absolute return strategies - a useful tool for today’s plan sponsors

7/28/2019 Absolute Return Strategies - A Useful Tool for Todays Plan Sponsors

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Institute for Fiduciary Education 1

Absolute Return Strategie

Introduction

The category of absolute return strategies is extremely broad and diverse, rangingfrom long-short equities and arbitrage strategies to commodities and timber.1 Thegrowing use of these strategies shows that they have earned a level of generalacceptance. Yet they take many different forms and are therefore used in differentways. To help determine if and how absolute return strategies can be used in ones

portfolio, this note presents a decidedly non-technical framework for understandingand assessing these strategies.

The reasons for the increased interest in and offerings of absolute return strategiesare many. Low equity risk premia, increased market operational efficiency, develop-ment of more liquid derivative markets, regulatory changes, a more competitiveinvestment management marketplace, and general technological advancement have allaided the continued development and interest in these strategies.

As a first step toward thinking about these strategies, it is useful to acknowledge thatthere is no widely-accepted definition for them. An absolute return objective hasbecome a catch-phrase for any strategy that is expected to exhibit low or negative

correlation with public equity or fixed income markets. As we will discuss, this doesnot mean that they have no systematic component of return (i.e., beta); in fact manydo. It does mean that any systematic component is significantly different from thesystematic component of the public markets.

As evidence of the variety of these strategies, Exhibit 1 sets forth a list of absolutereturn strategies culled from a variety of recent conferences, agendas and papers on thesubject. The following section will categorize these strategies along lines that will beuseful in understanding where and how they can be used in a pension portfolio.

Categorization

Alternative does not equal Absolute returnAs we see from the strategies listed in Exhibit 1, this category of investment covers

a very broad set of strategies. Some fit the description absolute return better thanothers. A private equity manager may be attempting to deliver only positive returns inevery period, but in reality private equity valuations and therefore, returns areimpacted by the overall valuation level of public markets. This contrasts with

Absolute Return Strategies: A Useful Tool for TodaysPlan Sponsors

Scott W. Clifford Managing Director, Head ofActive Equity InvestmentStrategy

Barclays Global Investors,N.A.

Scott Clifford, a CFA, has aB.S. in Economics from theUniversity of California,Berkeley

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1 We shall explore whether commodit ies and t imber truly qualify later in this paper .


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Market Makers 2002

Exhibit 1 Private equity Merger arbitrage Options volatility arbitrage

Timber Long-short equity PIPE investing

Market-neutral equity Convertible bond arbitrage Water rights

Statistical arbitrage Weather futures Event -driven valueIPO investing Fixed income arbitrage Real estate

Managed futures Distressed debt

convertible bond arbitrage, for example, which seekspositive returns in all periods no matter what thedirection of bond or stock markets this is a trueabsolute return objective.

To simplify the discussion, examples of directional

strategies, such as private equity, will be describedherein as beta-driven strategies. These strategiesrepackage the return premia of various systematicfactors such as equity risk, credit quality, andliquidity. Private equity falls into this categorybecause private equity returns rely on some of thesame valuation drivers as publicly traded equities.This is not to diminish the importance of privateequity managers skill in adding value, but merely toacknowledge that the general market valuations canaffect the valuations and returns of private equity.

The general valuation level is the tide that raises(or lowers) all ships.

Strategies which are non-directional, such as thearbitrage strategies described above, will be referredto as alpha-driven. This is because the strategysperformance is driven exclusively by non-systematicsources of return. In other words, the return of thisstrategy can only be attributed to the managers skillin capturing a market inefficiency or opportunity(i.e., the managers alpha).

Beta-driven vs. alpha-driven

There is not a hard and fast divide between whatare referred to herein as alpha-driven and beta-driven.The various absolute return strategies reside in a

continuum from mostly beta-driven to mostly alpha-driven. In fact, there are no purely beta-drivenstrategies. This would require an investment in thecategory that brought no manager-specific insight,alpha or risk. This is the equivalent of an index fund;

an index fund capturing all potential investments andopportunities in a given category so that anymanager-specific risk is diversified away. Obviously,in a category such as private equity this is notpossible. All strategies discussed here include asubstantial amount of manager involvement, yetsome are still influenced, and thus correlated, withmarket-level risk and return factors. Exhibit 2 setsforth a crude sort of the strategies presented inExhibit 1 into more beta-driven strategies and morealpha-driven strategies.

So how are these beta-driven alternativesdescribed as absolute return? This misnomerprobably derives from the fact that many of the beta-driven alternatives do not have readily liquidmarkets. This affords managers and investorsconsiderable discretion in valuing the securities andthereby defining periodic performance.2

Real estate and private equity are valued throughappraisals, which focus on long-term enterprise valueby determining the price a willing buyer would pay awilling seller for a given asset. This affords a

smoothing of values that can mask the true market-clearing price and thereby make a risk calculationbased on these smoothed values appear lower than itwould appear otherwise. The prices of publicly

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2In a recent interest ing development, Pensions & Investments repor ts that CalPERS wil l be evaluating managers based on their

returns of cash, not their periodic valuations, partl y to address the periodic valuation problem. This acknowledges the iss ues

surrounding the calcula tion of risk based on periodic, non-market-clearing valuations.


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Exhibit 2 More beta-driven More alpha-driven

Real estate Event -driven value Market-neutral equity

Private equity Long-short equity Options volatility arbitrage

Timber Managed futures Convertible bond arbitrage

Water rights Distressed debt Merger arbitrage

Weather futures IPO investing Fixed income arbitrage

PIPE investing Statistical arbitrage

traded securities (which underlie most of thealpha-driven strategies) reflect not only the price thatwilling buyers and sellers exchange a given asset, butalso how many of each show up at market. This cancause the appearance of higher volatility because the

prices reflect the demand for liquidity.

Uses and Advantages of Beta-Driven Strategies

Diversification of beta sourcesBeta-driven strategies, such as private equity or

venture capital, can have the beneficial effect ofdiversifying the overall exposure to the systematicrisk premium. Their use reflects the continuation ofthe trend to diversify systematic risk that has drivenincreased use of small capitalization stocks,international equities, and emerging markets. Each of

these asset classes has a systematic return expectation(the return that compensates investors for themarket-level risk). The manager of a given mandatemay also have the skill to deliver alpha above thegeneral asset class return, but the investor knows thatthey are exposed to both the beta and the alpha of thegiven mandate. The manager is not attempting tohedge-out the beta or market exposure.

These arent truly absolute return

The argument made here is that these are not truly

absolute return because the investor and themanager specifically accept the fact that the asset classelement of return can very well dominate the overallperformance in a given period. If equity market

valuations fall dramatically (perhaps due to asignificant increase in interest rates), then the value ofall equities, including private equities, will fall. Thisenvironment even impacts a manager with excep-tional skill. The skillful managers alpha may be

significant enough to overcompensate the generalmarket level, but nonetheless the total return hasbeen dragged down.

Uses and Advantages of Alpha-Driven Strategies

Most alpha-driven strategies explicitly seek toreduce or eliminate the exposure to any market-levelsystematic risks (and their associated returns). This iswhy they are more appropriately described asabsolute return; their performance is influencedonly by the managers ability to exploit market

opportunities or inefficiencies. These strategies aretypically characterized by long and short positions insecurities and/or derivatives that seek to exploit anarbitrage opportunity or target a specific company orfactor forecast.

The long and short positions in these strategiesoffset the price moves of the general market. If allstocks in the market are up the same amount, thesestrategies basically produce no return except for theshort rebate which affords a cash-like return to thefund.3 Any incremental return derives from the long

positions, on average, outperforming the shortpositions. It is because the neutral return to thesestrategies is cash-like in all markets that they are trulyabsolute return strategies.

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3The short rebate from ones prime broker reflects the ret urn an investor would receive on the cash raise d from selling less th e

cost of borrowing the stock. These operational detail s are not covered here in order to keep the discussion focused more

strategically.


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Market Makers 2002

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4This is because Enron represented only 0.53% of the S&P at the beginning of the year . The largest bet the manager could take

without shor t ing was to not own the s tock and thus be underweight the s tock by 0.53%. Since Enron lost 99% of i ts value, the

return to the portfolio was the underweig ht multiplied by the return of the stock less the re turn of the benchmark:

( -99% - -11.89%) x -0.53% = -87.11% x -0.53% = 0. 46%.

5For mo re on the no-shor t ing constraint , see The Surpr is ingly Large Impact of the Long-Only Constraint , Ronald Grinold and

Ronald Kahn, BGI Investment Insights (2000) .

The major caveat when hiring a manager in thiscategory is to be aware that the entire return fromthe portfolio is derived from the managers insightand execution of this insight. There is no tailwindfrom general market appreciation. Furthermore,

many of the opportunities that alpha-driven strategiesseek to capitalize on are very small. This oftenrequires a great deal of leverage to be used in order tomake the strategy appear competitive.

These alpha-driven absolute return strategies have anumber of advantages to the investor. Because theyhedge away any correlation with the overall market,they are highly efficient, very flexible, and can offer agreat deal of transparency.

EfficiencyAlpha-driven strategies are very efficient because

they allow the manager to direct all necessary capitaltoward the opportunities or inefficiencies on whichhe or she is attempting to capitalize. This means thatthere is no need to own a sampling of particularstocks merely because they are in the managersbenchmark. This sort of benchmark-hedging cantake a fair amount of a portfolios capital, thusdiluting the profits that could be earned from a morefocused portfolio.

In a related way, alpha-driven absolute return

strategies also overcome a major constraint in long-only type investing: the no-short constraint. Theno-short constraint inhibits the ability of a managerto take advantage of a negative view on a companybecause the manager can underweight (bet against)the company only up to the weight of the companyin the benchmark. For example, a manager whocorrectly predicted Enrons troubles, but wasprohibited from shorting and therefore chose not toown Enron at any point last year, could have addedabout 0.46% to their portfolio versus the S&P 500.4

Furthermore, the prohibition against shortinginhibits the overweight bets a manager can take onattractive stocks. Because every overweight in aportfolio must be balanced by an underweight, theinability to underweight unattractive stocks ends up

limiting the amount of overweight positions that canbe taken.5

FlexibilityThe flexibility of alpha-driven strategies is best

reflected in their use as portable alpha. Becausealpha-driven absolute return strategies deliver puremanager alpha without correlation with the broadmarkets, their returns are conveniently ported to adesired benchmark by means of futures or otherderivatives. For example, market-neutral strategiesare routinely combined with S&P 500 futures

contracts to produce a total return equal to the S&P500 plus or minus the market-neutral portfoliosreturn.

Because the futures are relatively low-cost and mostmarket-neutral managers will provide this overlay aspart of the overall relationship, this is an extremelyefficient way of capturing the benefits of an absolutereturn strategy without having to abandon onesstrategic asset allocation. This step of equitizingthe absolute return strategy can be made through anyfutures contract or through a swap contract,

depending on the specific index the investor desires.A swap can also be negotiated to deliver a bond indexreturn, thereby bondizing the strategy.

The ability to port the absolute return strategysalpha on to any number of asset classes reflects thehigh degree of flexibility these strategies offer. Nolonger are investors tied to their strategic assetallocation when searching for managers to add value.If one finds more successful small-cap managers thanlarge-cap managers, one can simply hire several small-cap managers in a market-neutral mandate and port

their alpha to the large-cap benchmark of choice.


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TransparencyFinally, because most of the alpha-driven strategies

invest in publicly traded stocks and bonds, theinvestor can have access to the same level oftransaction and valuation detail they are used to in

traditional mandates. This is critical in attributingperformance and understanding the risks taken in theportfolio.

Transparency also helps in gaining confidence inthe managers approach and skill. With the holdingsand sources of return, risk, and costs fully known,the investor is much better placed to access the futureviability of the strategy. A more subtle element oftransparency derives from the fact that many alpha-driven strategies, particularly market-neutral equities,build from the same stock-picking processes that

drive managers long-only mandates. Analyzing such

a strategy is simpler and more understandable thanone that uses new, arcane assets because the investoris already familiar with the stock-picking approach.

Conclusion

Absolute return strategies can play a variety ofimportant roles in ones portfolio, yet these are notthe investment panacea that many would like one tobelieve. As with any investment, investors need toassess return sources and the portfolio effects ofincluding these strategies to understand where andhow to use them. Investors are cautioned to lookthrough the hype to the true drivers of performancein each potential mandate and to ensure theappropriateness of their use. Once this is done, manyinvestors will see the myriad of appropriate ways to

apply these powerful and efficient strategies.

absolute return strategies - a useful tool for today’s plan sponsors

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