Understanding absolute performance

Since the bear market hit in 2000, the investment industry has been plagued with criticism on performance. With all the negative performance that has happened in the past few years, is there anything investors can do in the future to avoid these catastrophes?

Let’s talk relative performance

When the industry talks about performance, it typically uses two key benchmarks:

  1. The first benchmark is against a peer group. What you do is take a group of similar types of investments and calculate an average. Some funds will beat the average and some funds will not. When using this benchmark to judge performance, it is reasonable to prefer investments that are above average.While this makes theoretical sense, let’s say the average performance for a group of investments was -25% and your investment only lost 10%. Would you be happy that you ONLY LOST 10% instead of 25% or would you be upset that you lost 10%? Probably the latter.
  2. The second benchmark that the industry uses is relative to the index. Much publicity has centered on an investments ability to beat the index like the S&P500, TSX or the MSCI. The key to comparing against an index is to use the appropriate index. For example the TSX is used to compare against Canadian Equity Funds. It would not be appropriate to use a bond index or the S&P500. Many investors feel that the fees they are paying for owning a mutual fund are only justified if they can outperform an index. Therefore it may be important to determine if a fund has been able to beat the appropriate index.

Both these benchmarks are what we call relative benchmarks. The determinant of how well you do is relative to how well other things do. Many investors are getting tired of hearing about relative performance basically because they are tired of losing money.

The trend to absolute performance

New and old investments provide more peace of mind for investors because of a newer trend towards absolute benchmarks. In fact, absolute return managers comprise one of the fastest growing sectors of investment management among institutional and retail investors.

Absolute return managers seek to generate positive returns every year as opposed to beating the S&P index. Traditional managers may beat the index and their peer group, but may still generate negative returns. Absolute return managers on the other hand, measure their success by their ability to generate positive rates of return in all circumstances.

Absolute return managers have an objective to be uncorrelated to the stock and bond market. This means that their positive return occurs at different times from the rest of the portfolio and generates a balancing effect, which reduces overall portfolio volatility, or risk.

In Canada, absolute return managers are emerging and have become increasingly popular in the last few years. Assets managed by absolute return managers are expected to grow at an exponential rate as mainstream investors allocate higher percentages of their portfolios to this investment category.

Where can you find absolute return investments?

Obviously, any capital guaranteed investment could be considered an absolute return investment. GICs, index linked GICs, and principal protected notes are great examples.

When it comes to managed money, hedge funds have led the charge in the development of absolute return mandates. Hedge funds are ideal long-term investment solutions. Hedge funds employ alternative strategies that can mitigate against downturns in the financial markets. The downfall in the market over the past 3 years has left many investors with negative portfolio returns. The hedge fund industry has done a much better job providing investors with the opportunity to earn equity-like returns when the market performs well, as well as protecting principal during market downturns.

My two cents

There is no question that investors will find comfort in the theories of using absolute return benchmarks. However, even hedge funds do not guarantee against loss. Saying you are not going to lose money, guaranteeing you are not going to lose money and not losing money are three different things.

I believe that absolute return investments and managers have a significant place in portfolios so I hope the demand for absolute return products continues to grow.

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