Relative versus Absolute Returns
Relative return strategies measure performance relative to the movement of an unmanaged index of securities, e.g., the S&P 500, the Russell 2000, etc.
In the world of relative returns, you “succeed” if you meet or beat your benchmark index; you “fail” if you trail your benchmark index. The consequences of failure – i.e., being fired – are quite drastic. To avoid that fate, a relative return manager must at least match the index returns (on a risk-adjusted basis). As a result, many relative return managers simply “hug” the index, i.e., they construct portfolios that essentially mirror the index. In effect, they tie their fates to mimicking a benchmark. What does this mean?
- Relative return strategies are great during bull markets when indexes rise.
- Relative return strategies stink during bear markets – they offer limited, if any, protection when target indexes decline.
- Alice in Wonderland: relative return strategies can be “successful” even when they lose money! For example, if your index is down by 20% but your holdings are down by “only” 17%, you have beaten your benchmark – and you have “succeeded” even though you are down 17%. Conversely, if the index is up 20% and you are up “only” 17%, you have lagged your index by a substantial margin – and you have “failed” even though you are up 17%.
And so, when considering a relative return strategy, we ask the following questions:
- Why limit yourself to a world that can define a down year of 17% as “good” and an up year of 17% as “bad”?
- Why tether yourself to something as unpredictable and uncontrollable as an unmanaged index of publicly traded stocks?
- Why play only in a world where the goal is to be a mimic, where creativity to go your own way is discouraged?
Absolute return investing answers each of those questions with “there is a different way.” In the world of absolute returns, investors do not concern themselves with benchmark indices over which they have no control. Rather, they seek to generate positive returns independent of market movements, i.e., whether the market indexes move up or down.
Absolute return managers employ various techniques designed to take the market out of the equation. These techniques include:
- selling stocks, markets and/or sectors short
- using options, futures, swaps and/or other derivatives to manage risk.
- employing arbitrage techniques.
These strategies can have a profound impact on the risk/reward characteristics of a portfolio, and they are increasingly available to mutual fund investors.
The Case for Absolute Return Investing?
In our view, the case for absolute return investing is rooted in the following:
- People’s decisions to buy and sell move stock and bond prices. People might buy or sell in response to external events; however, it is an individual’s decision to buy/sell, and not the actual event, that contributes to the price of a security.
- We cannot know what will happen in the future; we cannot know the decisions other people are going to make.
As such, we view risk as the possibility that other people will make decisions that lead to outcomes different from what we desire, i.e., markets and/or individual securities will move against our positions.
Tools exist to hedge against such movements. Absolute return investing uses those tools. Properly used, those hedging tools can remove the market from the equation and lead to consistent, positive returns regardless of market movements.
Once hedged, investors are free to make decisions whenever they see value or opportunity. Hedging releases us from the fear — the risk – of being highly dependent on others’ actions and decisions. It frees us to act in the moment, to creatively access and choose from among the vast number of solutions that are available for any situation.
With that in mind, we invite you to explore the increasing marketplace of mutual funds devoted to absolute return investing.