Conventional investment strategies and managers seek to beat a pre-defined benchmark or basket of market indices across one or more asset classes and hence they measure themselves relative to this benchmark or index.  This is true of most Mutual Funds and Financial Advisors and Planners.  Thus, if the benchmark, say the S&P 500 index is down 39% like in 2008, the manager or strategy is considered successful if it “beat” the market, even if they generated a 35% loss that year.  A relative return manager, hence, has a built in excuse for not performing well with your investment, i.e. the markets were at fault. 

In contrast to relative return strategies, an Absolute Return strategy seeks to generate a positive return over a predefined period independent of whether an index or benchmark with similar risk characteristics is positive or negative over the same predefined period.  Also called “alternative” strategies, Absolute Return strategies can use fundamental, technical, or macro-economic indicators or a combination of these to determine investment positions or portfolio allocations that are adjusted with changing market conditions as represented by these indicators or otherwise.  Absolute Return strategies are almost as diverse as their developers and managers, and are not all created equal.  They can be simple or sophisticated, include one or more underlying strategies and risk management approaches, use instruments other than stocks or bonds (like options, futures, etc.) to hedge existing positions or enhance leverage, can take both long and short positions in different markets (i.e. align the investment with direction of prices), have different trading frequencies, and most importantly can perform differently with different degrees of risk.  In choosing Absolute Return strategies, the diligent investor will seek to gain an understanding of the underlying strategies, risks, and their performance before investing funds.

 

the absolute return opportunity

It becomes apparent after a quick study of a long-term price chart like the one above, that markets tend to trend – either upwards, or sideways-to-downwards and are not random.  If an investor had purchased stocks at the bottom of each of the secular bull markets since 1900 and sold them at the top of the bull market, then the investor would have earned an annualized real dividend re-invested return of 5.1% versus 3.2% if they had simply bought and held stocks for the entire century.  If the investor had shorted stocks during the secular bear markets, the investor’s real return would have increased to 6.9%.  But it is impossible to time the markets this way, you may be thinking.  To be this accurate, maybe not, however there are trend-following and trend forecasting techniques that have been shown to capture 25% to 50% or more of a trend and/or keep one’s portfolio out of trouble.

To illustrate this, a simple trend-following system constructed from a S&P 500 45 day moving average is shown along with its profitability from January 2008 to August 2010 in Figure 2 below.  A buy signal is given when the S&P 500 crosses above the moving average line and a sell signal is given when the S&P 500 crosses below the moving average line.  There is some filtering that has been included to reduce false signals. This simple trend-following system has provided an annualized return from January 2008 thru August 2010 of 21.8% versus an annualized 14.3% loss for the S&P 500 buy-and-hold investor.  In addition, the maximum drawdown of this strategy was 13% versus 56% for the Buy-and-Hold strategy using the S&P 500.  The green bars on the top graph show the growth of the initial $100,000 to $165,000.