More than a decade ago, before the Internet bubble burst, investors focused on return on capital. Today they seem more concerned with risk-adjusted returns. They want to know that their hard-earned savings are invested in vehicles that can hold up in volatile market environments.
That's where absolute-return investing comes in.
Let's set the record straight. Absolute-return investing is not about hitting a home run every time you step up to the plate. Instead, it's about seeking returns in excess of cash in all market environments. In many cases, the strategy is about attempting to get a few percentage points above the risk-free rate.
It's about working toward a positive absolute return and seeking to build wealth for investors over the long term.
By contrast, relative-return investing is making bets against a particular benchmark. Investors are trying to outperform that benchmark, but holdings and returns are likely to look similar to the benchmark.
Absolute-return investing, on the other hand, doesn't make investments relative to a designated benchmark. In fact, these strategies primarily benchmark against short-term cash instruments but certainly are not looking to replicate the holdings of a cash investment.
In addition to seeking to outperform cash, absolute-return investing seeks to provide low correlation to traditional asset classes such as stocks and bonds, and low volatility over time.
We believe these characteristics all are vital in the creation of a well-diversified portfolio in today's uncertain world.
To be sure, absolute-return strategies do involve risk, including possible loss of principal, and there is no assurance that their intended objectives will be met.
There are many approaches to absolute-return investing, including global macro, multistrategy, market-neutral and those that seek arbitrage opportunities in various markets.
While there are many different approaches, most have key traits in common. Perhaps most importantly, absolute-return strategies expand the investment universe beyond the traditional, incorporating asset classes and approaches not well-represented in most portfolios. Additionally, many absolute-return strategies begin with an assessment of the risk side of the investment equation, as opposed to more traditional approaches that often start with returns.
Geopolitical headlines have been a source of market volatility over the past few years, and we believe these fears have led markets to this “risk-on, risk-off” mode in which risky assets seem to move in the same direction, resulting in a general feeling of uneasiness among investors.
Absolute-return investing is aimed at removing those distractions.
HOW TO USE THE STRATEGY
There are two primary ways in which an absolute-return strategy fits into a portfolio.
The first is consistent with classic portfolio construction. The idea of an absolute-return strategy seeking to provide some consistency in returns that are also uncorrelated to traditional assets can be a powerful portfolio tool. We believe it would make sense to take a small piece from each part of a more traditional portfolio and reallocate those pieces in aggregate into absolute-return strategies.
The second way in which an absolute-return strategy fits into a well-diversified portfolio is by replacing a portion of the portfolio generally considered to carry low to moderate risk, such as traditional fixed income. Replacing a piece of a traditional fixed-income allocation with an absolute-return strategy that carries a similar historical risk profile but uses uncorrelated sources of returns is likely to smooth the overall returns of a portfolio over time.
Because there are so many different management approaches to absolute-return investing, we encourage diversifying among more than one approach.
While most have a similar return goal — performance in excess of cash in any market environment — different absolute-return strategies will react differently to a changing market environment. Utilizing more than one approach may help to “diversify the diversifiers” and potentially provide smoother performance.
Risks associated with absolute-return strategies include potential for high volatility, economic leverage (which can magnify losses) and low liquidity. In addition, remember that diversification cannot guarantee a profit or protect against a loss.
Brad Godfrey is a vice president and institutional portfolio strategist at Eaton Vance Corp.