I am a firm believer in integrating absolute return oriented strategies into portfolios. For that matter, I'm a believer in integrating non-traditional assets into portfolios. This category, for me, includes absolute return oriented strategies, real estate, commodities, and timber. For most investors, our options are limited to open and closed end funds and exchange traded funds. Closed end funds and ETFs can provide coverage for real estate, commodities (including currency) and timber, as well as other natural resources. Neither offers much in the way of absolute return (long/short) strategies yet, though I wouldn't be surprised if they're on their way. I have experience researching and developing potential "active" ETF strategies and, while they're difficult to implement, long/short strategies will be here soon.
Absolute return strategies have taken a media beating in early 2009 for not "living up" to their reputation. Several media pundits have lambasted the strategies as failures with high fees because they didn't deliver a positive return in 2009. This reminds me of my early days at my last firm as the hedge fund market exploded. Many institutional investors wanted exposure but needed transparency and liquidity so they turned to institutionalized hedge fund strategies. There was a common misperception among this group that an absolute return strategy would ALWAYS generate a positive return. After all, that's what absolute return means, right? However, absolute return is the OBJECTIVE of the strategy. The only strategy that I know of that ALWAYS returns a positive return, legally, is rolling 3 month t-bills. Those holding the belief that absolute return strategies are failures if they don't provide always a positive return are missing the bigger picture.
Absolute return strategies (AR) do offer very real benefits when added to traditional asset allocated portfolios. The better strategies are poorly correlated with equity and fixed markets and thus help reduce overall volatility. Almost all AR strategies have short exposure. This exposure reduces the beta of the strategy relative to long-only indexes and strategies tied to them. This is key to reducing overall volatility. These strategies are also poorly correlated to each other. The introduction of short exposure and optimization techniques used by many managers reduce intended exposures to only those in which the managers believe they have skill. AR strategies are very well suited to a pseudo "fund of funds" approach because of their lack of correlation to each other. This is the rationale behind Hedge Fund of Funds. Integrating several strategies, theoretically, can reduce overall risk substantially. This combined portfolio can then be plugged into the broad portfolio and really drop overall volatility. The key is to ensure these strategies truly are as poorly correlated as they appear to be.
So, AR strategies reduce portfolio volatility. The second benefit is the absolute return potential of these strategies. This objective can provide downside protection for a portfolio otherwise oriented to long-only strategies. 2008 demonstrates the damaging effects of long-only strategies on personal wealth. Adding strategies designed to truncate the downside can mean the difference between devastation and just plain disappointment with portfolio performance.
I scanned Principia and identified 31 absolute return oriented strategies. These covered equity market neutral, low-net (long-biased but the long exposure is well below 100%), merger arbitrage, global macro and fund of funds approaches. The average return for 2008 for these funds was (9.04%) so they did not generate a positive return. Given that only cash and Treasuries had positive returns in 2008, this shouldn't surprise anyone. Yet, I would guess in hindsigt that almost every investor would accept a (9.04%) average return for 2008 if offered the opportunity. This "portfolio" had positive returns in 8 of the past 10 years (the other negative year was 2002 down (0.93%)). Trailing returns through January 31, 2009 are similar - down (8.80%) for 1 year, up 0.17% for 3 years, up 2.13% for 5 years and up 3.45% for 10 years. This portfolio beats the S&P in every time period by at least 6.00% net of all fees. The 3 year R2 for this portfolio is 5 and the beta (both to the S&P 500) is -2.74 with a 3 year standard deviation of 7.54%. What that means is this portfolio is largely uncorrelated with equity markets and thus would have dropped overall volatility. That is a good thing.
If I was implementing an alternative approach, I'd screen further to eliminate the higher fee, load share strategies. I'd also dig deeply into the process and management. Is the process understandable and is it repeatable? Look for lurking size and style beta exposures. Does management have experience shorting assets (not as easy as it may seem)? Keep in mind as well, that these strategies are not designed to blow the lid off in good markets. Frequently, they're designed to out-perform 3 month T-bills (proxy for cash) by a certain rate, for example cash + 4%. That means, very high returns are unlikely, unless cash is also returning at a high rate (which wouldn't be a good thing because that suggests very high inflation or a deep lack of faith in the U.S. government!) I know there are good options available which are undeserving of the scorn currently being heaped on them. These strategies aren't for everyone but if you have the knowledge (or your advisor does) and you have the risk tolerance, consider adding absolute return strategies to your portfolio.
