Looking at Relative and Absolute Return Investment Strategies

by: Daniel Moser

Most investors lost money during 2008 and so far the losses continue to stack up in 2009. One culprit that no one has really mentioned is the general style of investing that the average person takes part in: relative return investing. Most participation in equity markets is done on a relative return benchmark. Whether investors are long equities, passive mutual funds, actively managed mutual funds, or low cost index funds, they are entirely too reliant upon relative returns.

In case you don’t know what I mean by relative return investing here is a simple definition of relative return:

“[A] return that an asset achieves over a period of time compared to a benchmark. The relative return is the difference between the absolute return achieved by the asset and the return achieved by the benchmark.”

Essentially, when an investor puts money into an actively managed equity mutual fund, the mutual fund manager constructs a portfolio that will track, and possibly beat, an underlying benchmark such as the S&P 500. In many cases the way these actively managed mutual fund managers attempt to “beat” the index is by modestly changing the weightings within their portfolio, i.e. if the S&P has a 20% weighting in the financial industry the mutual fund manager might hold 15% financials (said to be underweight) or hold 25% financials (said to be overweight). Low cost index funds literally buy the benchmark or engineer a portfolio to track the benchmark as close as possible so that tracking error is minimized. With low cost index funds, where the benchmark goes, so goes the index fund.

There is a phrase that is common in discussions involving relative returns, “you can’t eat relative returns”. The simple fact is that far too many investment managers sell a single product…a product that only does well when the market does well. Sure, some funds outperform and some funds under perform their underlying benchmarks, but when the benchmark has losses of any significance the investment manager undoubtedly loses money as well. I am sure this type of investing has its place in everyone’s portfolio. However, this is not the only way to invest.

Unfortunately, the U.S. government has defined two types of investors: sophisticated and unsophisticated. Interestingly enough, the only difference between the two is wealth. This stance has created an unintentional consequence, or at least I assume it was unintentional, within the financial services industry. Absolute return investment strategies were deemed off limits to most investors and thus, were grossly under-represented in individual portfolios going into the ever present financial storm that started in 2008.

In case you don’t know,

Absolute return differs from relative return because it is concerned with the return of a particular asset and does not compare it to any other measure or benchmark. Absolute return investment techniques include using short selling, futures, options, derivatives, arbitrage, leverage and unconventional assets.”

This style of investing attempts to profit regardless of the overall market direction. Presently, most absolute return investments are associated with hedge funds. I have come across some mutual funds that claim to be absolute return investments. It seemed more often than not, absolute return oriented mutual funds were fixed income investments.

The void of absolute investment products for the retail investors occurred because the government wouldn’t allow less than “wealthy” individuals to invest in hedge funds and the financial services industry didn’t take the initiative to create non-hedge fund absolute return strategies for average investors.

Why does this matter? Well, this void is still present. Investors are wondering if they can buy a share of stock now with the expectation of making money over the next 10-20 years. It’s time to innovate. I am not talking about expanding investment management laws to allow average investors to place money in hedge funds. But it is time for the financial services industry to create strategies that deliver acceptable returns regardless of the direction of the overall market that are not designed explicitly for the wealthy.

By simply expanding investment selection to include short sells, foreign debt, or even options trades such as put protection or bull calls, it is amazing how much risk can be reduced. In many instances, returns may even be enhanced. There might be regulatory constraints that prevent decent mutual funds from engaging in real absolute return strategies but that doesn’t mean that boutique investment advisory businesses can’t fill the void.

Many seemingly intelligent people argue that general stock market returns will not resemble the last 50 years of investing. They say that investors need to lower expectations for returns significantly. Their argument leads me to ask the following questions with respect to the next 50 years. If the stock market won’t yield decent returns, fixed income won’t yield historically high returns, pension funds are pretty much non-existent for modern workers, social security is all but bankrupt, private equity and hedge funds are off limits to most investors, how are investors ever expected to retire? Perhaps absolute return strategies for the retail investor are the next major frontier for investment solutions to these problems. Can anyone say merger arbitrage, market neutral, global macro, long short, relative value, statistical arbitrage, or event driven? Pretty much any investment strategy with low correlations to the general market is quite possibly the way of the future for everyone.

Disclosure: In the meantime, I remain long PCU, RIO, SCHN, NUE, PAAS, and short SPY.