Relative VS. Absolute Return Investing

Relative return strategies measure performance relative to the movement of an unmanaged index of securities,  the S&P 500, the Russell 2000, etc…

In the world of relative returns, you “succeed” if you meet or beat your benchmark index; you “fail” if you trail your benchmark index. The consequences of failure – i.e., being fired – are quite drastic. To avoid that fate, a relative return manager must at least match the index returns (on a risk-adjusted basis). As a result, many relative return managers simply “hug” the index, i.e., they construct portfolios that essentially mirror the index. In effect, they tie their fates to mimicking a benchmark. What does this mean?

• Relative return strategies are great during bull markets when indexes rise.
• Relative return strategies stink during bear markets – they offer limited, if any, protection when target indexes decline.
• Alice in Wonderland: relative return strategies can be “successful” even when they lose money! For example, if your index is down by 20% but your holdings are down by “only” 17%, you have beaten your benchmark – and you have “succeeded” even though you are down 17%. Conversely, if the index is up 20% and you are up “only” 17%, you have lagged your index by a substantial margin – and you have “failed” even though you are up 17%.

So, when considering a relative return strategy, we ask the following questions:

• Why limit yourself to a world that can define a down year of 17% as “good” and an up year of 17% as “bad”?
• Why tether yourself to something as unpredictable and uncontrollable as an unmanaged index of publicly traded stocks?
• Why play only in a world where the goal is to be a mimic, where creativity to go your own way is discouraged?

Absolute return investing answers each of those questions with “there is a different way.” In the world of absolute returns, investors do not concern themselves with benchmark indices over which they have no control. Rather, they seek to generate positive returns independent of market movements, i.e., whether the market indexes move up or down.

Absolute return managers employ various techniques designed to take the market out of the equation. These techniques include:

• Investing in stocks, and going to cash when market indicators dictate.
• Using high probability of success options strategies, to manage risk.
• Employing rotational sector strategies that rotate based on market conditions into equities, bonds, commodities, sectors, and international.
• Bond mangers that can rotate between cash, investment grade and high yield bond as indictors dictate.

These strategies can have a profound impact on the risk/reward characteristics of a portfolio, and they are increasingly available to individual investors.

Source: Investment CPR, Investing for Consistent Positive Returns