Absolute Returns, Maybe. Absolute-Return ETFs? Absolutely Not!

by: Joseph L. Shaefer

There are a number of absolute return funds, at least one ETF, and a number of published strategies that purport to keep you in positive territory in any market. Can this happen? Well, yes -- but it depends on how little you are willing to accept in return for the security of being able to sleep at night, no matter what the market does.

At my firm, we don’t believe this alleged Holy Grail of investing is a reasonable alternative. Instead, we work extra hard to dampen the downstrokes and increase our exposure on the upside. That’s worked particularly well for us, as our ten-year track record shows. But our approach requires us to be flexible in our thinking, highly mobile in being willing to move into cash or out, and ever vigilant for both opportunities and the scent of danger.

That’s quite distinct from what “absolute return” attempts to do, which is to establish what is basically a “set it and forget it” portfolio that, because of the nature of its diversification, will allegedly provide a constant return of some sort through thick and thin.

The only way to guarantee a “return” in any market is to take virtually no risk –like placing all your money in a money market fund all the time. Pre-inflation and pre-taxes, you’d always have some return. Right now, that would be around 0.9% per year. After taxes and inflation, today it would likely be a negative return. In a more normal market environment, however, it might keep you current with inflation and would certainly keep you in front of the taxes you’d pay on it.

Personally, I have nothing against money market funds – as short-term places to stash cash between investments, they beat taking the risks of trying to beat a dubious or devilish bear market. But that’s “short-term.” And “between investments.” Absolute return purveyors, funds and ETFs couldn’t justify their fees if they only kept you in 100% cash. So they line up a whole plethora of allegedly counter-to-each-other investments that are designed, occasionally successfully, to set and forget with the interplay between them all (“the sum”) doing better than any of them individually would (“the parts.)

What might such a portfolio look like? There are as many combinations and permutations as there are portfolio managers, so I’ll offer one purely as an example (click to enlarge):

Click to enlarge

In this example, 54% of the total portfolio would be in bonds, 32% in equities, 19% in other asset classes (cash, real estate and precious metals) and a minus 5% in shorting – ostensibly -- the weakest stocks. This kind of “automatic” portfolio will appeal to many investors. Engineers often love it. You place x per-cent in asset classes that provide solid income, occasional gains, and a certain contra-cyclicality to the overall market. It has a certain lyricism, the idea being that a fine conductor can make beautiful music from all these disparate instruments.

And yet I am not a fan. Why not? Because I believe quite strongly that this approach is seductive in its simplicity but ultimately destructive in its dimension. It does not reflect the dimension of TIME.

“What if” the US government were able, because of problems elsewhere in the world, to so depress interest rates for so long as to effectively pay 2 or 3% for years at a time? Would you still think having 30% of your portfolio (plus the 5% in REITs) tied to US interest rates was a great idea?

“What if” this 2000-2010 (so far) US secular bear market were to end tomorrow while at the same time emerging markets crumbled and developed markets lagged behind the US? Would you still be happy with a mere 16% in US equities – with another 16% in the overseas laggards and a 5% short position?

“What if” the nay-sayers are correct and we are entering the next Great Depression – would you be happy with 7% in gold and a 5% short position while you watch virtually everything else you own plunge to next to nothing?

Over TIME, you may want to adjust your portfolio.

I’ve made the case in a number of previous articles that the time for a static position like buy-and-hold is during secular bull markets – not in markets that gyrate wildly and ratchet up, down and sideways, which is typical of secular bears. This is the time for dynamism, not buy-and-hold, no matter how seductive the siren song of “absolute return”. Absolute return is the buy-and-hold of bear markets, holding out the promise, but seldom the delivery, of being able to set your portfolio and get on with your life.

By ignoring where we are in the great market cycle, however, it will typically fail to deliver. I want to have the flexibility to say, “This is a Time I want to be long more bonds (or short them).” Or “This is a Time I want to own many more emerging than developing markets.” Or “This is a Time I want to take a far greater position in precious metals and to sell puts for income.” No mechanical method, no matter how appealing on paper, offers that kind of flexibility for action based upon vigilance in surveying current markets.

Can you make more mistakes this way by getting it wrong? Sure. But I’d rather make mistakes and correct them quickly than stay wrong in pursuit of a mechanical system.

If you disagree, you’re welcome to survey the many mutual funds that employ this strategy or look at a brand-new ETF that claims to do so, the AdvisorShares Mars Hill Global Relative Value ETF (GRV). (Before you do, however, you may want to look at the performance of the absolute return mutual funds that have preceded this ETF…)

If, on the other hand, you believe the human mind should be used for something besides constructing a one-time portfolio and rigidly sticking to it; that we need to be more nimble in bear markets; and that the capital we preserve in bear markets is what affords us the luxury of a buy-and-hold approach when the bull returns, you might want to take a look at floating-rate bond funds that will protect against inflation (like TIP, WIP, PFL, and NSL), a little something for the downside (like VXX), solid income-producers (like NRP and PVR) some precious metals (like GG, SLW, GDX and our special-situation RBY), short-term bond funds (like MINT), select agriculture and energy ETFs like SGG, ENY and IEZ, special situations like Exxon (NYSE:XOM), Statoil (NYSE:STO) and Royal Dutch Shell (NYSE:RDS.B), a dollop of short-side ETFs like SDS, EUM, VXX and RWM, and lots of good clean cash.

All subject to change, of course. We’d prefer to trade as little as possible -- and we’ll keep every one of these as long as it makes sense to do so. Then we’ll fine-tune as needed. That’s how we strive for absolute returns in any market…