Absolute Return Investing: Aiming for Market Independence

Wouldn’t it be great if you could reduce your portfolio’s risk by some means other than simply reducing or eliminating your investments in highly volatile asset classes? Well, that’s the goal of absolute return investing. However, as with all investments, there’s a trade off. To try to reduce market risk, you’ll probably increase your exposure to other types of risk.

Benchmarks and Absolute Return
An investment typically is measured relative to its benchmark’s performance. For example, a negative return might still be considered successful if the loss was less than that of the benchmark to which it is compared. And an investment might have positive returns simply because its asset class is doing well.

By contrast, absolute return, or market-neutral, strategies attempt to make money each year–or at least not lose it–no matter what’s happening with the market. An absolute return portfolio’s performance benchmark might be the risk-free return on cash. For example, a manager might aim for a return equal to that of a short-term bank deposit plus three or four percentage points. (Of course, as with any investment, there’s no guarantee that it will achieve its goal.)

The Long and Short of Investing
Many absolute return investments attempt to eliminate market risk–that is, be market-neutral–by adopting so-called long-short strategies, which rely on the difference between being “long” and selling short. Short selling involves borrowing shares or other securities and selling them, in the belief that the price will drop and you will be able to buy them for less when you must replace them later. The difference between the price you got when you sold the shares and the price you paid to replace them is your profit. However, you also can lose money if the price rises and you must pay more to replace the borrowed shares than you got for them.

A short sale is bearish. By contrast, being long–buying a security outright–is a bullish position; if you think an investment will decrease in value, you probably won’t buy it.

Trying to Have it Both Ways
Market-neutral strategies try to have the best of both worlds by investing in both long and short positions, typically in equal proportion. For example, a manager might buy a security he or she considers undervalued, and sell short an equal dollar amount of a similar security that appears overvalued. The opposing long and short positions are designed to neutralize the ups and downs of that particular market–hence the name–and reduce a portfolio’s volatility. Because it strives to be independent of market behavior, a market-neutral portfolio’s performance is based almost exclusively on its manager’s ability to identify and trade under- and overvalued securities.

But wait–isn’t that exactly what an actively managed mutual fund does? Yes, but the typical mutual fund manager who’s concerned about a particular security or sector either invests less in it or avoids it. A market-neutral manager might actually short that sector or security, actively attempting to take advantage of its problems. In some ways, a market-neutral fund is the mirror image of an index mutual fund. Because an index fund is designed to replicate a particular market, it is 100% exposed to market risk; a market-neutral portfolio takes the opposite approach.

If It’s Not One Thing, It’s Another
Of course, even if a portfolio manages to be independent of market risk, that doesn’t mean it’s eliminated other risks. A market-neutral portfolio’s manager can misjudge which securities to buy or short, or the timing of those trades; also, there are specific risks associated with each individual security. Any of the above can have as unexpected and dramatic an impact as overall market movements. Though absolute return investing attempts to lower volatility and achieve a positive return, there are no guarantees it will do so, and it may not be appropriate for all investors.

Seeking Absolute Return
Hedge funds and institutional investors often rely on absolute return investing. However, in recent years, mutual funds with similar strategies have expanded the concept to a broader range of investors. A fund may focus on a single asset class, or include multiple asset classes as well as global investments.

If you’re considering an absolute return fund, you’ll need to pay attention to costs; a greater level of complexity can increase trading expenses. Consider also how a given strategy has fared in both up and down markets. Consult a financial professional to see if absolute return investing makes sense for part of your portfolio.