If you’re like many investors, you may be wondering what is so novel about that. Don’t all funds seek a positive return? The fact is, since the advent of performance benchmarks like the S&P 500 Index, most funds have defined success in relative terms. If a fund outperforms its benchmark, it’s considered a success, even if the fund’s return is negative. If a fund underperforms its benchmark, it’s considered a failure, even if that fund is meeting its stated objective. Relative return funds also rarely set absolute volatility targets, preferring again to compare their volatility against that of their benchmark indexes.
Absolute return funds take a different approach altogether. By doing away with conventional benchmarks and instead striving for consistently positive performance and lower levels of volatility, absolute return funds can offer a number of potential benefits when added to a broadly diversified portfolio:
· Reducing overall portfolio volatility
· Limiting losses in down markets
· Broadening the sources of investment returns
· Providing valuable diversification potential
· Improving a portfolio’s risk-adjusted return
One way to think about absolute return strategies is that they are the worriers of your portfolio. While other portfolio managers are thinking about what can go right in financial markets, absolute return managers are obsessed with what could go wrong, and manage risk accordingly.
How do they do it? Absolute return funds vary widely in the tools they use to implement their strategies. In fact, these funds are often referred to as unconstrained because they can invest in a vast array of financial instruments—stocks, bonds, currencies, derivatives, short positions—just about anything that may help deliver that positive return with less volatility.
What absolute return funds have in common is that they generally strive for returns that have a low correlation to traditional stock and bond markets. Correlation is a statistical measure that describes how investments move in relation to each other. If two assets have a correlation of 1.0, they are said to be perfectly correlated and will generally generate returns in the same direction, and to the same degree. If two assets have a correlation of –1.0, they are considered negatively correlated, meaning they perform in the exact opposite direction but to the same degree. A correlation of zero means the two assets have no performance relationship at all.
This lack of correlation can be helpful to a portfolio because there are times during market downturns when correlations rise among traditional asset categories such as stocks and bonds. In fact, during the 2008 sell-off, financial assets notoriously declined across a wide variety of asset categories around the world. The time-honored approach of mixing stocks and bonds in portfolio for diversification was simply not enough to prevent losses. Having a portion of a portfolio invested in absolute return strategies is one way of helping to limit losses—and potentially generating gains—when nothing else is going up.
Without traditional benchmarks as a guide, it’s not as simple to determine whether an absolute return fund is doing its job. Investors can also be disheartened during strong equity bull markets, when these relatively conservative strategies almost always trail their stock fund brethren. Fortunately, there are two commonplace metrics that together can shed light on absolute return performance.
measures the performance fluctuation or volatility of a financial asset or portfolio. An absolute return fund’s standard deviation should be significantly lower than that of any broad stock market index, 50% lower or less. All other things being equal, the addition of a low-volatility investment into a portfolio will reduce the overall portfolio volatility.
measures the incremental return achieved per unit of risk taken, as defined by standard deviation. A higher Sharpe ratio suggests better risk-adjusted performance.
The ultimate goal of adding an absolute return fund to a portfolio is to improve the risk-adjusted return of the entire portfolio, with a higher incremental return achieved from a less volatile mix of investments.
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