.

For younger investors, this downturn interrupted the compounding of returns, and this delayed wealth accumulation. For investors who had already built up savings and were relying on them to generate income, the impact of a bear market was even more devastating. Since their time horizon is shorter, older investors may have been forced to reallocate money to stocks or other higher risk assets in the hopes of a recovery in prices to potentially restore their wealth and purchasing power.

The ability to reduce one’s downside capture during periods of market weakness by employing absolute return strategies has the additional benefit of reducing the need to allocate to higher risk assets or the amount of time necessary to recover from any losses.

Previously, these absolute return strategies were available only to institutional investors though it has become clear that they can also serve important roles in individual portfolios as well.

If you find yourself amongst the masses of investors that are re-examining their investment assumptions, you may want to consider some absolute return strategies that can complement many of the traditional strategies you’ve already employed.

*This hypothetical illustration is based on mathematical principles and assumes monthly compounding. It is not meant as a forecast of future events or as a statement that prior markets may be duplicated. Recovery periods are rounded to the nearest quarter of a year.

Posted by Kelly

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