A look at some of the variations of absolute return strategies
- Returns and volatility are closely related.
- Long-only funds are unlikely to provide a positive return during prolonged market falls.
- It is necessary to consider the target volatility of absolute return funds.
There are many definitions of absolute return as an investment style, and most investors have their own succinct variation. Absolute return is best defined as any strategy where returns are generated with alpha, not beta.
The key question when considering such strategies is, what does the investor require in terms of performance? If volatility is the core concern, then ultra-low volatility approaches are available, but these are inevitably no more than cash proxies whose ability to generate any sort of significant return is severely restricted. Returns and volatility tend to go hand-in-hand. If a fund is persistently generating outsized returns in relation to its volatility, it could be that the risk is hidden and has yet to reveal itself.
More usually, absolute return strategies are employed to enhance and to smooth out the returns generated by a conventional portfolio of equities and bonds – in short, to hedge beta during market downturns. This is described by some as crisis alpha and it is these strategies that this article seeks to examine.
In general, equity markets tend not to melt up, but they do periodically melt down, often in response to an unforeseen or black swan event. Such a move is often accompanied by increased volatility leading to the reasonable conclusion that volatility spikes are, on average, bad for the equity allocation within a portfolio.
This tendency, where the speed and scale of a market fall is usually greater than a rise, can lead to a negative skew in the distribution of equity returns, where there are frequent smaller gains and fewer extreme losses. Hedging this characteristic, achieving the desired goal of smoothing and enhancing portfolio return, clearly requires an approach with different attributes.
Working to find the right hedge – the right absolute-return approach – using measures of correlation is, on its own, less helpful than one might imagine. Investment strategies may be closely correlated yet generate widely divergent results.
Counter intuitively, negatively correlated strategies may result in similar results. It is, see examples, possible for two funds to have an identical return over a period of time and be correlated -1.0 over that period. By the same token, it is no guarantee that two funds correlated 1.0 will both produce a profit over that same period (see figure).
While it is desirable to allocate to strategies that are uncorrelated or negatively correlated to existing investments within a portfolio, it is a mistake to assume that just because a fund is uncorrelated or negatively correlated to another fund within the portfolio, it will produce a profit if the other fund generates a loss.
To provide the most effective hedge against a market shock, an absolute-return fund should demonstrate a positive skew in the distribution of its returns – to balance the negative skew predominant with most traditional long-only investments. To achieve this, it must also be able to produce positive returns in falling and rising market conditions. In short, it must be generating alpha.
The Sharpe ratio, simply defined as the average return earned in excess of the risk-free rate divided by the standard deviation of those returns, treats upside volatility and downside volatility equally. It therefore considers that volatility associated with positive returns is the same as volatility associated with negative returns.
By comparison, the Sortino ratio differentiates between downside volatility and total volatility by only taking the standard deviation of those returns below the risk-free rate. These need not be negative numbers; a monthly return of +0.08% where the risk-free is +0.10 % would therefore be included in the calculation of downside volatility.
In equity markets, the Sharpe ratio tends to be higher than the Sortino ratio, demonstrating that the excess volatility is derived from negative returns on the left hand side of the distribution curve. In effective, positive skew, absolute-return strategies such as trend-following managed futures, the Sortino ratio tends to be higher than the Sharpe ratio, reflecting that the excess volatility derives from positive returns on the right hand side of the distribution curve. The most desirable scenario is one where the absolute-return strategy generates outlying positive returns, on the right hand side of the distribution curve, at the same time as traditional long-only strategies are generating outlying negative returns, on the left hand side of the distribution curve.
While there are many well-managed long-only funds that are producing alpha, they are extremely unlikely to be able to provide a positive return during a prolonged market fall. It is therefore imperative to have an unconstrained strategy with the ability to take both long and short positions.
If the aim is to lower the volatility of a portfolio, buying low-volatility beta is a mistake; what is required is alpha. As well as buying alpha, you need to buy alpha with volatility, at least at the same level as the portfolio you are looking to hedge is generating, in my opinion. In fact, it is likely that if a fund is generating real alpha, and not ‘beta dressed up as alpha’, that the higher the fund’s volatility, the more it will lower the overall volatility of the portfolio in question, up until the efficient frontier is reached.
In broad terms, there are two types of alpha-generating absolute-return strategies seeking to improve portfolio performance. The first of these is focused on generating consistent returns and will realise as little or as much volatility as the manager requires in order to achieve the fund’s target. Clearly, in a flat, low-volatility market environment, the amount of leverage required to achieve the targeted return may become prejudicial to health.
The second type ignores performance targets and focuses on targeting a constant level of volatility, which in some time periods will prompt the strategy to generate substantial returns and in others, rather less so. True, the volatility element within the strategy may cause some investors to cavil but it is important to recognise that the higher the volatility target of the fund, the smaller the allocation to it required within the portfolio.
Finally, it is necessary to consider the target volatility of such a fund when assessing it. Take, for example, a managed futures fund that charges a 1% annual management charge (AMC) and 20% performance fee and targets volatility at 10%. To some, such a fund appears to be cheaper than an equivalent fund that charges 1.5% AMC and 20% performance fee
and targets volatility at 20%, but it is not. The investor needs only allocate half as much capital to the latter compared with the former to achieve the same level of returns.
Darran Goodwin is a member of Garraway Capital Management and the manager of Garraway Financial Trends