Morningstar Advisor - February/March 2013 - (Page 26)

In Practice Approaches to Absolute-Return Investing By Jeffrey Ptak Investors need to tackle these basic questions about how to build a portfolio that uses alternative funds. Absolute return is one of the hottest things going in the investment business these days. Morningstar estimates that U.S. investors have pumped a net $53.9 billion into alternative mutual funds since 2008. Not surprisingly, fund companies have responded by launching a slew of new funds, including nearly 60 in 2012 alone. This has been a double-edged sword for investors. On the plus side, investors never have had more funds to choose from, making it easier to construct an absolute-return strategy. Yet, the options can vary dramatically in quality—unproven funds abound, as often happens in areas experiencing rapid growth. And as the space has become more diverse, the definition of “absolute return” has gotten blurrier. This, in turn, has raised more basic questions about how to build a portfolio that uses alternative funds. (We’ve been managing an absolute return portfolio for clients since March 2005, so we know these challenges all too well.) While there’s no one-size-fits-all solution, we offer our perspective on the key decisions that an aspiring absolute-return investor is likely to face, as well as a brief explanation of how we’ve tried to tackle those issues. 1. Short or Long Term? If it’s called absolute return, time horizon 26 Morningstar Advisor February/March 2013 wouldn’t seem to matter much. Whether it’s one month, a few years, or even a decade, the return is supposed to be absolute, after all. But time horizon does indeed matter—the shorter it is, the more difficult it becomes to build an absolute-return portfolio that lives up to its name. Why? Unless you’re stuffing the portfolio with bonds or “tail protection” securities like put options and precious metals, it’s likely to suffer the occasional drawdown. Extend the time horizon and you buy yourself some wiggle room, allowing for stakes in nontraditional strategies that are less correlated to the stock and bond markets but court the risk of losing money over shorter periods of time in the process. Like all forms of investing, absolute return is about trade-offs, time horizon being crucial among them. Time horizon is important in another, morebasic respect—when it’s short, there’s greater pressure to maneuver the portfolio. In an ideal world, an absolute-return investor would zip around the market, nimbly sidestepping a loss or bagging a quick gain. In reality, that’s tough to pull off, with reams of evidence suggesting that traders do more harm than good. An absolute-return-minded investor with a short time horizon faces a stark choice—load up on drawdown-resistant securities like bonds (which court their own set of issues) or tactically jump in and out of riskier assets (a practice that’s highly error-prone). Potential Solution: Split the Difference In our practice, we’ve tried to split the difference—we invest in a relatively stable mix of capital-preservation-minded stock and bond funds, hedge-fund-like strategies, as well as diversifying agents like commodity futures and global REITs. Because the portfolio makes use of lower-beta alternative funds as well as fixed income, we think it’s suitable for investors with intermediate time horizons, but who can’t stomach the full arc of the market’s swings. However, the portfolio has meaningful exposure to traditional stocks and other market-sensitive securities, so it’s not invulnerable to losses, making it a poor choice for short-term investors. Finally, we don’t try to outsmart the market over shorter periods as part of a tactical overlay. 2. Real or Nominal? You also have to ask whether the absolutereturn strategy is seeking to generate positive nominal or real returns over the specified time horizon. The answer can dramatically alter the complexion of the portfolio, from one that skews to fixed income (which boasts predictability of nominal returns, but is susceptible to inflation) to another that makes liberal use of stocks, hard assets, and nontraditional strategies (which are more volatile, but likelier to generate positive real returns over longer periods).

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2013

Morningstar Advisor - February/March 2013
Letter From the Editor
Social Media, the Old- Fashioned Way
Do You Use Active Strategies?
Youth Appeal
How to Buy the Unloved 2013
Morningstar Managers of the Year
Investments á la Carte
Investment Briefs
Approaches to Absolute-Return Investing
In Agriculture, It’s Good to Be Strong
Yes, There Are Good Active Funds
The Decoupling
Where It Could Pay to Be Active
The Active Fund That Defies Obsolescence
The Epitome of an Active Manager
Lines of Communication
The Existence of Market Timing ‘Intelligence’
A Route to Commodities that Bypasses the Futures Market
Best Positioned for Health-Care Reform
Diversified Stock Funds That Earn Their Stars
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
A Twisted Debate

Morningstar Advisor - February/March 2013