As an active portfolio manager, I'm often asked if my goal is to achieve absolute returns for my clients. Meaning to strive for positive results no matter what the stock or bond markets are doing.
On the surface this seems like an obvious goal that everyone should be trying to achieve. I mean who wants to ride out years like 2008 when you can move to cash, add short positions, or otherwise reduce your risk profile during the falling market?
These types of unconventional strategies often employ concentrated positions, aggressive risk management techniques, or high allocations to cash. In addition, they can often seek out non-correlated holdings in alternative assets or sophisticated trading strategies.
Hedge funds are famous for this manner of investing, but they aren't the only ones to try and move away from a relative return versus a benchmark. Many investment advisors, mutual funds, traders, and other professional investors also try to accomplish the same feat.
In my opinion, the biggest upside to this style of investing is that you have the potential to significantly outperform your peers during a sharp correction or even prolonged bear market. Yet the obvious and more important downside is that you can have atrocious performance during big up years in the market.
According to the website Barclay Hedge, which tracks a range of hedge funds, the average return in 2013 was a gain of just 11.12% versus 32.27% in the iShares S&P 500 ETF (IVV). Even a traditional 60/40 stock and bond mix such as the iShares Core Growth Allocation ETF (AOR) did 15.88% that year. In fact, AOR has beat the Barclay Hedge Fund Index every year since 2011.
Obviously fees are going to play a big part in the hedge fund underperformance story and there is a big embedded disclaimer that each hedge fund should be independently evaluated for their own merits. However, the more important concept to grasp is the risk versus reward of non-correlated investment strategies. They are often times filled with unfulfilled potential and marketing buzzwords that fall short in real life practice.
Many investors have now gravitated towards the concept of using low-cost, index-based ETFs in their portfolio. These tools provide you with instant diversification and a wide range of asset classes at your disposal. Yet more importantly, they should be combined with an investment framework that allows you to implement them successfully.
I'm not a die-hard indexer that rebalances based on a schedule set by an atomic clock. So instead of setting rigid asset allocation and investment commandments that are carved in stone, I have created guidelines within each of my portfolios to allow a marginal level of flexibility.
Setting upper and lower exposure limits for stocks, bonds, alternatives, and cash can allow for some elasticity in your portfolio without going fully robotic. For instance, if your normal target is a 60% allocation to stocks, you may want to set bands at 45% on the low side and 75% on the high side.
These types of investment policies will allow you to size each sleeve of your portfolio according to risks and opportunities in each asset class. The variance in each investors bands will likely correlate with their risk tolerance and comfortability making changes over time. More aggressive or active investors may want to set bands of 20% on either side, while others will only be comfortable with a 5%-10% margin. More importantly, you can still compare your returns relative to an appropriate index or benchmark and use conventional asset classes with dependable results.
This setup will also keep you from falling into the trap of full blown capitulation during periods of volatility or attempting to outsmart the market when you think it's getting ready to turn. Anyone who has been investing long enough has experienced how trying to get too cute can get you in big trouble in a short period of time.
The Bottom Line
Successful investing is difficult enough under the best of circumstances. Trying to institute a complicated investment process with the goal of consistently beating the market may ultimately result in frustration and lackluster returns. The method I outlined above will likely help some active investors to create a simple and structured investment plan with enough flexibility to satisfy their risk profile.