Volatility: If executed successfully, over the medium term, such strategies tend to exhibit a lower risk profile than a long-only or short-only strategy. While that may be true for long/short strategies in general, any specific investment allocation may prove to be riskier than a long-only investment, as it is possible to lose money on both the long and the short positions.
Positive or Negative Carry? That depends. As long/short strategies, they tend to borrow (go short) in something to buy (go long) something else. Depending on the strategy, they might have a positive or negative carry; that means the carrying cost of an absolute return strategy might be low (although this is not necessarily the case).
Track records? One reason many investors have moved on from absolute return strategies is because they had a lackluster track record during the roaring bull market. In the context of this discussion, this should neither come as a terrible surprise, nor be a reason not to consider them going forward. During the bull market, higher risk assets tended to outperform, whereas anything that was lower volatility by design quite possibly under-performed. Further, when equities go up, up and up, the risk/return tradeoff for alternative investments appears less appealing to some. To us, we see what we believe are compressed risk premia in equities as a reason to favor alternatives.
A challenging sandbox. A common criticism of absolute return strategies is that they play in a difficult sandbox. There is no ‘beta', i.e. there often is no benchmark. So comparisons are difficult. An equity investor leans back and feels smart when the markets go up. An absolute return investor has to ‘generate alpha', i.e. have an ability to make money independent of market direction..
Nobody said it's easy. The criticism is fair, but the reason why some - including yours truly - pursue absolute return strategies is because we see a world where asset prices are expensive and where traditional ‘carry' strategies might go into reverse. An absolute return strategy might offer investors the opportunity to diversify and help navigate challenging markets. Notably, it may be worthwhile to consider an alternative strategy that deals in markets that are liquid, such as the currency space. In the UK, some real estate funds have suspended redemptions - that's not the type of alternative we are thinking of. Investors that believe stocks always go up, should not bother. However, others might want to have a look.
It's about investment process and risk management. So how does one choose an absolute return strategy if the track record has been lackluster? In our opinion, it's about investment process and risk management. With regard to investment process, it's about understanding how the portfolio manager seeks to generate absolute return. With regard to risk management, the proof may be in the pudding when it comes to rough patches in the market.
Case study: Merk Absolute Return Currency Fund. Blatantly self-serving, let me discuss this in the context of our own absolute return strategy. I'll conveniently skip over any rough patches the Fund has had in the past (feel free to contact us to discuss these in more detail), but would like to explain why we have dedicated large resources to make this product into the one it is today. The motivation is obvious: we are negative on both stocks and bonds, but want to do something about it rather than merely complain. While we may not have the solution to all the ills in the world, we believe absolute return strategies may have the potential to help investors navigate what's ahead.
When it comes to investment process, the Fund may utilize statistical currency analysis to manage overall portfolio risk. We have turned risk analysis into what may be considered its own volatility strategy. That is, the Fund may take different risk environments and risk dispersion amongst currencies into account. When markets show signs of stress, we have the ability to emphasize risk sentiment analysis; in contrast, when markets are quiet, we have the ability to emphasize other strategies that may be more suited for calmer environments. We call this regime management. In the context of our discussion that we may be in an environment where negative carry wins the day, it may be noteworthy that this Fund might benefit from a focus on risk as a strategy.
That's not the same as risk management, which is a separate layer. While the vote for the UK to leave the European Union ("Brexit") may be just a brief data point, let me just state from the Fund's attribution analysis: "The period around the U.K. referendum generated another spike in volatility in global markets, which MABFX managed to profit from due to its regime framework analysis and focused risk management." In our outlook, we write:
We continue to see more evidence that global markets have entered a new risk regime of increased asset volatility and financial instability. In past outlooks, we have warned that investors are vulnerable to these trends, and continue to believe that our blend of fundamental and quantitative systematic investing, using a non-directional approach, is the appropriate strategy to extract uncorrelated alpha in this environment.