Issue: June/August 09
Are AR benchmarks okay?
Far from it. ROLAND ROUSSEAU rips through the myths
that retirement funds commonly accept.
Rousseau...put skill to the test
Absolute-return (AR) investing is an
important way to control risk, but we
need to define the concept carefully.
Typically, AR refers to any type of
investment that allows the manager to
go both long and short so that the overall portfolio risk
can be reduced and potentially provide positive returns
in both rising and falling markets.
Although there is no guarantee of absolute returns,
the ability to go long and short could still provide
significant risk benefits to investors. This is the
noble and exciting aspect of AR funds. In addition,
AR pundits will correctly point out that long-only
investing prevents active managers from utilising
negative forecasts and profiting from these views
through short-selling. Much research now shows how
constraining long-only investing really can be.
But things start going off the rails with the
commonly-held belief that traditional long-only,
benchmark-relative, investing is bad and that AR
managers therefore don’t need benchmarks. The constraining influences that benchmarks place on a
manager trying to beat the JSE’s Alsi or Swix indices
are seen as too punishing. The benchmark is then
blamed for restricting manager skill.
Not having a benchmark, however, is like having a
society without morals. Major problems occur when
you claim you don’t need benchmark. How would
you know whether you’re getting value from your AR
fund? To measure any investment skill, a benchmark is
Make up your mind: absolute vs relative returns
The biggest setback in the history of investing is
the adoption of cash returns, or the consumer
price index plus x%, as ‘benchmarks’. By accepting
them as ‘benchmarks’, we lose our bearings. Simply,
they cannot reflect the risks in the active fund under
If your benchmark has a totally different risk profile
from the AR fund with which you’re comparing it, it’s impossible to draw conclusions about how much
value is being added for you as the investor. Taking
for example an AR fund with annual volatility of
10% against a cash benchmark with zero volatility,
is like comparing Michael Schumacher with Lance
Armstrong. Cash returns, or cpi+x%, can never act
as benchmarks. They are nothing more than return
targets or hurdle rates.
An equity market’s passive index such as the Alsi
can outperform, for years at a time, a cash or cpi
benchmark. Does this mean the passive market index
has ‘skill’ or has generated absolute returns? Of course
You are merely comparing the equity asset class,
with its much higher level of risk, to a riskless cash
return. This is meaningless. Yet we seem to think it
acceptable and continuously repeat the mistake with
AR funds. It’s a global problem that will eventually
come home to roost.
Need to match risks, not returns
So how do you correctly benchmark an AR fund?
You need to identify upfront with the pension fund
or consultant all the significant risk factors or ‘betas’
to which you will expose the fund – such as small caps
and emerging markets, also known as the risk budget
– and then calculate the residual return that remains
after accounting for these pre-defined beta returns.
This residual return is deemed to be skill or ‘alpha’.
Smart AR managers might argue that their funds
are market- or beta-neutral and therefore are not
exposed to market risk. They’re right, except that the
funds must nevertheless be exposed to other risks or
betas because they will necessarily have volatility.
It’s misleading to contend that market-neutral
funds, because they have a beta of zero to some
arbitrary equity-market index, have no beta risk. The
sub-prime crisis has proven that AR funds did and do
indeed have risks, lots of them, in the form of common
Long/short investing is undoubtedly a valuable
pursuit if implemented correctly. Critically important
is how we attribute the source of returns. Merely by
calling a fund AR does not make it immune to risk.
Excess return comes primarily from excess risk, not
AR funds, even the good ones, are less risky than
long-only funds. But still they’re risky, and at times
might be highly risky. We can’t marvel at the term ‘absolute’ when nobody can actually see the ‘absolute’
AR managers should rather accept a spade as a
spade. They should deliver ‘asymmetric returns’ which
is a much more tangible, easy to explain and factually
accurate term. The long-short, risk-controlled,
philosophy behind the inaptly-named AR concept will
probably blossom. But let’s clean up the act and get
the benchmarking right. Avoid creating nuclear bombs
like ‘absolute alpha’ that will explode. And accept that
correctly measured alpha is a zero-sum game where,
for every winner, there must be a loser.
Roland Rousseau is an independent consultant
focusing on portfolio construction and design of
investment strategies for industry roleplayers such as
pension funds, fund-of-funds and hedge funds. Having
worked for 14 years at Deutsche Bank, implementing
global best-practice quantitative solutions for clients, he
now advises CIOs of large investment funds in the UK,
Europe, Scandinavia and Australia.