Absolute Return: Preparing for an Uncertain 2010David Bogoslaw
It's a sign of the times that even after a 65% runup in the Standard & Poor's 500-stock index over the past nine months, investors still feel nervous about what 2010 may have in store for them. The official end of the recession in the third quarter has all but quelled speculation about a double-dip economic downturn. Still, plenty of doubts remain as to how the economy will respond to the withdrawal of the government's massive fiscal stimulus and the open-ended questions around unemployment and mortgage foreclosures rates. The sting from the wide-scale wealth destruction of last year and early 2009 was enough to scare all but the most risk-averse investors into the arms of money managers whose primary goal is to reduce volatility and downside risk in their clients' portfolios. That's the bedrock of the absolute return approach. Think of it as the market equivalent of the medical profession's credo "First do no harm," which in this case applies to a client's principal. Absolute return strategies have been common in hedge funds, but are now filtering into the broader investment world in the form of mutual funds, says Jeremy T. Welther, a principal at Brinton Eaton Wealth Advisors in Madison, N.J. The 1940 Investment Act regulations that govern mutual funds require that all assets be kept in custody at a bank, that the net asset value of all assets be calculated daily, and that all assets be liquid. (Hedge funds are exempt from having to pursue these safety features.) It's important to distinguish between two major tracks within absolute return: long/short and market-neutral. With a long/short equity bet, for instance, you're relying purely on a manager's skill at identifying stocks that will keep appreciating in value (the "long" part of the strategy) and those headed for losses (the "short"). A market-neutral strategy is a bet on the fund's ability to eliminate the variability of the market from the returns, says Jerry Miccolis, a principal at Brinton Eaton. using a long/short portfolio anchorTom Samuels, portfolio manager of the Palantir Fund (PALIX), a no-load mutual fund with a global long/short strategy in all market cap segments, thinks the lower-volatility features of an absolute return strategy can be a key tool for minimizing a portfolio's downside risk in the uncertain year ahead. "If you anchor your portfolio with a long/short approach, it allows you to be more market sensitive in other parts of your portfolio because you know you have that anchor," he says. Samuels has been using pair trades a lot, especially in the second half of 2009. This consists of getting exposure to any given sector by matching up a stock whose fundamentals point to continued upside with one that you believe will sell off under tougher market scrutiny. For example, within the retail sector, he's been long Timberland (TBL) for a while, citing its low debt level and proven ability to expand its business into foreign markets and via the Internet. He counters this with a short position on Tiffany & Co. (TIF), which he sees as overpriced at nearly 22 times estimated earnings for fiscal 2010. If consumers continue to pull back on the margin, luxury retailers such as Tiffany will likely disappoint on quarterly earnings reports, he says. Here's how it can work: Say the retail sector as a whole declined 10%, but Timberland only dropped 5%, while Tiffany shares fell 12%. You would lose 5% of your portfolio's exposure in that sector on the drop in your long position but gain 12% on your short bet, for a net gain of 7%, vs. the sector's 10% decline. The Palantir Fund was up 12.6% year-to-date as of Dec. 3 and up 20% for the year ended Dec. 3. absolute return for fixed-income, too"When we think market risk is elevated, we'll put more and more of the portfolio into pair trades," says Samuels. "[That] protects us from a sudden drop in the market and allows us to hold more of a particular name we feel good about, even if it declines some, and maybe even add some more [to it while it declines] and have our risk ameliorated with the short." For investors who prefer fixed-income assets over equities, there's the Aston Lake Partners LASSO Alternatives Fund (ALSOX), which is up 14.2% since its launch on Apr. 1, 2009. While it doesn't offer much of a track record, the fund uses the same strategies that Lake Partners, the hedge fund consulting firm that manages it, has run as separately managed accounts for 11 years, using assorted fixed-income instruments to reduce volatility. Since its inception in 1998, the LASSO portfolio is up 67.8%, vs. a 1.8% gain for the S&P 500, with one-third the daily volatility of the S&P 500. The fund includes long/short credit strategies such as the JPMorgan Strategic Income Opportunity Fund (JSOSX), which might go long certain mortgage-backed securities whose underlying homes hold substantial equity and are in well-established neighborhoods, while shorting lower-quality commercial MBS whose pools include office buildings that have dropped in value. The LASSO fund also makes capital-structure arbitrage funds such as the Driehaus Active Income Fund (LCMAX) available to retail investors. These funds look for market anomalies company by company, typically buying a debt instrument they see as undervalued and shorting another kind of debt of the same company that they think is overvalued. Earnings surprises unwelcome to someAnother component of the LASSO fund is global bond exposure through vehicles such as the Eaton Vance Global Macro Absolute Return Fund (EAGMX), which might be long high-quality U.S. agency bonds and short the sovereign bonds of a country believed to have challenging fiscal issues, such as Greece. Like most philosophies, financial and otherwise, there's a sense of orthodoxy in the world of absolute returns that some advisors insist be followed. Money managers in this area don't have the same discretion as hedge funds to invest in anything they deem appropriate because they must adhere to certain strategies laid out in a fund's prospectus, says Welther at Brinton Eaton. "We're not looking for surprises, upside or downside. When you see them [diverging from their stated target return], it shows the manager's going away from the core strategy," he says. "If you had an absolute return strategy and you were looking to earn 10% and it earns 20%, something doesn't smell right there." Michael Aronstein, chief executive of Marketfield Asset Management, takes a more flexible view of how the strategy works. He dislikes the pervasive portfolio model, which provides a big menu of choices and transfers the burden of asset allocation back to the client. "If you have a good money manager, you should afford them as much latitude to do what they want as possible," he says. "We tell customers: 'If things don't work out, you can blame us entirely.' There are risks to that. We are making broad allocation decisions that in most cases the customer wouldn't agree with." U.S. intervention hurt 2008 shortsHe's referring to what every investor knows in his head but can't embrace emotionally at the crucial moment—the directive to buy low and sell high. Around Thanksgiving of 2008, at the height of the forced selling across all asset classes, the Marketfield Fund (MFLDX) began to take advantage of the bargains. By early March, with the market nearing its low, the fund "had a very aggressive, pro-cyclical posture," he says. The fund was up 28% year-to-date as of Dec. 3 and up 33% for the year ended Dec. 3. Investors need to be aware that absolute return strategies can pose risks even if asset managers are right and the market takes another nosedive. That may seem mystifying because that's precisely what these strategies were designed for, but consider this: In 2008, the long/short equity strategy didn't perform as well as it could have because the U.S. government became "more aggressive about intervention [to prevent some companies from failing] and not being bound by precedent regarding how it will intervene and how it changes the rules along the way," says Samuels at the Palantir Fund. This makes it hard to analyze which stocks are safe to short, he says. Take Washington Mutual, whose overleveraged balance sheet and huge exposure to the subprime market made it an ideal candidate to short until Uncle Sam altered mortgage rules in 2007, watered down mark-to-market accounting rules in 2008, and engineered the troubled thrift's takeover by JPMorgan Chase (JPM) in September 2008. "You don't get to give the full benefit [of shorting a stock] to your shareholders," says Samuels. "It can get tricky even if you're right because the rules can be malleable in a crisis situation." Still, amid such uncertainty, the appeal of a disciplined approach like absolute return is undeniable.