With equity markets near all-time highs and interest rates near all-time lows, consensus return forecasts have dwindled and many institutional investors have turned to absolute return strategies to address their challenges. And while the potential of low correlation and downside protection from absolute return is great, finding the right strategy is challenging. Unfortunately, absolute return can bring on governance heartburn!
Our ever-inventive industry continues to devise numerous ways of building portfolios with an absolute return objective. Disappointingly, many of these products use combinations of instruments that are often complex, illiquid, expensive and lacking transparency. And these problems often result in capacity limits that prevent large, institutional investors from making meaningful investments.
Equities to the Rescue?
Using equities for absolute return can overcome these shortfalls, but equity beta exposure can have a catastrophic impact on your portfolio. So, why even bother considering them for absolute return? Because we believe they offer the best potential for addressing the pain of absolute return.
In our paper, “Why Equities for Absolute Return?,” we offer a look at the challenges with implementing absolute return today, the traditional problems with using equities to produce absolute return and a brief introduction to how Intech found a different way to use equities for absolute return results.
We found a new path by listening to the needs of our institutional clients and their consultants. They didn’t talk about risk parity, relative value or convertible arbitrage. They described the outcomes they desired and the challenges they faced with available offerings. Eventually, we built a strategy that attempts to address both issues, but starting with outcomes was paramount and our approach is instructive for investors evaluating any absolute return strategy.
Begin with the End in Mind
Any asset in an institutional portfolio should serve to improve risk-adjusted returns. And for absolute return, specifically, institutions typically seek three key attributes to meet that end: positive returns, low correlation and downside protection.
Generating positive returns over a market cycle provides a consistent alpha source to help fund future liabilities. Therefore, you need an alpha source that’s reliable in both up and down markets. Even if that exists in theory, execution is often tricky.
Strategies that have low correlation with existing assets are essential to improving diversification and portfolio efficiency. But these are rare. You need to uncover managers who have an investment philosophy that’s materially different from the crowd.
Mitigating the main risk to portfolio drawdown – equities – is key to increasing compound returns. But escaping the perils of beta risk leaves very little alpha, sacrificing beta’s contribution to total return.
Now Address the Pain
With outcomes squarely in focus, you can now search for absolute return strategies that deliver on them and circumvent implementation pitfalls:
- Liquidity
- Fees
- Transparency
- Complexity
- Capacity
To overcome these challenges, investors need to deal with the causes of the problems, not the symptoms. For example, negotiating redemption fees or gate provisions to address liquidity is at odds with the fact that many managers see illiquid securities as critical to generating absolute return. The problem is not gate. The problem is the use of private equity, distressed debt, etc.
We detail the causes for each of these problems in the paper. Ultimately we believe publicly-traded equities – the bread and butter of our investment process for over 30 years – offer an abundant source of uncorrelated alpha that’s highly transparent, extremely liquid and far cheaper to implement in absolute return strategies than many competing approaches.
We invite you to learn more.
