Bumpy ride can be a fortuitous trip

The absolute return investment route is peppered with pitfalls and does not deliver consistent results. The wise investor should diversify across different asset classes for a smoother ride.

Forward-thinking investors are establishing and benefiting from two complementary investment premises: absolute return investing and diversification across multiple traditional and alternative asset classes.

The post-technology, media and telecoms bubble period has been characterised by a transition from a relative to an absolute return focus. Many investors became enthralled with the prospect of 20-30% a year returns from equities in the 1990s and relative returns were of utmost importance. Post-crash investors realised that markets go down as well as up and refocused on the importance of absolute return investing.

Investors often have short memories and think that the 15-20% a year returns equities have delivered since 2003 can be consistently achieved. However, what equities have actually delivered over the past 15, 30, 50 and 100 years is approximately 4% in excess of cash per year. These returns have been delivered erratically. For example, equity investors have experienced drawdowns of 30% over the past 15 years, as measured by the FTSE All-Share, and of more than 50% over 30 years. Absolute return investors target real returns to meet objectives and/or liabilities.

This is no different to relative return investors, who have similar long-term obligations or investment goals but seek to meet those objectives by making strategic allocations to equities and bonds that will give them the long-term returns they require.

The difference is that, unlike absolute return investors, they are willing to embark on the potentially bumpy ride that an allocation to these asset classes entails. The traditional approach to absolute returns for retail investors has moved from pure tactical allocation between equities, bonds and cash to capital protected notes, with profits and now to hedge funds.

All three of these methods have benefits, but there are drawbacks as well. For example, the hedge fund industry has burgeoned based on the promise of absolute returns with low risk. However, they are expensive and with a lot more beta than many investors realise. They also have the problems of illiquidity and their risk is not captured by standard statistics. Portfolios that include hedge funds with true expected alpha are hard to find, but they do exist.

It is because of the stated drawbacks of hedge funds, combined with the reality that beta exposure can be achieved more cheaply outside the hedge fund universe, that hedge funds do not provide a complete or optimal solution for absolute return investors. To achieve absolute returns in excess of cash, investors can target alpha and beta with risk premiums attached. Investing is about managing a combination of beta and alpha attributes. A well-managed portfolio combines the beta exposures of the portfolio, which are inexpensive to achieve, and only pays active fees where positive alpha is expected.

Another developing trend in fund management addresses many of the drawbacks that have beleaguered absolute return investors. The emergence of multiple-asset-class investing is beginning to grow and has the potential to reduce the need to rely on expensive alpha and, more importantly, beta masquerading as alpha. Pension funds and endowments are already making use of alternative investments in their strategies. More flexible investment regulations under Ucits III and Nurs allow retail investors to benefit from alternative asset classes such as property, directional funds – where managers can essentially use short instruments and markets that were previously long-only for retail investors – commodities and private equity.

Harry Markowitz’s pioneering work “Portfolio Selection” in 1952 showed the benefits of diversification across a portfolio made up of equities and bonds. Markowitz demonstrated how to maximise the risk-reward characteristics of a portfolio. This concept can be applied across multiple asset classes and can result in dramatic improvements in portfolio efficiency. For example, commodities have had little correlation with equities, bonds, or real estate over a market cycle and have often had attractive returns in times of equity market crisis – as commodity and oil price shocks have triggered equity sell-offs in the past – and have delivered similar excess returns to equities.

Depending on the index used, real estate has little to marginal positive correlation with equities and bonds, and has delivered returns greater than equities over the past 13 years. Broad hedge fund indices have had positive correlation with equities and commodities over the past 13 years, but are still a source of diversification and potential alpha. The more flexible regulations are allowing fund launches that combine multiple asset classes.

This flexibility can provide the basis for absolute returns, without the expense, illiquidity and opaque nature of hedge fund investments, and is proving to be an effective manner of targetting absolute returns for investors. Sceptics may claim that with more flexibility comes more risk – and this is a legitimate concern. Asset managers need to understand the features of different asset classes and have risk management procedures and systems in place that can handle the idiosyncrasies and potentially non-normal return distributions that alternative asset classes bring.

There is also a need for asset managers to demonstrate a competitive advantage in managing active alternative asset classes. An asset management house that is strong in equities may not have the resources or skill to add value in property, for example. However, the most simple and effective way to reduce risk is a portfolio that combines uncorrelated alphas and betas and, given the new regulations, many funds are now benefiting from this.