Five reasons why absolute return investing is less volatile than index investing

ST Wong, 8 Sep 2016

Which is likely to be the least volatile approach to investing: buying an index, such as the ASX 300; or investing in an “absolute return” approach, which aims to deliver positive returns in all market conditions?

Many investors fall for the myth that index investing is safe and less volatile than active stock selection investing. However, indices are by nature inefficient and cannot be relied on to cushion market falls. There is no capital protection built into an index, meaning investors are at the full mercy of market sentiment.

Absolute return strategies can include mechanisms to protect capital, such as increasing their cash allocation in times of volatility or where there is a lack of investment opportunities. In this way, it’s possible for the ‘absolute return’ approach to exhibit less volatility than the index.

One feature making typical index benchmarks inefficient is that they tend to top heavy, which is they have to allocate more exposure to large companies simply on the basis of size. Also consider that when you are in an index you will hold stocks which may not be good investments on their own terms. You may also be over-represented in certain sectors – for example, in Australia you will have an over-representation of materials and financial stocks.

In contrast, absolute return strategies can have a low correlation to the market, which is an advantage during periods of volatility.

Here are five reasons why absolute return strategies may be a better choice to cope with volatility:

One: Lower drawdowns than the market: Absolute return funds can exhibit lower drawdowns than the benchmark – that is, when the market falls they tend not to fall as far as benchmarks. Using the Prime Value Opportunities Fund as an example – the fund experienced a maximum fall (drawdown) of 5% between May 2013 and June 2016. In the same period, the ASX 300 index experienced a much larger 13.5% maximum drawdown.

Two: Benchmarks are inefficient: Investing in a benchmark tilts your exposure toward size ahead of quality. Benchmarks lock you into the bigger stocks regardless of their investment prospects. The top 20 stocks account for roughly 54% per cent of the ASX 300, which means you own the stocks in the top 20 regardless of their investment prospects.

The inefficient nature of benchmarks creates opportunities for investors through stock selection and portfolio construction (more on those below). For example, the Prime Value Opportunities Fund is free to uncover investment opportunities across the ASX, and has outperformed the market since inception, delivering at the end of August a 15.6% annualised return since November 2012. In the FY to 31 July 2016 the Fund returned 18.2% to investors, compared with 2.9% from the ASX 300 index.

Three: Capital Protection: Absolute return strategies use various methods to protect capital, so that market pullbacks don’t have the same negative effect an index will. For example, the option to convert 100% to cash as a safety valve during tough markets. Few funds had this option during the GFC, and many funds are still unable to take this action and will need to be fully invested even as markets are falling.

Four: Managing risk through portfolio construction: Portfolio construction is key for both generating returns and managing risk. Portfolio construction accounts for half the process (the other half being stock selection). It’s about using proven methods to ensure you are spreading the risk and invested in the right opportunities. The Prime Value Opportunities Fund is constructed around five different criteria, such as: core companies, which are stable companies with strong balance sheets; growth companies, which are generally smaller companies with good growth prospects; companies due for a ‘turnaround’, which are undervalued by the market; and certain thematics – companies that are exposed to structural or cyclical themes, such as an ageing population.

Five: Stock selection: Stock selection is the other half of the process. Absolute return managers use skill and judgement to locate quality, and will have a strong list of criteria which needs to be met before buying. Any stock investment must be compelling and be able to justify its place in a portfolio, or you risk clogging it with poor performers.

The ability to find opportunities across the market has given active managers an edge. It has been a stock picker’s market over the last couple of years, as most of the best ideas on the Australian market have come outside the top 20 stocks. This trend looks set to continue.