Most investors, individual or institutional, tend to view returns on a relative basis, that is, how did we do relative to a benchmark like the S&P 500. I don't think this is necessarily a good thing. My issue is that these benchmarks are long-only. Relative performance doesn't mean much when your portfolio is down 30% and the S&P is down 37%! My view is that investors should focus on returns in an absolute sense. There is still a benchmark involved which means there is still a yardstick against which manager performance can be measured. In fact, it is a much more difficult benchmark because most mutual funds are also long-only and thus will struggle when prices decline. So I'm proposing investors hold their managers to a benchmark which is much more difficult to beat and against which their portfolios are structurally mis-aligned.
Doesn't make sense, right? My argument is that most investors should perceive their portfolios as endowments. I believe it is the intent of most investors to grow their endowment during their lifetime such that that endowment will fund their retirement in its entirety and potential provide a legacy for future generations. Focusing on an absolute return orients investors toward achieving this goal. Long-only benchmarks go up and down while absolute return benchmarks, primarily 3 month T-bills, don't. This orientation changes how a manager perceives the asset allocation. If the objective is to generate a consistent positive return, the manager must consider investments outside of the traditional long-only asset classes. That means such options as commodities, real estate, timber, absolute return, market neutral, and long-short (such as 130/30 strategies). Now you're incorporating more poorly correlated assets into your portfolio which should improve diversification, should reduce volatility and should orient the portfolio return objective toward an absolute return. It is a challenge to accomplish in the retail mutual fund world but I believe it can be done.
