As we discussed in “Why an Absolute Return Strategy”, most investors, knowingly or not, rely on long-only passive strategies. These investors may shift between stocks, bonds and cash at various intervals, but generally their portfolio returns mimic those of well-known stock and bond indices. Alternatively, active or absolute return investors rely on many different strategies that are not dependent upon a positive market direction to generate positive returns. To continually build wealth through good and bad markets, absolute return investors require a diverse, alternative set of strategic tools. This article describes a number of strategies used by absolute return investors to help them achieve their goals.
Global macro – By far the most complex and difficult of strategies, managers use a fundamental assessment of global economic dynamics to establish long or short positions in every asset class available to them.
Deep value – This strategy seeks to invest only in opportunities that are heavily discounted and/or extremely out of favor and thus appear to have very limited downside risk. This strategy tends to have longer holding periods than most.
Option strategy – Managers employing this strategy predominately engage in the exchange-traded options market (put/calls) and/or over-the-counter options (swaptions). At times, options are combined with long or short positions in the underlying securities to create the desired profile.
Event driven – This is a strategy where managers attempt to identify specific catalysts related to a company, a sector or an economy and position for the ultimate realization of that event.
Arbitrage – In this approach, managers look for pricing anomalies among related instruments and seek to extract risk-free profits by being long or short those instruments at the same time.
Volatility – This strategy uses long or short positions and options to produce opportunities through low (and rising) or high (and falling) price swings in those instruments.
Long/Short – Predominantly used by managers in the equity markets to pair a long position in one stock against a short position in another with the intent of limiting market risk while taking advantage of perceived richness and cheapness in selected securities.
Trend Following – This strategy is generally a technical approach which relies upon the momentum of price action in a security or an index to generate profits. Managers use long or short positions as a trend establishes itself, then take profits and reverse positions as the trend weakens or reverses.
Fund of Funds – Firms with expertise in identifying talented investment managers look to diversify investment dollars among many managers and strategies, including those listed above.
The strategies listed above represent a subset of strategies commonly used by those seeking returns that are not highly correlated with market returns. Like any strategy, those summarized above tend to go through periods where they are effective or ineffective, therefore selecting strategies based on the current or anticipated market environment is important.
It is important to stress that the strategies detailed above are typically beyond the scope of amateurs. We highly recommend speaking with a knowledgeable investment manager and conducting extensive due diligence before investing in such strategies.