Absolute or real return products are vital for retired investors who cannot simply reduce risk by holding cash and term deposits in the current interest rate environment, writes Pengana Capital’s Damian Crowley.
The traditional investment portfolio which recommended a ‘balanced’ approach and allocated 60 per cent to equities and 40 per cent to fixed interest has changed little in recent years.
Allocations are still made on a notional basis and an analysis of the risk associated with most modern portfolios would find that the overwhelming majority of the downside risk comes from the equity exposure.
Yet this traditional approach is failing investors. In the last 10 years, the traditional balanced portfolio has only outperformed what most would consider a reasonable investment objective of CPI+5 per cent in 41 per cent of months on a rolling five-year basis.
This methodology should be questioned further in the current investment environment which is displaying signs of stress across numerous asset classes.
A better approach to portfolio construction is to determine the investment objectives and the total level of acceptable portfolio risk.
Investment allocations should then be scaled based on the level of risk associated with those assets as opposed to any form of capital equalisation or notional allocation.
Although this approach represents an improvement on the traditional portfolio approach, the investor is still making assumptions about the potential risk of each asset class which may or may not prove to be accurate.
Absolute return investing refers to a strategy with a return objective that is independent of a traditional benchmark.
For example, a long-only shares fund would generally be measured on a relative basis to a stock index and would be known as relative return. Real return refers to an inflation-adjusted return objective.
Ideally one would construct an absolute return portfolio of non-correlated assets with positive return expectations.
This means that all the assets in the portfolio would go up and down at different times although the general direction would be positive.
The ups and downs would partially cancel each other out and the investor would have a very smooth, stable and stress-free journey.
Numerous strategies are actively trying to achieve this objective, particularly in a nascent field called risk premia investing.
Reducing vulnerability for retirees
My view is that some form of absolute return orientation is vital for an investment portfolio.
This focus is not a replacement for traditional beta (the risk of general market exposure) but rather a way to enhance the overall risk/return characteristics of the portfolio.
A slow and steady approach generally wins the long-term investment race and this is achieved by avoiding the worst market drawdowns.
This can be easily illustrated with the well understood example that a 20 per cent drawdown requires a 25 per cent return to make up those losses and a 50 per cent drawdown requires 100 per cent return to break even.
Retirees are particularly vulnerable to large market swings.
How different would the life of pensioners be if they retired at the start of the bear market in late 2007 compared with the start of the equity market recovery in early 2009.
Absolute return products are vital for retired investors who cannot simply reduce risk by holding cash and term deposits in the current interest rate environment.
Absolute return strategies are usually subject to fewer constraints and can invest in a wide range of opportunities to achieve the most efficient risk-adjusted returns for investors.
Accordingly, it is critical to understand the mandate and strategy of an investment to ensure strategy diversification and the diversification of the return drivers.
Diversification is no less important in this category of investing than in any other.
Absolute return funds will generally be included in an investment portfolio to:
While no broadly accepted definition of what constitutes an absolute return fund exists, strategies in the sector often seek to capitalise on one or more of the following opportunities:
Damian Crowley is the director of distribution at Pengana Capital.