(February 20, 2013) — Relative returns are dead; only absolute returns will do. But how do you choose from the vast array on offer?
A raft of new products proffering absolute returns hit the market in 2012–some 60 new funds, according to Morningstar Investment Services. Jeffrey Ptak, CIO at the firm, has put together a handy guide for investors considering constructing a portfolio that incorporates the strategy, noting what questions to ask before committing.
1. Short or Long Term?
“If it’s called absolute return, time horizon wouldn’t seem to matter much. Whether it’s one month, a few years, or even a decade, the return is supposed to be absolute, after all. But time horizon does indeed matter–the shorter it is, the more difficult it becomes to build an absolute-return portfolio that lives up to its name.”
Ptak says investors should extend their time horizons and buy some wiggle room. This allows for stakes in non-traditional strategies that are less correlated to the stock and bond markets but court the risk of losing money over shorter periods of time in the process.
“An absolute-return-minded investor with a short time horizon faces a stark choice: load up on drawdown-resistant securities like bonds (which court their own set of issues) or tactically jump in and out of riskier assets (a practice that’s highly error-prone).”
2. Real or Nominal?
“You also have to ask whether the absolute return strategy is seeking to generate positive nominal or real returns over the specified time horizon,” says Ptak, as the answer can completely change the complexion of a portfolio.
Considering the exterior investment landscape, such as inflation, interest rate and growth figures, may also skew the construction of the portfolio.
Ptak recommends constructing two models: One geared toward nominal returns (absolute return), and the other more explicitly targets positive returns after inflation (real return). Each has a different asset allocation universe, targeting a mixture of uncorrelated returns and downside protection.
3. Diversification or Upside?
“Hyperbole aside, most alternative mutual funds have proved to be pretty mediocre diversifiers. The bulk of alternative funds are equity- or bond-like, with relatively few exhibiting what one might consider non-correlation,” Ptak says, citing a range of supposedly diversifying funds.
In fact, very few funds have low correlations with major stock or bond indices and even fewer have been tested over an entire market cycle, Ptak says.
However, this low correlation does not mean they produced impressive returns. “The reason is simple: market-neutral funds dominate the list and such funds are built for stability, not speed.”
Morningstar’s solution is to create a model that targets the upside, but using a risk-aware framework that uses bonds and lower volatility strategies.
“We’ve found it very difficult to find reliable diversifiers, and have only become more leery as investors have converged en masse on the alternatives space (as it’s often a prelude to higher future correlations),” says Ptak. “We seek at least 40% of the equity market’s upside, but without the associated downside and volatility.”
4. Absolute or Relative?
The key is to set expectations, according to Ptak. “If the goal is literally to deliver positive returns come hell or high water, then the portfolio is unlikely to have much bounce in its step during rallies and probably will be sensitive to changes in interest rates … Conversely, a portfolio aiming for relative returns will, for all of its upside potential, be more volatile, prone to drawdowns, and highly correlated with the equity market.”
Time horizons are, again, crucial, Ptak says, as this affects risk tolerance and acceptance of losses.
Morningstar’s solution is to not try to avoid losses at all costs, but target good upside potential through a range of strategies.
“Rather than manage the portfolio per a rigid risk-parity policy in which we have to peg the beta or volatility to a target, we aim for a consistent mix of assets and disciplines. In effect, we accept fluctuations in correlations and volatility in exchange for higher future potential return,” Ptak says.
5. Gross or Net?
Ptak warns investors not to get carried away with the exoticism promised by alternative strategies and note the final return figures after fees.
“To state the obvious, alternative mutual funds aren’t cheap: the median expense ratio of the 250-plus alternative funds peer group we examined was a hefty 1.7%. Given that many of these funds don’t appear to deliver much incremental diversification (exceptions duly noted), you essentially pay a premium for the manager’s security selection chops,” says Ptak.
Some funds are also cheap for a reason, Ptak warns and watered-down high octane strategies are not a good choice for many. Investors should also be aware of the distribution and adviser fees that are often glossed over.
“We take a dim view of any strategy that costs more than 1.5% in annual expenses.” says Ptak.
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