The Downside Of Absolute Return

Over the years I've written quite a few posts about absolute return products and strategies. These posts tended to be more popular through much of 2008 as things for the market were looking quite grim. Back then there were more than a few comments from readers who, based on their comments, were considering shifting a very large portion of their portfolio into absolute products.

My general reply was doing so after a 30% decline or 40% decline or 50% decline would be a bad time to make that kind of move. On the way back up, I think when the S&P 500 first got back to 1000, I rhetorically asked what number on the index you were saying "if we only get back to...then I'll..." and suggested that after such a large snap back someone inclined to make a big shift into absolute would be better served after that large snap back not before.

The reason to write about the topic so much is that it is a good way to learn about risk adjusted returns and how to possibly implement a modest exposure. In my experience a little absolute goes a long way toward smoothing out the ride in a normally diversified portfolio (normal meaning an equity target between 50-75%). But for someone who was emotionally desperate a year ago, bargaining with themselves for some level this might be a good time for such an overhaul. The market is way off the low and only a little off the recent high.

That being said this would not be a strategy I would ever recommend for several reasons. First is that too much of anything becomes a lopsided bet that could have some sort of bad consequence as things like this go wrong every so often and very few people seem to see it coming. If you have a modest exposure however you don't have to see it coming.

A more subtle issue is isolated in this chart comparing the S&P 500 to the iShares Diversified Alternatives Trust (ALT) and the Hussman Strategic Growth Fund (HSGFX). The chart goes back to last November when ALT first listed. You can see that by April the S&P 500 had a decent lift that ALT and HSGFX completely missed.

That those two funds completely missed the move does not make them bad funds. It would be nice if the were up a couple of percentage points but this may not be a bad result. The Hussman fund targets a return over an entire stock market cycle. From the low in March 2009 the S&P 500 was up about 75% through mid April but the Hussman fund was only up a little over 1% (I imagine any dividends would need to be added to that result). However from the peak in October 2007 it is only down slightly (if you look for yourself you need to factor in an enormous dividend in November 2008) while the S&P 500 is down about 30% in the same time.

This raises two potential behavioral issues. Looked at over the entire cycle the Hussman fund has behaved as advertised. Anyone who bought in relative size in 2008 is no doubt really kicking themselves. To reiterate the time to give up on stocks is not after they crater. Additionally the people who chased the safe thing at the wrong time also have to grapple with their own ability to be patient. If you buy a fund whose objective is some result over an entire stock market cycle then you need to hold it for the entire stock market cycle unless you have a knack for timing which some folks do but of course some other folks say this sort of timing is impossible.

Psychologically, volatility is not a bad thing on the way up. But how might someone who gave up on stocks at exactly the wrong time likely to react reading, seeing and hearing about all these people who supposedly bought like crazy in March and have made a fortune while he, the person who threw in the towel near the low, is up 3%.

The absolute fund I've written the most about, and still own for clients, has been the Rydex Managed Futures Fund (RYMFX). We target it at a 2-3% weight. It was a home run in terms of smoothing out the ride. About a year after the peak when the S&P 500 was down 48% RYMFX was up 21%. Since that time the fund has drifted slightly lower. At a modest weighting like we have, it is the only absolute fund we hold, the slight drift lower has not been a meaningful drag on the portfolio.

To my way of thinking this is how these funds were meant to be used; to smooth out the ride in a diversified portfolio not be the entire portfolio.