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Complete Guide to Absolute Return Strategy

Absolute return investing describes a category of investment strategies and mutual funds that seek to earn a positive return over time—regardless of whether markets are going up, down, or sideways—and to do so with less volatility than stocks.

What is Absolute Return Strategy?

Absolute return investor seeks to earn a positive return on their investment over a given period of time, but does not necessarily require returns to exceed the relevant market index. It is an investment strategy where return is not relative to a benchmark, but rather is an absolute dollar amount. The objective of an absolute return strategy is to provide investors a positive return regardless of how the market performs.

Absolute return strategies include a variety of investment approaches that seek positive returns in all market conditions while limiting downside risk. These funds are best suited to buy-and-hold investors looking for income and those with a moderate risk tolerance.

An absolute-return strategy is one that aims to achieve positive returns in adverse market conditions, and does not seek to match the performance of any market index. Thus, these managers, in certain market conditions, may generate negative returns which are more than offset by positive returns in other conditions.  – CFA Institute Research Foundation

The above definition of absolute return investing is comprehensive. It covers most forms of absolute return investing. However, it excludes two strategies: investing in derivatives and employing leverage.

The Trouble with Leverage

Leverage amplifies both positive and negative returns. If you invest in a stock, trade options on that stock, or invest in a leveraged ETF, you are leveraging your position.

The trouble is, it’s possible to lose more than your original investment. Even if the market moves your way, the combination of leverage and interest payments may require that you add more capital to the trade to reduce or eliminate your losses.

In a volatile market, a leveraged strategy can work against you. You may be forced to add more capital into a position to reduce your losses, thereby increasing the risk of further losses, and compounding the problem.

The combination of leverage and interest payments (which can be substantial on leveraged ETFs) can also make an unproven strategy prohibitively expensive. You may have to reinvest 100% of your capital numerous times while your portfolio earns a suboptimal return.

It’s important to note that many people invest in leverage on their own without using a leveraged ETF, fund, or advisor. In other words, anyone who invests on margin is using leverage.

Most margin account owners lose money.

The Trouble with Derivatives

The second trouble with leveraged ETFs, funds, and certain types of advisors is that they may use derivatives to amplify the returns on a portfolio (and, if leveraged, to amplify the losses on a portfolio). Derivative trading can create extremely large profits or losses, particularly on the short side. Derivatives are much riskier than stocks or bonds; in fact, derivatives are virtually unregulated in the U.S.  See Options: All the Risk and No Regulation.

Derivatives, especially short positions, can be quite risky. They also tend to magnify losses by substantial amounts. On the other hand, if you have a good reason to believe that an underlying is overvalued, or you think that it will decrease in value, a short position can be very profitable. But make sure that you can afford such a loss.

Just as leverage can magnify your gains, you should expect that losses will be magnified as well.

This is why institutions hire experts to trade in derivatives; it requires years of training to properly understand the products and their specific risks. You should not attempt to trade in these products unless you have expert guidance.

A related issue is the ability of the fund manager to make short sales at all. Some funds cannot make short sales because the proceeds from short sales must be held one year before they can be used to purchase stocks for a long position. If the fund doesn’t own the stock to begin with, it can’t go short.

Even if a fund manager can short stocks, selling short is only about half the profit equation. These days, shorting stocks is generally more expensive than it used to be. The bid/ask spread for shorting a stock is effectively about 20%, and the short interest for most stocks is very large (meaning increased liabilities).

For certain strategies it may be wise to take the opposing position at times. For example, if you are bullish on gold, it can be prudent to sell a puts on GLD at times, or vice versa. The sale of put options increases the price of a put option. Therefore, if you claim to be able to sell puts on GLD, and increase the price of the GLD puts, you would be incorrect. You must sell puts to decrease the price of GLD puts.

Most of the time, you don’t want to sell puts on a stock, ETF, or index. The problem with derivatives is that you don’t know exactly how much money you will make. You can make a lot, but if you have to use a lot of capital to buy puts, it may be more than you can afford to lose. Again, the use of large amounts of leverage is extremely risky and only appropriate for expert advisors or knowledgeable investors.

An Absolute Return Strategy is Different Than a Relative Return Strategy

A relative return strategy is one that matches the performance of a given market index over a period of time. If you invest 50% of your portfolio in stocks and 50% in bonds, fund a $5 million dollar U.S. Treasury Bond fund, and the S&P 500 Index earns 5% in a given year, then your portfolio grows to $5.25 million. You made a 5% return over the year. However, if the S&P 500 Index earned -5%, then your portfolio would decrease from $5 million to $4.76 million. In this case you would have a negative return.

The same is true of an international equities market index; changes in the value of the index will affect the value of your portfolio. An international equities market index fund may invest in foreign stocks in various countries around the world. If the index falls in value, then your portfolio will likely fall in value.

Although equities, fixed income, and blended indexes provide superior returns over the long run, even these go down in value in a market downturn. The end result of investing in a relative return strategy is that your portfolio will likely go up and down, depending on the performance of the market.

On the other hand, absolute return strategies seek to generate a positive return, regardless of how the market performs. As such, they are primarily concerned with factors in the marketplace that affect its underlying value. These factors can include valuation, the level of interest rates, and other factors.

An absolute return strategy attempts to forecast the overall level of valuations in the market, and invest accordingly. For example, if the fund manager were bullish on the markets, and thought that the market was overvalued, he would likely sell short put options to profit from the reduced prices of stocks. If he is wrong, and the market rises quickly, he might lose a lot of money.

Is an Absolute Return Strategy Suitable for You?

The bottom line is that most of us are better off investing in the market rather than an absolute return strategy. It’s important to realize that the decision is difficult, and that it is highly individual. Think about it this way – the stock market has historically provided some of the best returns of any long-term investment. If you own stocks for 10 years or longer, your chances of making money go up dramatically. However, during market downturns, your portfolio can fall in value significantly.

I believe that it is more prudent to invest in a broad market index, such as large-cap blend or large-cap value, rather than other markets or investment strategies. This is not to say that you should never invest in other markets, or that you should never invest in an absolute return strategy.

Many investors don’t have the time or the expertise to follow the markets regularly. A couple of hours per month is not enough time to develop your own investing strategies, let alone the expertise to determine market conditions and whether or not an index is overvalued.

The vast majority of your investment portfolio should go into a broad-based passive or index fund, such as an S&P 500 index fund or ETF, and you should invest in very low-cost index funds. If you have the time, patience, and interest, then you can invest in individual stocks or other types of investments. Make sure that you do your homework first.

Keep in mind that, in an absolute return kind of strategy, you have to be correct on the direction of the market before you can make money. This means that you must spend time and energy researching the markets so you can take a contrary position. However, if you are wrong, and the market continues up, you will be hurt. Likewise, if the market goes down sharply, and you failed to take a short position, you will lose money.

Variable Annuities

One of the most insidious and dangerous traps in the financial services industry is the variable annuity. Variable annuities are similar to mutual funds because they generally invest in stocks, bonds, and other investment assets. However, there are a number of important distinctions. First, variable annuities are sold through brokers and insurance companies, and are very expensive.

A decent mutual fund runs about 1.5% annually for management and 12b-1 fees. A variable annuity that provides similar access to the market may charge a management fee between 2.5% and 3% of assets, plus 12b-1 fees of up to 1%, and an additional surrender fee of between 3% and 7%. In addition, these funds are usually structured as Medicaid cements, meaning you can’t touch your money until you reach the age of 59½. Other than that, you can’t cash out early, even in a financial emergency.

Variable annuities are sold by salespeople, and not financial planners or advisers. Salespeople are paid on commission, which can be as much as 10% of the first years premium, plus an additional 3% of the annual premium. Unfortunately, this is not the worst part. In addition to the commissions, salespeople will get from 5% to 10% each year they keep the money invested in the variable annuity.

Variable annuities aren’t really insurance. In fact, the only thing insurance is good for is paying off creditors in case you die. If you have a variable annuity and live too long, you will find out just how valuable the insurance is!

Variable annuities are often sold on commission, which makes the sales representative’s salary dependent on your decision to purchase the annuity. National surveys have found that more than 70% of all variable annuities are purchased simply because the investor/purchaser doesn’t want to disappoint the sales representative.

To make matters worse, regulatory authorities haven’t done anything to protect investors from misleading sales pitches. To keep costs to a minimum, many companies only offer one variable annuity option. That means you are basically forced to purchase the one variable annuity offered on the market.

Variable annuities are almost always structured as life-time income annuities, meaning that you can’t access the assets until you reach the age of 59½. They are not always bad. It all depends on how the annuity is structured. There are some variable annuities, called equity indexed annuities, that offer a feature called a living benefit rider (LBR).

A living benefit rider allows you to tap your account for a portion of your initial investment while you are still alive and invested. Usually, if you are 75 or 80 years old, you can withdraw a limited amount of your investments. The amount you can withdraw is usually lower than what is called the payout rate.

The LBR is a benefit because it allows you to withdraw some portion of your assets while you are still alive. However, because the “limited withdrawal” is lower than the “retirement payout rate” (the rate at which you can draw the funds after you reach 59½ years of age), your investment will decline with each withdrawal.

Variable annuities also have high expenses. For example, Fidelity Freedom 2055 (FIOOX), which is a low-cost index fund that tracks the S&P 500, charges an expense ratio of 0.15% each year. By contrast, an annuity sold by an insurance company might charge 2.15% annually. If you invest $100,000 into the Freedom 2055 account, you will have $675,015 after 30 years. However, if you put that same $100,000 into a variable annuities, such as Fidelity Freedom 2055 (FFTHX), you only have $639,818 after 30 years. We are talking about a difference of more than $35,000 by investing in the S&P 500 index fund.

Variable annuities are really tax traps. With variable annuities, it is very difficult to get tax deductions on contributions. Your money is NEVER deductible until you pay appropriate taxes at withdrawal. This means that you pay taxes on your principal before you pay taxes on your interest, which is a change from regular traditional tax-deferred retirement accounts. For example, if you have $100,000 in a traditional IRA, and you are in the 28% tax bracket, your tax rate will be a maximum of $28,000. Within a variable annuities, since you don’t get the benefit until you remove the funds, each year you are paying $24,200 in taxes. Assuming a 6.5% return on your money, when you withdraw from the annuity, you pay taxes on your interest and your principal, plus the amount you withdrew from the annuity.

Annuities aren’t bad, but variable annuities are dangerous for the following reasons:

  1. They are expensive.
  2. They are sold by commission-based salesmen.
  3. They are not always true annuities.
  4. They don’t allow for tax write-offs until you withdraw your principal.
  5. They are structured like complex insurance products.
  6. They don’t offer you the option of paying your premiums out of income.

The more I look at variable annuities, the better index funds look. You can get better tax benefits and the same kind of returns using index funds as you can from a variable annuity. To do that, you still have to invest about $10,000 annually over 30 years. Not doing this will prevent you from withdrawing the funds in retirement.

In other words, if the market is down by more than 20% when you retire, you won’t be able to get any money from the market (unless you have a living benefit rider), much less the money you put into it.

In the current market, you may find it’s a good idea to invest in variable annuities. In a low-yield environment, cash is king. People who are typically conservative and experienced tend to lean towards cash. However, even these people recognize that their exposure to the market might add value to their investment. A variable annuity might be a reasonable option in this kind of environment.

However, even if you are a conservative investor, you probably shouldn’t wear two hats. I know people who are otherwise conservative investors, but when it comes to variable annuities, they take on the risk of buying variable annuities. Instead of putting the money into a riskier asset class, it might be best to allocate your funds in a different way.

If you are a conservative investor, you might consider a high-yield bank account, possibly from a mutual fund itself. As I said earlier, one of my investment heroes, Warren Buffett, has said almost all of his money is in extremely safe cash investments.

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