In recent years, the use of derivatives and absolute or total return strategies has become an increasingly prominent part of the investment dialogue. The strategies and performance of some hedge fund and managed futures managers have gained wide attention. Yet, for many institutional investors, absolute return strategies remain a mystery, even though assets allocated to these strategies total more than $400bn (E375bn). Increasingly, these strategies are under consideration by plan sponsors, who follow wealthy family groups, endowments and foundations in their acceptance and use of absolute return strategies.
Despite concerns about various hedge fund and managed futures strategies, some academic research on these strategies has shown that use of derivatives for investment within a managed futures or hedge fund is in many ways less risky than traditional investments. These strategies often trade in the highly liquid, government-regulated futures and options markets, in which price transparency and standardised contracts offer protection from counterparty risk.
Whether the use of derivatives takes the form of alpha transport, portfolio overlay or direct investment, absolute return strategies offer unique return opportunities compared to traditional equity markets. These strategies are especially valuable to the investor when traditional markets experience their worst returns, and offer increased return efficiency when added to existing stock, bond, or stock and bond portfolios.
Absolute return strategies actively seek positive returns under a variety of market conditions. While tracking error relative to a benchmark is important, absolute return managers are equally concerned about safeguarding against the possibility of loss of principal. Since these strategies typically embrace both long and short positions, a wide variety of markets, derivative products, techniques and often leverage, performance is largely independent of traditional stock and bond market returns. The best of these strategies exhibit high correlation with traditional investment vehicles during up markets but low correlation during down markets.
We have long taken the view that using derivative instruments can be a cost-effective way to gain exposure to markets, eliminate exposure to markets or hedge positions. Derivatives also permit the pursuit of enhanced strategies that get market exposure through futures while actively managing cash instruments. The prudent use of derivatives is appropriate in investment strategies and is, in fact required because best price and cost-effectiveness are part of the fiduciary requirement.
Now it must be noted that derivatives require more sophisticated monitoring than physical securities and oversight by senior management is a must. Counterparty credit risk must be monitored and evaluated regularly and even plain vanilla futures contracts need analysis, which is specialised. We have long held the belief that convoluted structures should be avoided and portfolio managers must be reminded that derivatives are instruments, not strategies. So when you read about derivatives blowing up, we need to ask again whether the instrument was understood because these instruments do what they are supposed to do but if misunderstood they can be horribly misused.
Let us also remember that certain structures have been designed to get around restrictions and may have asymmetrical payoff patterns. These should be avoided or used cautiously in the institutional portfolio.
John Serhant is a principal with State Street Global Advisors in Boston