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In Practice: Approaches to Absolute-Return Investing

Investors need to tackle these basic questions about how to build a portfolio that uses alternative funds.

Jeffrey Ptak, 02/19/2013

Absolute return is one of the hottest things going in the investment business these days. Morningstar estimates that U.S. investors have pumped a net $53.9 billion into alternative mutual funds since 2008. Not surprisingly, fund companies have responded by launching a slew of new funds, including nearly 60 in 2012 alone.

This has been a double-edged sword for investors. On the plus side, investors never have had more funds to choose from, making it easier to construct an absolute-return strategy. Yet, the options can vary dramatically in quality—unproven funds abound, as often happens in areas experiencing rapid growth. And as the space has become more diverse, the definition of “absolute return” has gotten blurrier. This, in turn, has raised more basic questions about how to build a portfolio that uses alternative funds. (We’ve been managing an absolute return portfolio for clients since March 2005, so we know these challenges all too well.)

While there’s no one-size-fits-all solution, we offer our perspective on the key decisions that an aspiring absolute-return investor is likely to face, as well as a brief explanation of how we’ve tried to tackle those issues.

1. Short or Long Term?
If it’s called absolute return, time horizon wouldn’t seem to matter much. Whether it’s one month, a few years, or even a decade, the return is supposed to be absolute, after all. But time horizon does indeed matter—the shorter it is, the more difficult it becomes to build an absolute-return portfolio that lives up to its name. Why? Unless you’re stuffing the portfolio with bonds or “tail protection” securities like put options and precious metals, it’s likely to suffer the occasional drawdown. Extend the time horizon and you buy yourself some wiggle room, allowing for stakes in nontraditional strategies that are less correlated to the stock and bond markets but court the risk of losing money over shorter periods of time in the process. Like all forms of investing, absolute return is about trade-offs, time horizon being crucial among them. Time horizon is important in another, morebasic respect—when it’s short, there’s greater pressure to maneuver the portfolio. In an ideal world, an absolute-return investor would zip around the market, nimbly sidestepping a loss or bagging a quick gain. In reality, that’s tough to pull off, with reams of evidence suggesting that traders do more harm than good. An absolute-return-minded investor with a short time horizon faces a stark choice—load up on drawdown-resistant securities like bonds (which court their own set of issues) or tactically jump in and out of riskier assets (a practice that’s highly error-prone).

Potential Solution: Split the Difference
In our practice, we’ve tried to split the difference—we invest in a relatively stable mix of capital-preservation-minded stock and bond funds, hedge-fund-like strategies, as well as diversifying agents like commodity futures and global REITs. Because the portfolio makes use of lower-beta alternative funds as well as fixed income, we think it’s suitable for investors with intermediate time horizons, but who can’t stomach the full arc of the market’s swings. However, the portfolio has meaningful exposure to traditional stocks and other market-sensitive securities, so it’s not invulnerable to losses, making it a poor choice for short-term investors. Finally, we don’t try to outsmart the market over shorter periods as part of a tactical overlay.

2. Real or Nominal?
You also have to ask whether the absolute return strategy is seeking to generate positive nominal or real returns over the specified time horizon. The answer can dramatically alter the complexion of the portfolio, from one that skews to fixed income (which boasts predictability of nominal returns, but is susceptible to inflation) to another that makes liberal use of stocks, hard assets, and nontraditional strategies (which are more volatile, but likelier to generate positive real returns over longer periods).

The real/nominative choice can also have an impact on portfolio construction itself. For example, a low-inflation climate is likely to be friendlier to an absolute-return strategy that invests for nominal return. Yet, it stands to reason that most bond-heavy “conservative” portfolios would also fare well in such a climate, which presents a quandary—why resort to absolute return when bonds will do? The answer might be to build an absolute return strategy that invests in lower-volatility arbitrage strategies that are less levered to interest rates and inflation, thereby enhancing diversification. On the flipside, when inflation is on the upswing, equity-like strategies such as opportunistic long/short and real assets are more likely to come in handy.

Potential Solution: Construct Two Models
We offer two different nontraditional models. (Exhibit 1 shows a sample.) One is geared toward nominal returns (absolute return), and the other more explicitly targets positive returns after inflation (real return). The portfolio-construction approaches are distinct. Our absolute-return model invests in a grab bag of assets and disciplines, including traditional and non-traditional approaches, with an eye toward muting volatility and boosting diversification. For its part, the real-return model allocates more heavily to areas like commodities, TIPS, and bank loans, is less concerned with downside avoidance, and tends to be more correlated with the stock and bond markets. We split the two apart not because the goals of each portfolio are wholly incompatible, but rather because we felt that we could better differentiate and, thus, convey the objectives and attributes of each model to clients.

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