All absolutes are not created equal
During recent years, particularly since 2000, there has been substantial and growing interest in absolute return investing. We believe there are two types of approach to absolute return investing and it is critical to understand the differences.
One form is the hedge fund style – an approach that targets relatively predictable, consistent and positive returns regardless of market
The second form focuses on the long term and targets high absolute returns without reference to a market benchmark. It accepts that some shorter-term declines in asset values will occur at times but that higher risk-adjusted returns should result over longer time periods to compensate. The difference is substantially about time horizon.
Understanding the merits of both forms requires reference to relative return approaches and market benchmarks. The overwhelming majority of funds favour this approach to investment strategy which is based on two principal foundations:
q The strategic asset allocation for a fund and the accompanying benchmark portfolio which turns the asset allocation into an actual portfolio against which the performance can be monitored; and
q A series of investment manager benchmarks specified for each manager which collectively sum to the benchmark of each fund as a whole.
Funds that have adopted these two strategic foundations can be said to have implemented a benchmark approach. There are advantages associated with this approach:
q Strategic asset allocation can easily be modelled (generally using asset liability modelling) and this can be used to produce efficient specific solutions fitted to client circumstances, such as different liability structures;
q The performance of the managers can be monitored in a way that isolates their skill.
But this approach has come under criticism in recent years and benchmarks seem to involve three principal disadvantages:
q They can discourage managers from holding investments outside the benchmark universe;
q They can encourage managers to hold investments they do not like solely for risk control purposes;
q In bear market conditions, there is limited protection to offset the downward influence of benchmarks (which became readily apparent during the acute equity bear market of 2000-2003).
Market conditions between 2000 and 2003 led many to question funds’ reliance on equity-type benchmarks and an increased focus on the absolute return approach has been the result.
The hedge fund type of absolute return is probably the best understood. Here ‘absolute’ is used to denote ‘positive’ and so the purpose of this investment approach is always, regardless of market conditions, to generate positive returns. We might also add another characteristic – that this is concerned with the return of the asset being looked at and does not compare it to any other market benchmark.
Absolute return strategies of this type generally have these targets or characteristics:
q Relatively stable and predictable returns – preferably targeting positive returns on a monthly basis but, failing that, returns should be positive on an annual basis;
q Achieving returns above cash – targeting LIBOR + 4% or 5% per annum would be quite normal in the hedge fund world;
q Volatility that is lower than equity markets – most hedge funds target single-figure volatility.
The story of hedge funds goes back to 1949 when Alfred Winslow Jones and four others created a new type of investment vehicle which bought stocks that were deemed attractive and shorted stocks deemed unattractive.
The original hedge fund also
limited itself to wealthy individuals who had a desire for capital preservation over capital growth, and this client focus continued intact until the 1990s.
While hedge funds as a group are diverse, two features which typically draw them together are the ability to short market securities as well as the associated focus on achieving positive absolute returns over even short time periods, often through being net short overall to avoid the impact of bear markets.
Hedge funds with their short-term focus can also produce very competitive longer-term performance (compared with long-only portfolios), but this is most likely in decades of below average market performance. This suggests that the approach works better as a part of the strategy alongside other approaches in a line-up of diverse mandates and strategies. This should help to dampen down the impact of a decade of below average market performance, while also allowing funds to gain access to a different set of risk/return drivers. An additional approach within a diverse line-up of strategies could be the long-term absolute return strategy.
Let us look now at longer-term absolute return. A ccording to Warren Buffett: “My favourite holding period is forever.” This approach uses very wide investment discretion to create high absolute returns over time. Here ‘absolute return’ is used to differentiate from ‘relative return’. In absolute return investing there is no investable market benchmark to construct a portfolio around and so no significant investment constraints. There is also no assumption that the returns will be consistently positive in the short term.
Absolute return strategies of this type generally have these targets or characteristics:
q Long-term performance above the market return and well above inflation – CPI +6% pa would be a typical target;
q No explicit shorter-term downside target – short-term loss of capital is expected periodically;
q Volatility of close to or a little less than the market.
While investment theory anticipates positive absolute real returns over the long term from all asset classes apart from cash (otherwise why take the risk?), this longer-term investing approach depends on improving such positive absolute real returns. This improvement originates from a general disregard for the performance of reference benchmarks, meaning that such approaches cannot be tracked on a passive basis. As this approach has absolute return targets instead of market benchmarks, investors in this approach should judge the performance of their managers in relation to these targets with a more long-term view.
To understand the potential benefits of this approach to investment, it is first necessary to answer the question “Isn’t the long term just a succession of short-term periods, making the distinction above unnecessary?” We would argue that it is not. The fundamental difference is that successful long-term investment can often result in poor short-term performance, indeed the sort of performance that would lead to manager termination in mandates that are not specifically engaged on long-term monitoring parameters.
We believe that the returns available to investors have the potential to be higher if the constraints arising from the use of benchmarks are relaxed or removed. The four main arguments in support of this case are:
q Access to certain long-term investment styles which exploit the mispricing of assets. Market prices tend at times to overshoot and undershoot their true fair values. A long time horizon is often required for prices to ‘correct’ themselves and a fundamental value investment style can exploit this, provided the manager has the patience (or its clients let it have the patience);
q Avoiding unnecessary trading costs. Long-term investors buy and sell assets less frequently than short-term investors, which results in lower overall costs in commissions, trading spreads and taxes paid;
q Earning a liquidity risk premium. Most investors value the efficiency (in terms of time and cost) at which an asset can be sold for cash. As such, there is a cost associated with liquidity that investors pay for. Long-term investors who do not require liquidity can instead earn a liquidity risk premium by investing in illiquid assets;
q Providing beneficial macro effects on corporate wealth creation. Long-term investors can engage more successfully with their investee companies and directly encourage these companies to favour long-term wealth-creation strategies. One would expect to see a virtuous cycle of efficient capital deployment, profit distributions and capital reallocation developing between investors and corporations.
We find attractions in both approaches to absolute return, but most institutional investors, even in the face of changes to international accounting standards, have a natural orientation towards the longer-term and less need for short-term stability, given the term of most liabilities. This suggests that the allocations to longer-term absolute return strategies would generally be greater than to shorter-term absolute return strategies.
In both, there are big challenges in selecting skilful managers and monitoring them well. These approaches fit best with the best governed institutions. We should also recognise that these approaches are used by many of the best investors in the world and are set to play a much bigger part in the industry.
Roger Urwin is global head of investment consulting at international consultants Watson Wyatt