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Absolute return portfolios, and the role of hedge funds Back  
Pat McCormack describes the approach one leading wealth manager - Barclays - adopts in designing absolute return portfolios
Stock market volatility - both in 2000-02 and in 2007-08 - has prompted many investors to abandon equity investment altogether, or at least prompted them to find more reliable ways of producing positive absolute returns. Such returns contrast with the ‘relative’ returns that traditional investment funds offer. Traditional strategies may or may not perform well compared to a market benchmark, but they always lose money in absolute terms in a falling market - the so-called ‘long only’ constraint. Investors’ focus on absolute returns has resulted in the rapid growth of alternative investments - including hedge funds, commercial property, private equity and commodities - over the past decade.

Within the world of alternatives, it is of course hedge funds that garner most of the headlines. In the past, this has been because hedge funds have often delivered returns in excess of those generated by traditional investment funds, sometimes with lower volatility. However, the market gyrations seen in the summer of last year (and the subsequent heavy losses at a number of hedge funds employing quantitative strategies) has served to highlight that sound manager selection with the hedge fund universe is just as important as it is in the world of traditional funds, if not more so. And while individual hedge fund strategies may vary significantly from fund to fund, it’s the outcome that’s most important, specifically achieving positive absolute returns. Here again, manager selection is critical.

Absolute return portfolios consist of a scientifically-blended range of strategies, with investments grouped according to their particular strategic objective (rather than along the more traditional lines of asset class). However, there is always one common objective: to deliver returns in excess of cash rates, regardless of the specific skill (or strategy) employed. Primarily, these absolute returns are delivered via hedge funds, although Liquid Transparent Arbitrage Strategies (LTAs) also have an important role to play.

As far as hedge funds are concerned, we seek to provide a robust core offering along with innovative and exclusive products. This is possible because we employ an ‘open architecture’ approach to manager selection, allowing us to leverage both our own extensive in-house resources and those of the wider market; we recognise that no-one has a monopoly on good ideas. That’s why our three-stage approach to manager selection is extremely rigorous. The first stage in manager selection is quantitative screening, where we assess a universe of over 25,000 hedge funds. Our quantitative models seek to identify superior - and persistent - risk-adjusted returns. They do this by scoring funds on information ratios (the risk-adjusted return over a given benchmark generated by active investment decisions), the trend in the information ratio, the efficiency of returns (both in terms of absolute returns and volatility), time-weighted returns and drawdown (peak to trough loss).

The second stage is due diligence, where we assess a manager’s investment philosophy, investment process and risk controls. We also seek to understand how and why the manager thinks that their strategy will consistently deliver added value over time, regardless of broader market conditions. The third (and final) stage of the process is investment approval, which includes ongoing peer group reviews and continual monitoring of individual funds. This is vitally important, as few investors have the time or resources to continually assess a universe of 25,000+ funds. Underpinning our hedge fund manager selection at all times are our three guiding principles of quality of management, proven track record and liquidity.

While the term ‘hedge fund’ will be familiar to many investors, Liquid Transparent Arbitrage Strategies (LTAs) have yet to slip into popular parlance. However, despite the somewhat clumsy name, LTAs can perform a very useful role in generating absolute returns. Quite simply, LTAs aim to capture and exploit market anomalies, more commonly known in the industry as ‘arbitrage’. As with hedge funds, the selection of LTAs is very thorough, with each strategy assessed individually. LTAs must demonstrate positive excess returns at least 80% of the time and the track record must also include at least one period when equity markets have been in recession. Daily liquidity, full transparency, scalability and sustainability (over a typical horizon of one year) are also key considerations.

Recent market events have helped to prove the old adage that ‘time spent on reconnaissance is rarely wasted’. The complexity and diversity of hedge fund and LTA strategies means that it is almost impossible for investors to stay completely in touch with the multitude of opportunities available, while identifying those strategies that can consistently produce positive absolute returns is a task that is simply too time intensive for an individual to consider. This is why we have invested huge resources in manager selection; as with so much else, the devil in choosing the right manager - and indeed in generating absolute returns - is in the detail.

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