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February 10th, 2011 by

A Breed Apart – Absolute Return strategies

Last week I talked about uncorrelated strategies and how to achieve them. I hope that was useful, please let me know. Now I want to take you down further the rabbit’s hole and speak about the Absolute Return strategies and how it will save your portfolio and avoid the types of collapse of 2008.

If you are a trader and not an investor, you are yawning already, so I recommend you move on. If you are an investor and you want to figure out how to pay for your kids college education, then I ask you to stay with me.

In the world of investing, there are two white elephants that investors don’t talk about, one is the Short Biased strategies and the other is Absolute Return strategies. They don’t talk about the first because of fear and they don’t talk about the second because of greed.

The fear of short biased strategies is because it is hard to consistently make money shorting, but worse than that, it is technically possible to have an infinite loss. I will discuss this at another time.

The greed is because the Absolute Return strategies are boring and will not deliver 20-30% years. What they will do is deliver consistent returns in any market, up, down or sideways.

Be careful and don’t compare the returns of the Absolute Return strategies to typical long/short strategies, which outperform Absolute Returns. It is completely unfair comparison because typical long/short strategies are basically long strategies with some hedge, some of the time.

So first, some explanations. The Absolute Returns strategies come from the hedge fund world. Sometimes they are called market neutral strategies, although they are not completely equivalent, for the sake of this discussion we will call them similar.

So what the managers of these funds do is use various asset classes, various hedging techniques, including derivatives and short exposures to achieve stable returns with moderate volatility. The stable part is key, they are trying to achieve the holy grail of any serious investment objective and that is about 1% monthly return with equivalent volatility, month after month, after month, after month.

The reason this is called the holy grail of investing is that by default we don’t like surprises. Especially negative swings of our portfolios. Our human nature makes it so that equal percentage swings of our portfolio up or down, it is the down swing that will hurt more than the joy of the equivalent up number. So if you if you are an investor and not a trader, you want to avoid big swings.

If you have been reading WSJ, Barron’s, etc., you most likely have noticed more and more ads for Absolute Return products. Look at Putnam as one example, there is not a week that goes by that you don’t see an advertisement for their Absolute Returns funds. Eaton Vance is pushing their fund as well. Now be aware that these are not ETFs, they are mutual funds and lack all the wonderful attributes of the ETFs that we love.

It is no wonder that with currently unjustified (my and my company’s opinion) markets highs, much economic uncertainty and certainly global political instability, the Absolute Returns strategies are gaining mind share of investors and certainly market share. We want stability, we want to avoid surprises and hopefully have our investment portfolio deliver the proverbial 10% per year return.

Unfortunately the ETF market does not offer (yet) an Absolute Returns ETF, but I see it coming!

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