One of the biggest lessons I’ve learned over the past 25+ years is that investors tend to be “long term” oriented in their investment strategy as “long” as they are making money! It has been my experience that once losses start to crop up, it is truly amazing how quickly all those well meaning investors tend to get depressed, panic, and give up.
Up until recently, the mutual fund and financial planning industries chastised these finicky investors as being naive for succumbing to such a silly emotion as not wanting to lose money. The answer to all investment ills was to remember that you were investing for the long-term and a mountain of somewhat one-sided academic evidence proved that as long as you stuck with it, you usually did quite well in the stock market.
While the idea of “time, not timing” always raised the hackles of active investment managers or anyone trying to do something as ignorant as “buy low and sell high,” the public bought the mountain chart story hand over fist and solemnly swore that they were “in it for the long term.”
But that was then. That was BEFORE the tech bubble burst and cost anyone owing a growth fund about half of their investment. That was also BEFORE the Credit Crisis hit and turned 401(K)’s into 201(K)’s. And that was BEFORE people realized that their mutual funds and those set-it-and-forget-it asset allocation plans are still down BIG so far this decade. (And for those of you keeping score at home, we’re now more than 9.5 years into this decade – which, by most definitions, is probably considered long term.)
While it may be just my opinion, I will suggest one of the main reasons the hedge fund industry exploded over the past 10 years is that investors don’t like losing money. In short, hedge funds sprouted up and had dollars thrown at them by the billions because hedge fund managers could offer investors what they wanted – solid returns in any kind of market.
The snag was that since the hedge funds were largely unregulated, investors had to have substantial wealth in order to get in the door. Thus, the investment strategy that the vast majority of Americans REALLY wanted was unavailable to them. And as such, the public was stuck with the buy-and-hold mantra that was being fed to them.
I will also opine that maybe, just maybe, the investing public has had it right all along. Let’s face it; losing money is NOT fun! And hey, what’s wrong with “buy low and sell high” anyway?
An Old Idea Whose Time Has Come
Two weeks ago, I wrote a “Big Picture” piece entitled The New Normal: An “Absolute” Objective. The point to the article was I believe it is time to think differently. It is time to abandon the concept of relative return (performance that is based on and compared to the S&P 500 or some other benchmark index) and concentrate on the idea of “absolute return.”
I’m guessing most readers will agree that the concept of making money in any and all environments sounds like a great idea. And I’ll also bet that at least a handful are saying, why isn’t this approach being used now?
As I pointed out last time, up until VERY recently the average investor didn’t have access to the tools necessary to play the “just win, baby” game. There simply weren’t liquid investment vehicles for the average investor to take positions in various countries, indices, sectors, themes, commodities of all shapes, colors, and sizes, currencies, bonds, or an inverse version of all of the above. Yes, you could gain access to these arenas in the past, but it most definitely wasn’t easy and/or inexpensive.
However, the good news is that the wide, wide world of ETF’s (exchange traded funds) has changed all that! Nowadays, you can invest in just about anything at any time – and do so at any point during the trading day. For example, if you think the BRIC countries are the way to go, you’ve got your choice of a handful of ETF’s to choose from (we currently own the EEB). Or if you only want half a BRIC, you can invest in “Chindia” (China and India) via the FNI (which I own, by the way). Or, if you only want either China or India, you’ve got a bunch of ETF’s to review. Do you like real estate in Japan? No problem, there’s an ETF for that. Thinking about energy as your big idea for an improving economy? You can buy and/or short everything from oil to natural gas to coal in the blink of an eye. Got an itch for gold? Yep, there are at least 20 ways to play the yellow metal.
The Next Logical Step In Managing Risk
The key point here is that the vast array of investment alternatives offered via ETF’s is a game changer for investment managers and investors alike. For example, I have ALWAYS been a manager of risk. However, up until recently, this has meant selling stocks when they broke down on a chart basis and raising cash in portfolios when things got ugly.
In short, “losing less” was the battle cry. You see, if you lost 15% or 20% when the market lost 40%, it meant you had a lot more capital available when the next bull came around AND you needed a lot less of the gains from next bull to recoup your losses. So, while it was never any fun to lose money, “losing less” was a very successful long-term strategy.
Yet, when you think about it, this approach means we’re still fighting the last war – a secular bull market environment. Here the goal was to lose less during the brief declines and then get back in the game when the bull returned. But since this is now a secular bear market environment, perhaps it is time to think differently.
Enter the inverse ETF’s. We now have tools available that allow for strategies aimed at actually making a little money during market downturns via inverse ETF’s. And while playing the short side of the game is indeed tricky, there are times when this would be a great alternative to have at your disposal.
For example, although hindsight is indeed 20/20, it is fairly obvious that the year 2008 had two major trends. First, there was the continued advance of commodities and then the massive decline in U.S. stocks. So, if you had a plan in place to capture at least some part of the major trends, you’d have been golden.
But please, please, please understand that I am NOT suggesting one needs to either be long or short the U.S. stock market at all times. Remember (FYI, I’m relying only on my recollection of the data here), the U.S. market goes sideways something on the order of one-third of the time. And during a sideways market, such a narrow long/short approach will inevitably produce a lot of churning/losses. This may be a fine tactic to manage the U.S. market, but in reality this is also a “relative return” approach designed to compete with the U.S stock market – and therefore is NOT an “absolute return” strategy.
Absolute Return is NOT:
While the concept of finding a way to make some money in all environments via an opportunistic investing style makes sense to me, speaking with reps and clients about the idea of “absolute return” has made me realize there are a lot of misconceptions out there. For example, my view of “absolute return” investing does NOT include:
- Quant-based “black box” strategies which hold longs and shorts at all times
- Long/short market timing approaches
- Stock portfolios that also own put options at all times
- The 130/30 (or some variation thereof) strategy
- Short-term/day trading strategies
- Targeted return strategies (such as those Absolute Return 100, 300 etc. that Putnam is currently promoting)
While all of the above may be fine investing strategies, none of these meets our definition for “absolute return.” Again, we are proposing a flexible approach designed to be able to go anywhere to find returns.
Absolute Return IS:
Just to make sure we are not misunderstood; we’ll run the risk of being exceptionally redundant here. In short, our idea of “absolute return” investing IS:
- An opportunistic/flexible approach to investment markets designed to create positive returns in all environments
- The recognition that there ARE ways to make money in all markets
- A logical extension of risk management strategies
- A strategy focused on grabbing “the low hanging fruit” of the investment world
- The utilization of the new tools available to us as investment managers
- What the public REALLY wants!
In my humble opinion, there is no longer any excuse not to manage risk in portfolios and there is not excuse for managers not to use all the investment tools available to them.
The Pitfalls
If you are like me, you’re probably thinking, “Gee that sounds great, but what are the pitfalls of the absolute return approach?” In short, the problems are fairly straightforward and based primarily on “management risk.” For example, a manager can always wind up in the wrong place at the wrong time. This is simply a risk associated all flexible investment approaches. And second, since you are attempting to be flexible, avoid losses, and grab the low hanging fruit, you may not make as much money as possible if you were focused on say the U.S. market.
So there you have it; a brief “white paper” on the approach we are now taking with our flexible portfolios. If you have a minute, feel free to let us know what you think.
Finally, while we don’t mean to sound like pitchmen, the portfolios offered at TSP that focus on absolute return include the following:
- MacroTrade (Up +26.14% YTD)
- FlexPro Portfolio (Up +11.11% YTD)
- ActiveTrader (UP +9.2% YTD)
Wishing you all the best for a profitable week ahead,
David D. Moenning
Founder TopStockPortfolios.com
Positions in Stocks Mentioned: None
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