Meditations on Money Management

Andrew Silton: Two investing concepts you should definitely understand

CorrespondentNovember 2, 2013 

Are you an adherent of relative return investing or absolute return investing? Many of you probably aren’t sure. However, it is important to understand these concepts because they define how investors think about the returns they expect to generate from their portfolios and the risk they are taking. In addition, money managers and Wall Street have seized on these concepts to lure investors into all sorts of financial products.

Before I discuss these concepts and how to apply them, I owe you an explanation of what each term means. Relative return investors measure the performance of their portfolios against benchmarks like the S&P 500 or Barclays Bond Index, or universes of similar managers. These investors are measuring the success or failure of their investments based upon on whether they are beating or trailing a benchmark or universe. For example, your financial adviser might trumpet the success of your balanced mutual fund by saying that it beat a benchmark consisting of 60 percent S&P 500 and 40 percent Barclays Bond Index. Similarly, an advertisement might tout a mutual fund because it beat a universe of comparable managers such as the Lipper averages or achieved a four or five star rating from Morningstar.

Take note that success or failure of relative return investing isn’t defined by whether or not you made money. If your stock mutual fund declined by 10 percent but the market was down by 15 percent, relative return investing would define this as a success because your fund beat the market by five percentage points. In a declining market, victory might also be also be declared because your fund’s 10 percent loss was better than the 12 percent loss achieved by the average manager. Measuring returns on a relative basis seems pretty unsatisfactory when markets decline. After all, how can you possibly define success by losing less money than the market averages or the average money manager?

Shift in approach

Absolute return investing is the alternative approach. Under this method, investors are concerned with making their capital grow consistently without incurring a loss in any given year. The idea is to trade off some of the stock market’s best gains in exchange for avoiding the market’s worst swoons. Investors are seeking to target a return above and beyond inflation or a money market rate with as little volatility as possible. Thus, the benchmark is often defined as something like Treasury bills plus 6 or 8 percent. In today’s investment environment where T-bills yield about 0.1 percent, the benchmark would be a consistent 6 percent to 8 percent return with little year-to-year variation. Doesn’t that sound attractive?

In 2009 as the stock market was completing its rapid descent (of course, we didn’t know that at the time), money managers, brokers, and financial advisers began to market the absolute return approach in earnest. While university endowments had taken this type of approach for years, most individual investors had been relative return investors since the bull market began in the early 1980s. While active managers had underperformed their benchmarks, stocks and bond portfolios appreciated throughout most of the 1980s and 1990s. The losses generated by the credit crisis led many retail investors to question relative return investing. It only took a nudge from their advisers to switch over to absolute return investing.

Regrettably, it hasn’t worked well for retail investors. Absolute return strategies either have to rely on a heavy dose of fixed income or hedge funds in order to eliminate the volatility associated with the stock market. In the years following the credit crisis, most absolute return strategies have fallen well short of generating attractive returns. In addition, many investors who abandoned stocks in 2009 have watched the stock market recover while their portfolios are still well below their peak values.

Can’t have it both ways

Is one of the approaches inherently better than the other? No. Under the appropriate circumstances, relative return or absolute return can be valid approaches. However, as much as investors would like to, they can’t have it both ways. In other words, you can’t be a relative return investor in bull markets and then become an absolute return investor when the markets tank. No one can predict with any precision when bull markets are going to end, so only intermediaries such as brokers and traders benefit when you decide to bail out of one approach and try another. They earn fees and commissions, and you bail out at precisely the wrong time.

There’s no reason for sophisticated endowments to abandon absolute return investing. These organizations have the boards and staff to evaluate the complex investment required to execute these strategies. More importantly, the cash flows coming into endowments and subsequently flowing out to fund programs are amenable to the absolute return approach. Most of these investors also know that absolute return investing can lead to some nasty negative surprises when capital markets are disrupted. So absolute return investing isn’t perfect, but it works for many endowments.

For the rest of us, I think relative return investing is still the preferred route. This form of investing enables individual investors to build long-term wealth using well-established benchmarks. But doesn’t relative return investing force investors to endure the full force of the market’s periodic swoons? Most of the time, the market’s ups and downs are very manageable. It’s like modest turbulence when a jet is cruising at 30,000 feet: unpleasant, but not dangerous. The only time volatility truly matters is when your children are approaching college or you’re nearing retirement. It’s at that point that you need to shift some of your money out of the most risky assets, such as stocks, and into bonds or cash. For those of you who don’t trust yourself or your financial adviser to make those decisions, there are plenty of low-cost target maturity funds that set a reasonable glide path as you approach your goal.

Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog

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