A Shot Of Absolute Return – Fortifying A Traditional Investment Portfolio

A Shot Of Absolute Return – Fortifying A Traditional Investment Portfolio by 720 Global

In the seven years since the financial crisis, most asset prices have experienced significant appreciation, allowing for even the most inexperienced of investors to increase their wealth. As the saying goes, “a rising tide lifts all boats”. For investment managers, assessing the tide of financial momentum and making fitting allocation decisions are extremely important. Accordingly, we have warned on numerous occasions, most recently in “Dear Prudence” and “Price to Sales Ratio – Another Nail in the Coffin”, that valuations in the equity markets are extreme, economic growth is stagnating, and corporate earnings are declining. These warnings are not an emotional reaction to a “feeling” we have, they are a quantitative assessment based on analytical rigor and durable historical precedence. In simple terms, we believe the tide may be turning and considering new investment strategies would be wise.

In this article we highlight the benefits of an Absolute Return (AR) strategy and discuss how this alternative strategy can help protect a portfolio when traditional strategies offer poor expected returns. We also explain how investment managers can utilize an AR portfolio as part of a traditional stock/bond portfolio to limit risk and potential losses.

What is an Absolute Return Portfolio?

The primary goal of investing is to increase wealth or purchasing power. Warren Buffet is quoted as saying “Rule number 1 of investing is never lose money. Rule number 2 is never forget rule number 1.” The hidden message in these seemingly obvious statements is that building wealth depends much more on preventing large losses than it does on achieving large gains. If you need a reminder on the value of limiting your losses please read “Limiting Losses”.

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While all investment strategies aim to make money, most investment managers employ different variations of a passive approach commonly known as a “relative return” or Modern Portfolio Theory (MPT) model. Under this approach, managers diversify investments between asset classes and sub?classes (typically stocks and bonds) and then hope for the market to deliver positive returns. In the end, however, they get the return the market provides. The performance of a relative return manager is largely dependent upon the general direction of the market.

Investors in passive strategies expect a market?based return with the hope for additional gains, otherwise known as alpha. The embedded assumption, whether the investor realizes it or not, is that the market will continue to rise indefinitely and at a rate greater than inflation. As we know, and were reminded of in 2000 and again in 2008, this is not always the case. The 2000?2002 and 2007?2009 declines reduced the stock market value by over 50% in both instances. It can be difficult to build wealth with such a strategy in an environment like the last 15 years, as one’s net worth routinely gets impaired significantly. While true that the stock market, as a long term investment, has generally delivered relatively good returns, there have been long stretches of time where this has not been the case. The graph below highlights such periods where the real, or inflation?adjusted, price of the S&P 500 stagnated.

Absolute Return Portfolio

An alternative, action?based strategy to investment management is an AR strategy. It is “action?based” because the returns of the portfolio are derived primarily from the actions of the investment manager. The manager is not beholden to a pre?determined, model?based asset allocation but rather is continually engaged in finding cheap securities to own or over?valued securities to sell. AR managers also tend to use a wider variety of asset classes than relative value managers. In short, an AR manager seeks to generate positive returns without regard for whether the market trend is bullish or bearish.

AR strategies typically seek return objectives based on a spread over the rate of inflation as opposed to passive strategies which base returns on historical assumptions that the market will return say 8%, just because “it always has”. AR managers use sound logic to arrive at a reasonable target that, if achieved, guarantees an increase of real wealth and therefore purchasing power. Their objective truly is geared toward avoiding losses over some reasonable time?frame at all costs. For them, being down 25% when the market is down 50% is not success.

An example of an AR goal may be CPI + 3% for a retiree. At that rate, the retiree can potentially sustain their lifestyle without eroding their capital base. An endowment with a 6% spending policy would aim for a target return of CPI + 6% on a similar premise. Achieving or exceeding the targeted return, CPI, ensures that wealth and purchasing power are, at a minimum, sustained. This approach also affords a clear and specific benchmark against which a manager may be held accountable.

AR strategies require more knowledge, skill and rigor than traditional passive strategies, which make them inherently more difficult to execute. This helps explain why so many investment managers choose to pursue market?dependent, passive strategies. After all, who wants to be held accountable if, in bad years, they can simply throw their hands up and say “who knew the market would fall 50%?” Your clients deserve more.

Blending AR with a Traditional Asset Mix

Many investment managers do not have the flexibility or a mandate to enact a pure AR strategy. However, despite these limitations, many managers have the ability to employ an AR strategy within a traditional relative value portfolio. While we could certainly make a convincing argument that an AR strategy with a performance benchmark/objective tied to a client’s cost of living is more appropriate than a strategy and benchmarks tied to the equity market, we are aware of “how the business operates” and the reluctance for investment managers and their clients to change.

For managers and clientele benchmarked to market returns, an allocation to an AR strategy can be a valuable risk management tool, especially when equity and fixed income valuations are expensive and their expected returns are poor. In this vain we analyze expected future returns for the U.S. equity and fixed income markets to help assess the suitability of an allocation to AR. We then take a look at the last 16 years to show how different strategic allocations between traditional and AR strategies performed.

Expected U.S. Equity Returns? While there are many ways to forecast equity returns, we prefer a simple cash flow model. In 720 Global’s model, ten years of expected cash flows (purchase, dividends and sale) are generated based on numerous assumptions. The two most important assumptions are that the Price to Earnings ratio regresses to its historical average and that earnings and dividends grow 2% a year. With said expectations, our model currently calculates expected equity returns of 1.48% based on the last 12 months of earnings and 0.42% when we base returns on 10 year average earnings (CAPE10 ? P/E ratio based on 10yr average earnings).

The expected returns are stated in nominal terms and could easily turn out to be negative if inflation is the same or higher than it has averaged over the last 10 years.

We share the graph below to help affirm our model’s expectations. The scatter plot below