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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.

3. Diversification or Upside?
Hyperbole aside, most alternative mutual funds have proved to be pretty mediocre diversifiers. To illustrate, Exhibit 2 plots the median since-inception one-year correlation of returns for alternative mutual funds to the broad U.S. stock and bond markets. (In other words, we tallied up rolling one-year correlations to the stock and bond markets and calculated the median for each fund that was at least one-year-old as of Nov. 30; we excluded inverse and currency funds.) As shown, the bulk of these alternative funds are equity- or bond-like, with relatively few exhibiting what one might consider non-correlation.

Of the alternative funds whose returns have been relatively uncorrelated with the stock and bond markets, many are new to the scene. Indeed, when we examined alternative funds whose median one-year correlations to the S&P 500 and Barclays Capital U.S. Aggregate Bond indexes were less than 0.2, we found that only 11 had been around since October 2007, when the S&P hit its all-time high. (That figure rose only slightly, to 22, when we expanded the scope to include alternative funds whose median correlation to the S&P and BarCap was less than 0.6.) You’ll be hard-pressed to find many alternative funds that truly go their own way from the stock and bond markets and, of the few that do, have been tested by a full market cycle.

When you find those needles in the haystack, the challenge isn’t downside protection, but rather upside participation—the average rolling one-year upside capture ratio of the 11 alternative funds was a measly 3%, though 22% when we expanded the scope to the 22 alternative funds that had correlations of 0.6 or less. The reason is simple—market-neutral funds dominate the list and such funds are built for stability, not speed.

Potential Solution: Think Upside
We’ve built our absolute-return model with upside in mind, albeit in a risk-aware framework that makes abundant use of bonds and lower-volatility disciplines like market neutral and merger arbitrage. We’ve found it very difficult to find reliable diversifiers, and have only become more leery as investors have converged en masse on the alternatives space (as it’s often a prelude to higher future correlations). We seek at least 40% of the equity market’s upside, but without the associated downside and volatility. This explains the mix of traditional and nontraditional funds that encompass the model.

4. Absolute or Relative?
There’s a big difference between building a portfolio that’s impervious to losses and one that seeks to split the difference between equity-market upside and bond-like volatility. With the former, you’re probably going to lean on inflation-protected bonds, precious metals, and lower-volatility alternative strategies like merger arbitrage and market neutral. With the latter, you’ll have more room to roam, with opportunistic long/short, traditional equity, and commodity futures playing a role.

The key is to set expectations. If the goal is literally to deliver positive returns come hell or high water, then the portfolio is unlikely to have much bounce in its step during rallies and probably will be sensitive to changes in interest rates, traits that clients should be made aware of up front. Conversely, a portfolio aiming for relative returns will, for all of its upside potential, be more volatile, prone to drawdowns, and highly correlated with the equity market. These, too, are key attributes that ought to be highlighted.

It’s worth noting that time horizon is usually pivotal to this decision. If you set a short time horizon, it stands to reason that there’s little tolerance for risk and losses, dictating an absolute-return focus. If, on the other hand, you set a longer time horizon, it should afford the breathing room needed to endure the occasional drawdown.

The absolute-vs.-relative decision can also inform portfolio construction. For example, if you insist on keeping the portfolio’s market sensitivity, or beta, constant even as the market fluctuates, it’ll mean dynamically ratcheting position weights higher (to risk-up when markets are placid) or lower (to risk-down when volatility kicks up). This epitomizes a “relative” approach. Or, instead, you can largely dispense with that by investing in a stable mix of low-beta assets or alternative disciplines that are more explicitly risk-averse.

Potential Solution: Aim for Consistency
We have not attempted to build an absolute return strategy that’s draw down-proof. Instead, we aim to strike a distinctive risk-and-reward profile that complements traditional stock/bond allocations. Our reasoning is that we’re not willing to load up on bonds or invest in alternative strategies with limited upside potential. We think it’s inconsistent with the intermediate-term time horizon that’s appropriate for a moderate strategy like absolute return. Along those lines, rather than manage the portfolio per a rigid risk-parity policy in which we have to peg the beta or volatility to a target, we aim for a consistent mix of assets and disciplines. In effect, we accept fluctuations in correlations and volatility in exchange for higher future potential return.

5. Gross or Net?
If you’re building an absolute-return portfolio, it’s easy to get carried away. Many of the funds are new, ply exotic strategies, and boast the panache of “alternative investing” and all that the term conjures. Price might not be an object the way it would in choosing, say, traditional stock or bond funds. But you can’t get carried away—you have to ask if the goal is to deliver positive returns before or after fees. That means weighing the expenses each fund levies, plus any other fees that you (or others you partner with) might be charging.

To state the obvious, alternative mutual funds aren’t cheap—the median expense ratio of the 250-plus alternative funds peer group we examined was a hefty 1.7%. Given that many of these funds don’t appear to deliver much incremental diversification (exceptions duly noted), you essentially pay a premium for the manager’s security selection chops. How much is too much? On logic, it might depend on the risk-adjusted return potential you see in the strategy concerned; but on principle, it might be “no more than 1.5%,” or whatever figure represents the max you’d pay for a manager.

If you want to build an absolute-return portfolio on the cheap, the pickings are slim: Only a handful of alternative funds charge less than 1%. The best you can usually hope to do is keep expenses below the norm. Even that entails trade-offs, as the lower-cost funds tend to skew towards the dowdier end of the spectrum, where you might find market neutral and covered call funds. If you’re determined to wring costs out of the portfolio, you could end up with a lower-octane strategy that has rather limited upside potential.

That’s a good segue to the second category of expenses that you have to be mindful of: Advisor and overlay fees, which normally range from 1% to 2%. Suppose you thoughtfully construct an absolute-return portfolio using lower-cost alternative funds; because it tilts toward market-neutral and merger arbitrage, you think it will chug along at cash-plus-3% and be a decent diversifier to boot. Sounds good, right? Sure, provided you ignore the cost of building the portfolio and rendering ongoing advice. Factor those expenses in, though, and you don’t have much to show for your efforts, as the additional costs consume much of the return the portfolio generates.

The rub is that the more mouths there are to feed on the distribution chain, the stronger the imperative to allocate to higher-potentialreturn alternative strategies. Why? It’s the only practical way to clear the expense hurdle.

Potential Solution: Don’t Pay Up
We don’t think it makes sense to pay an arm and a leg to invest in alternative mutual funds. We seek to minimize expenses. True, the overarching portfolio-construction goals will ultimately drive the mix of funds. That, in turn, will largely explain the price we pay. But we’ll never pay up for novelty. We take a dim view of any strategy that costs more than 1.5% in annual expenses.

 

Note: The opinions expressed herein are those of Morningstar Investment Services; are as of the date written and are subject to change without notice; do not constitute investment advice and are provided solely for informational purposes and, therefore, are not an offer to buy or sell a security; and are not warranted to be correct, complete, or accurate. Morningstar Investment Services shall not be responsible for any trading decisions, damages, or other loses resulting from, or related to, the information data, analyses, or opinions or their use. The terms “us” and “we” refer to the industry as a whole and do not necessarily refer to Morningstar Investment Services.

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