Pursuing positive returns largely independent o market direction

Absolute return investing is a resource ul strategy that can supplement traditional

investments such as stocks and bonds. While investors justifably look to stocks and
bonds to build wealth over the long term, in the short term traditional strategies
typically expose investors to signifcant market volatility and sustained periods o
negative per ormance. Both o these risks inter ere with the goal o accumulating
wealth and purchasing power.
Absolute return strategies pursue more consistent results in both the short term andthe long
term. An absolute return strategy seeks to earn a positive total return over a ull market cycle
with less volatility than traditional unds and largely independent o market conditions. An
absolute return strategy can outper orm broad markets duringperiods o at or negative
market per ormance.
This paper discusses absolute return investing, its undamental properties, and how it
can serve investors with qualities such as
‡ A ocus on providing positive returns over time with less volatility
than more traditional unds

‡ Potential or outper ormance in down markets

‡ Flexibility to pursue global investment opportunities

‡ Diversifcation across newer and alternative asset classes

‡ Progressive risk management with modern investment tools, including derivatives

Absolute return investing
Pursues targeted returns above in ation with
less volatility over time.
M rch 2010
Rob A. Bloemker
Managing Director,

Head of Fixed Income

Washington University, B.S., B.A.

22 years of investment experience

Jefrey L. Kn g , CFA
Managing Director,
Head of Global Asset Allocation
The Amos Tuck School of Business,
Dartmouth College, M.B.A.,
Edward Tuck Scholar
Colgate University, B.A.
23 years of investment experience
2
Traditional investing ocuses on maximizing returns relative
to a benchmark index
Investors turn to stocks and bonds as a way to build long-term wealth because these
asset classes have a historical track record o positive per ormance over the long term.
While stocks and bonds have greater risks than short-term securities such as Treasury
bills, over the long haul investors have been rewarded or taking these risks by earning
higher rates o return (see Exhibit 1).
ExhiBit 1: RELAtivE REt R F R E tRA iti AL A Et CLA E
Cash
3% InÀation
Bonds
Stocks
9.8%
5.4%
3.7%
Annualized returns (12/31/25±12/31/09)
Source: Morningstar, 2009. Stocks are represented by the Ibbotson S&P 500 Total Return Index,
bonds by theIbbotson U.S. Long-Term Government Bond Total Return Index, and cash by the
Ibbotson U.S. 30-day TreasuryBill Total Return Index. The indexes are unmanaged and measure
broad sectors o the stock and bond markets.You cannot invest directly in an index. Past
per ormance is not indicative o uture results.
Most traditional mutual unds task the port olio manager with outper orming a stock
or bond benchmark such as the S&P 500 Index or Barclays Capital U.S. Aggregate Bond
Index. The manager is usually constrained to invest only in the domestic market or in a
specifc asset class. According to the Investment Company Institute, 95% o mutual und
assets are in unds ocused on a specifc asset class ² stocks, bonds, or money market
securities. Hybrid unds are an exception. These traditional unds have greater exibility to
invest across global asset classes. However, only about 5% o industry assets are invested
in hybrid unds. Furthermore, some traditional unds may have even tighter constraints,
such as bond unds that invest only in government bonds or high-yield bonds, and stock
unds that invest only in small companies or growth stocks. Such constraints beneft
investors in that they discourage a money manager rom taking a range o unintended
risks and they ocus e orts on security selection.
At the same time, constraints carry a disadvantage as well. In a general market decline,
when securities all in price or systemic, rather than specifc, reasons, there is little that
a constrained manager can do to avoid a negative result. In act, a manager may do what
is considered a good job ² by outper orming the market benchmark ² yet, during a bear
market, the und might post a signifcant decline or shareholders.

A rela e re urn und

can ou per orm s

benc mark ye s ll

reg s er a s gn can

decl ne n a bear marke .

3
There have been 12 bear markets in stocks since World War II, with prices declining20% over 14
months, on average. Bear markets pose substantial risks. For youngerinvestors, a downturn
interrupts the compounding o returns, and this delays wealth
accumulation. For investors who have already built up savings and may be relying
on them to generate income, the impact o a bear market can be devastating.
For sa ety, such investors typically avor more conservative investments, which,
with lower rates o return, require a number o years to recover rom a downturn
(see Exhibit 2). Since their time horizon is shorter, older investors cannot reallocate
enough money to stocks to beneft rom a recovery in prices and restore their wealth.
For retired investors, a bear market poses special risks. Withdrawing money duringdeclines locks
in the low stock prices and leaves investors with a smaller position orwhen the market recovers.
In short, retirees are particularly vulnerable to bear markets,which can shrink savings and reduce
the potential or generating a uture income
stream, because retirees are unable to add to their port olios rom occupational income.
ExhiBit 2: h w L E it tAKE t REC vER FR A ARKEt w t R ?
Rate of return
Size of bear market downturn
-10%
-20%
-30%
-40%
-50%
2%
5.25 years
11.25 years
17.75 years
25.50 years
34.75 years
4%
2.75 years
5.50 years
9.00 years
12.75 years
17.25 years
6%
1.75 years
3.75 years
6.00 years
8.50 years
11.50 years
8%
1.25 years
2.75 years
4.50 years
6.50 years
8.75 years
10%
1.00 year
2.25 years
3.50 years
5.25 years
7.00 years
This hypothetical illustration is based on mathematical principles and assumes monthly
compounding.
It is not meant as a orecast o uture events or as a statement that prior markets may be
duplicated.
Recovery periods are rounded to the nearest quarter o a year.
To understand the heightened bear market risk or retired investors, consider the
example o the stock market decline o 2000±2002. Exhibit 3 compares two investors,
one who retired in late 1999, at the start o a bear market, and one who retired in late
2002, near the beginning o a recovery. The frst investor¶s port olio declines during
the bear market and remains well below its original value even a ter the market
recovers, leaving the investor with less fnancial security. The other investor benefts
rom market per ormance, and the port olio even appreciates or several years. The
di erence highlights the damaging impact o a bear market.
For more in ormation on the importance o stable returns in retirement, visit
theretirementsavingschallenge.com.