Asymmetric strategy is a better bet

Several firms engaged in portfolio management services (PMS) are interested in offering absolute-returns strategies.

As the name suggests, these are strategies that are meant to generate positive returns irrespective of the market movements. High net-worth individuals (HNWIs) will no doubt be interested in taking such exposure.

The question is: Can firms achieve absolute returns? And if so, can firms do so consistently?

This article explains absolute-returns strategies. It then shows why it would be optimal for firms to instead offer asymmetric-returns strategies.

To understand absolute returns, it is important to define relative returns. The latter refers to investment strategy that is relative to a pre-defined benchmark.

An equity mutual fund may choose to have Nifty as its benchmark index. Its performance would, hence, be compared with the Nifty.

An absolute-returns strategy in contrast does not have a benchmark. The strategy is expected to provide positive returns irrespective of the market movements.

Portfolio managers are expected to adopt strategies that will carry higher upside returns and low or no downside risk.

It is quite obvious that such strategies are only possible if the portfolio manager carries both long and short positions in the portfolio.

Specifically, such long and short should be hedged such that the portfolio does not carry any market risk. The hedged portfolio is expected to carry zero or near-zero market risk or beta. That way, the portfolio will be almost unaffected by the market movement.

The question is: What is the source for absolute returns?

Portfolio returns consists of two components — one correlated with the market, captured by the beta, and the other uncorrelated with the market, called the alpha.

Alpha is nothing but the excess returns that is due presumably to manager's skills (portfolios can generate alpha due to luck as well). We wish to reiterate that while alpha is easily measurable, skill is not.

The point is that if alpha is excess returns, it has to be relative to some benchmark. A fully hedged portfolio typically has cash benchmark because it carries little or no market risk.

Models in portfolio management state that investors will be inherently rewarded for market risk or beta. Alpha or excess return, on the other hand, is a zero-sum game. This means that there is, indeed, risk in engaging in alpha strategies.

US-based funds following absolute-returns strategies lost significantly during 2008 sub-prime crisis, though losses were substantially lower than the broad market index. The point is that using the term “absolute returns” is most likely to mislead the investors into thinking that the strategy does not have downside risk at all.

Asymmetric returns

Firms can instead offer asymmetric-returns strategies. As the name suggests, these are strategies that offer greater upside potential compared with downside risk.

These are essentially hedge-fund replication strategies such as merger arbitrage, fixed-income arbitrage and relative-value strategies. Suffice it to know that these strategies are betting on relative mispricing of assets.

The essential difference between asymmetric returns and relative returns lies in managing risk.

The latter strategy typically manages risk in terms of tracking error, which is the standard deviation of the difference in returns between the portfolio and the benchmark.

The alpha for an active long-only fund is adjusted by the tracking error to arrive at the risk-adjusted alpha.

Asymmetric-returns strategies, on the other hand, are managed to total absolute risk. The key is in preserving capital by avoiding large drawdown in the portfolio. It is important to note that these strategies extend beyond the first generation structured products such as the capital protection fund offered by mutual funds.

Conclusion

Asset management firms appear to be interested in offering absolute-return strategies.

Such strategies are unlikely to give consistently positive returns when the broad market declines. We believe that firms can instead offer asymmetric-returns strategies to high net-worth individuals.

Such strategies will offer hedge-fund replication to a market that is devoid of such products.

Importantly, such strategies will fit well inside the satellite portfolio and complement the low-cost beta exposure providing by mutual funds.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at >enhancek@gmail.com)

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