Many investors allocate a portion of their assets using traditional asset allocation models and measuring results against benchmarks. Some investors also allocate a portion of their assets to absolute-return strategies, a goal of which is to generate good returns and protect capital regardless of market environments. There are several benefits of investing in absolute-return strategies. One important, and often underappreciated, benefit of absolute-return strategies is that the asset allocator should have to answer only two of the three typical questions when deciding to make an allocation.
Regardless of which overall allocation criterion is used, investment committees typically have to answer three questions:
1) What sector and strategy should we invest in?
2) Which management firm(s) should we hire for that strategy?
3) When should we make the investment?
Answering each of those questions can be very resource-intensive, and proper analysis and decision-making in regard to each is very important for successful long-term investing. Consider, though, the substantial value that would be added to the decision-making process if one of the questions could be eliminated. I believe a benefit of investing in absolute-return strategies is that investors in such strategies do not have to answer that third question. If investors allocate a portion of their portfolio to absolute-return strategies, the timing of the investment, by definition, is not a crucial concern. In my experience, an absolute-return strategy presents significantly fewer concerns about where we are in the market cycle, whether the asset class in question is currently overvalued or cheap, and whether an allocation should be made today or at some point in the future.
The primary goal of investing a portion of an investor's assets in absolute-return strategies is that those assets are likely to perform reasonably well regardless of the investing environment. Within the absolute-return strategy, there are many substrategies. For many, but not all, of these substrategies, the manager will likely underperform when most markets are quite strong, and will likely outperform when most markets are weak. Investors would not typically want all their assets invested in absolute-return strategies because they don't want to give up the sizable upside potential during robust market environments. However, true absolute-return strategies, if properly executed, should give the investor comfort that the portion of their assets allocated to the strategy is likely to be positive if and when many of their other allocations are negative.
An additional important benefit of investing in an absolute-return strategy is that the timing of the decision to exit (which might be even more important for some strategies than the decision to buy) is not as critical as with more traditional strategies. In my experience, a true absolute-return strategy can be a core position, held throughout various cycles, allowing the investment committee more time to focus on whether to exit the more volatile non-absolute-return strategies.
Are there risks to this approach? At first glance, one might conclude that if the third question is not asked, then the investor must place extremely high reliance on correctly answering the first two questions. This is not a risk unique to the absolute-return space because correctly answering the first two questions is always important to selecting outside managers. It seems to me the primary risk is investing in a strategy that claims to be absolute-return but turns out to be otherwise. Thus, as with any strategy, proper preliminary due diligence on the manager, as well as diversification within the strategy, is imperative.
One of the subtle challenges in traditional benchmarking and asset allocation is that when investors attempt to make their decisions by focusing on, or reacting to, larger market movements, they can miss some of the best investment opportunities, which might be of value precisely for their non-obviousness. Consider the investment landscape today. We are five years into a bull market in equities and credit, and the Fed stimulus that has propped up prices has begun to taper. Consequently, there are fewer asset classes that look attractively valued, especially over the intermediate to longer term. During time periods like this, I believe a focus on absolute-return strategies should be particularly beneficial.
Consequently, in my experience I have found that many people believe that for at least a part of an investor's portfolio, the investor should put aside the complexities of asset allocation theory and hire managers who are likely to deliver a positive return without excessive risk, in any market environment.
For investment committees, here is a checklist of questions that I believe can help identify those absolute-return managers in any asset class that are worth hiring for the long term, irrespective of where one believes we are regarding market or economic timing:
- What is the manager's track record … in the worst of times? Everyone likes to tout their good years. And it's easy to make excuses and blame the war or the weather or various other crises. Frankly, measuring managers relative to a benchmark often institutionalizes this excuse-making. But those excuses won't pay the employee pensions, university scholarships or other purpose for which the investments are intended. The test of a money manager must be how well it can be expected to handle the unexpected.
- Is a manager too big to be sufficiently flexible? My view is that the bigger the fund, the less likely it will be able to take advantage of unique, but often limited opportunities. Big funds can certainly have their place, but it's crucial to not equate size with value.
- Does the manager have the courage to say no? Listen carefully for a culture that is disciplined about value. Does the manager sell positions when prices get too high, even if it might leave it underinvested? Is the manager willing to keep some of its funds in cash when conditions warrant, even if it might dampen returns in the shorter term? Has the manager expanded outside of its historical area of focus if the manager can't find enough opportunities? Does the manager's buy decisions consistently reflect the intrinsic value of each situation, or does the manager compromise its standards, even subtly so, and chase returns when markets are more aggressively priced?
- Does the manager conduct the necessary and sufficient fundamental research? If you want to find opportunities that are distinct from market trends, you need to look at individual companies and issues.
On this last point, let me speak up for what might nowadays be seen as an old-fashioned goal: preserving capital. Sure, if your time horizon is 20 years, you might well ignore fluctuations from year to year. But, we've seen over and over that even century-old endowments must scale back their activities (and perhaps replace some decision-makers) if the value of their investment account falls sharply over a relatively brief time period.
In fact, just one significant down year causes trouble for most every investor, not to mention investment managers. When you are in a hole, you have to work hard simply to dig your way out, and it's difficult to focus on the very best new opportunities and to not make — consciously or unconsciously — changes to a philosophy, strategy or style that had worked previously.
So while removing questions about timing might seem counterintuitive, allocating to absolute-return strategies has the potential to provide a way to save time and stress in the management selection process. Yes, you need to talk to the managers more about their approach to research and risk. But then you can take the before- and after-the-fact question of timing off the table.
Phillip S. Schaeffer is senior portfolio manager at Scott's Cove Management LLC, a New York-based event-driven, long/short, credit-focused investment manager.
