Relative Performance vs. Absolute Returns
"And so instead of absolute places and motions, we use relative ones; and that without any inconvenience in common affairs; but in philosophical disquisitions, we ought to abstract from our senses, and consider things themselves, distinct from what are only sensible measures of them." invest in cervino capital management invest in cervino capital management invest - Isaac Newton, 1687
It seems simple but knowing whether a portfolio manager is doing a good job can be a challenge. It's difficult to define what good is because it depends on how the rest of the market is performing. For example, in a bull market 2% is a horrible return. But in a bear market, when investors are down 20%, just preserving your capital would be considered a triumph. In that case 2% doesn't look so bad.
Absolute return is the fixed percent an asset or portfolio returned over a certain period. Therefore, the 2% mentioned in the paragraph above is considered absolute return. If a mutual fund returned 8% last year, then that 8% would be its absolute return.
Relative return, on the other hand, is the difference between the absolute return and the performance of the market (or other similar investments), which is gauged by a benchmark or index such as the S&P 500. Relative return is the reason why a 2% return is bad in a bull market and good in a bear market. For example, if the absolute return of your portfolio is 10% and the performance of the S&P 500 during the same time period is 6%, then you have a relative return of 4% greater than the market (10% - 6% = 4%). If, however, during this same time period the S&P 500 returns 15%, then you have a relative return of -5% (10% - 15% = -5%).
Why is relative return so important? Because it is the generally accepted method for measuring the performance of actively managed portfolios, which should get a return greater than that of the market. After all, you can just buy an index fund that has a low management expense ratio and will proxy the market’s return. However, if you’re paying a portfolio manager to perform better than the market and the investment doesn’t have a positive relative return, it may be worth finding a new manager or just buying an index fund.
But this is where it can get complicated. Who is to say what the “market” is? The S&P 500 index is often cited as the benchmark for the U.S. stock market but in actuality it represents mostly large capitalization stocks. The Russell 2000 serves as a benchmark for small-cap stocks in the United States, while the Lehman Aggregate Bond Index is comprised of fixed income securities to simulate the universe of bonds in the market. Relative return can also be used within a context smaller than the entire market. For example, a technology fund's performance could be measured or benchmarked against other technology funds. What about foreign stock markets? Have you heard of the FTSE, DAX, Nikkei, or All Ordinaries? These benchmarks represent stock indices for London, German, Japanese and Australian equities, respectively.
It’s wise to look at relative return to see how an investment's return compares to other similar investments. The trick is finding a comparable benchmark in which to measure your investment's return; then make a decision of whether your investment is doing well or poorly. That said, in the final analysis, the power of compounding is best accomplished with consistent positive returns year-in/year-out regardless of market conditions. Investors re-learned this fact after the 2000-2002 bear market, and this is why so many institutional investors have substantially increased their allocations to absolute return programs.
Realizing that traditional methodologies may not be sufficient in helping achieve investment goals leads to the problem of finding absolute return strategies. In order to accomplish this sophisticated investors have increasingly embraced a new paradigm that rejects total return as the measure of a strategy's worth. The concept is that any strategy's total return can be divided into a market return (beta) and 'ideally' a net excess return (alpha). What is of real value is an investment strategy's ability to consistently generate alpha.
The bottom line is it is not easy to find strategies that consistently generate risk-adjusted excess returns. For example, investors must be able to distingish market returns (beta) from excess returns resulting from skill-based actions ("true" alpha) and excess returns resulting from non-skill-based actions (e.g., consistently holding large cash positions, taking increased benchmark risk, or using leverage). Even when one is knowledgable about these performance evaluation concepts, the investor must have access to alternative investment managers (many have high minimums and require "accredited investor" status), be comfortable with the structure, and after making an investment, monitor existing managers to ensure their approach continues to provide desired alpha.
The greatest barrier to acceptance for this investment approach is often psychosocial: the unwillingness to try something new based on frequently cited "conventional wisdom" that is marketed by an industry riddled with conflicts of interest, not to mention regulators and regulations that end up institutionalizing "good" from "bad" investment approaches. The herd mentality always tends to rule. Luckily, innovative investment strategies, such as those offered by the regulated approach called managed futures or unregulated vehicles known as hedge funds, are increasingly becoming accepted as a desirable means for diversification. (In the opinion of this author, hedge funds should be regulated but not the investment strategies they promote.)
The move to the new paradigm of alternative investments, absolute returns, separation and recombination of beta and alpha requires that investors think differently about the investment process and their investment portfolio. No one is claiming that investors should rush to embrace this new paradigm. Instead, they should carefully evaluate this shift to determine its benefits and risks. This understanding will alow investors to develop a prudent plan so they can properly respond to new opportunities.
In conclusion, the separation and recombination of beta and alpha is only one of the fundamental principles of the new investment paradigm. The other, the acceptance of alpha-based strategies as a part of an investor's asset allocation policy is equally important. The search for alpha is difficult, especially when the source of alpha is the asset class itself, such as with managed futures. The key objective for investors is to distinguish manager skill from market returns and factor in investment management costs; that is, pay minimal fees for beta, and only pay for uncorrelated alpha.
The Diversified Option Strategy of Cervino Capital Management is an example of an absolute return program where returns are derived primarily from skill-based trading decisions. While past performance is not necessarily indicative of future results, the program has been able to sustain consistent positive monthly performance since inception as well as very low correlation when compared to the S&P 500 index. Positions are diversified across various financial and commodity markets, and entail complex option strategies that have varying degrees of market direction exposure: long, short or neutral. A key part of this strategy is recognizing that options are a wasting asset. Accordingly, the trading model is similar to the insurance business model whereby premiums are collected and risk management is the primary focus. For more information, visit www.cervinocapital.com.
- Mack Frankfurter, Managing Director
It seems simple but knowing whether a portfolio manager is doing a good job can be a challenge. It's difficult to define what good is because it depends on how the rest of the market is performing. For example, in a bull market 2% is a horrible return. But in a bear market, when investors are down 20%, just preserving your capital would be considered a triumph. In that case 2% doesn't look so bad.
Absolute return is the fixed percent an asset or portfolio returned over a certain period. Therefore, the 2% mentioned in the paragraph above is considered absolute return. If a mutual fund returned 8% last year, then that 8% would be its absolute return.
Relative return, on the other hand, is the difference between the absolute return and the performance of the market (or other similar investments), which is gauged by a benchmark or index such as the S&P 500. Relative return is the reason why a 2% return is bad in a bull market and good in a bear market. For example, if the absolute return of your portfolio is 10% and the performance of the S&P 500 during the same time period is 6%, then you have a relative return of 4% greater than the market (10% - 6% = 4%). If, however, during this same time period the S&P 500 returns 15%, then you have a relative return of -5% (10% - 15% = -5%).
Why is relative return so important? Because it is the generally accepted method for measuring the performance of actively managed portfolios, which should get a return greater than that of the market. After all, you can just buy an index fund that has a low management expense ratio and will proxy the market’s return. However, if you’re paying a portfolio manager to perform better than the market and the investment doesn’t have a positive relative return, it may be worth finding a new manager or just buying an index fund.
But this is where it can get complicated. Who is to say what the “market” is? The S&P 500 index is often cited as the benchmark for the U.S. stock market but in actuality it represents mostly large capitalization stocks. The Russell 2000 serves as a benchmark for small-cap stocks in the United States, while the Lehman Aggregate Bond Index is comprised of fixed income securities to simulate the universe of bonds in the market. Relative return can also be used within a context smaller than the entire market. For example, a technology fund's performance could be measured or benchmarked against other technology funds. What about foreign stock markets? Have you heard of the FTSE, DAX, Nikkei, or All Ordinaries? These benchmarks represent stock indices for London, German, Japanese and Australian equities, respectively.
It’s wise to look at relative return to see how an investment's return compares to other similar investments. The trick is finding a comparable benchmark in which to measure your investment's return; then make a decision of whether your investment is doing well or poorly. That said, in the final analysis, the power of compounding is best accomplished with consistent positive returns year-in/year-out regardless of market conditions. Investors re-learned this fact after the 2000-2002 bear market, and this is why so many institutional investors have substantially increased their allocations to absolute return programs.
Realizing that traditional methodologies may not be sufficient in helping achieve investment goals leads to the problem of finding absolute return strategies. In order to accomplish this sophisticated investors have increasingly embraced a new paradigm that rejects total return as the measure of a strategy's worth. The concept is that any strategy's total return can be divided into a market return (beta) and 'ideally' a net excess return (alpha). What is of real value is an investment strategy's ability to consistently generate alpha.
The bottom line is it is not easy to find strategies that consistently generate risk-adjusted excess returns. For example, investors must be able to distingish market returns (beta) from excess returns resulting from skill-based actions ("true" alpha) and excess returns resulting from non-skill-based actions (e.g., consistently holding large cash positions, taking increased benchmark risk, or using leverage). Even when one is knowledgable about these performance evaluation concepts, the investor must have access to alternative investment managers (many have high minimums and require "accredited investor" status), be comfortable with the structure, and after making an investment, monitor existing managers to ensure their approach continues to provide desired alpha.
The greatest barrier to acceptance for this investment approach is often psychosocial: the unwillingness to try something new based on frequently cited "conventional wisdom" that is marketed by an industry riddled with conflicts of interest, not to mention regulators and regulations that end up institutionalizing "good" from "bad" investment approaches. The herd mentality always tends to rule. Luckily, innovative investment strategies, such as those offered by the regulated approach called managed futures or unregulated vehicles known as hedge funds, are increasingly becoming accepted as a desirable means for diversification. (In the opinion of this author, hedge funds should be regulated but not the investment strategies they promote.)
The move to the new paradigm of alternative investments, absolute returns, separation and recombination of beta and alpha requires that investors think differently about the investment process and their investment portfolio. No one is claiming that investors should rush to embrace this new paradigm. Instead, they should carefully evaluate this shift to determine its benefits and risks. This understanding will alow investors to develop a prudent plan so they can properly respond to new opportunities.
In conclusion, the separation and recombination of beta and alpha is only one of the fundamental principles of the new investment paradigm. The other, the acceptance of alpha-based strategies as a part of an investor's asset allocation policy is equally important. The search for alpha is difficult, especially when the source of alpha is the asset class itself, such as with managed futures. The key objective for investors is to distinguish manager skill from market returns and factor in investment management costs; that is, pay minimal fees for beta, and only pay for uncorrelated alpha.
The Diversified Option Strategy of Cervino Capital Management is an example of an absolute return program where returns are derived primarily from skill-based trading decisions. While past performance is not necessarily indicative of future results, the program has been able to sustain consistent positive monthly performance since inception as well as very low correlation when compared to the S&P 500 index. Positions are diversified across various financial and commodity markets, and entail complex option strategies that have varying degrees of market direction exposure: long, short or neutral. A key part of this strategy is recognizing that options are a wasting asset. Accordingly, the trading model is similar to the insurance business model whereby premiums are collected and risk management is the primary focus. For more information, visit www.cervinocapital.com.
- Mack Frankfurter, Managing Director
posted by Cervino Capital Management LLC at 8/01/2006
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