Absolute Return: A Modern Approach to Diversification

Absolute Return A Modern Approach to DiversificationWith interest rates still hovering near zero and the stock market remaining at record highs, the prospect for broad-market returns averaging the customary 8-10% into the future are dim, at least over the next decade. Investors, especially retirees, will need to pursue alternative strategies if they want to meet their retirement goals.

Absolute return is one such alternative strategy. And in a recent white paper, Putnam Investments argues that absolute return strategies offer modern diversification.

Absolute Return Defined

Absolute return strategies pursue returns independent of traditional benchmark indexes like the S&P 500 and the Barclays U.S. Aggregate Bond Index. They can “go anywhere,” investing in stocks, bonds, and alternative assets, and are thus considered flexible and “unconstrained.”

Absolute return funds focus on providing positive returns over targeted time frames, with less volatility than traditional stock or bond mutual funds. They also have the flexibility to pursue global investment opportunities, and to use “modern tools” in pursuit of positive returns in flat or declining markets.

Traditional Fund Shortcomings

According to the Investment Company Institute 2013 Fact Book, 92% of mutual fund assets are held by funds focused on a specific asset class – generally stocks or bonds or money-market securities. This doesn’t allow for true diversification within a single fund.

Traditional stock funds and bond funds follow and are measured against market benchmarks, such as the S&P 500 or the Barclays U.S. Aggregate. Since the performance of most stocks and bonds have fairly high correlation to their benchmarks, stock funds and bond funds inevitably have high levels of market risk; and since volatility is tied to market risk, traditional funds can’t escape it.

Over time, this volatility can take a bite out of returns, and bear markets can be especially devastating. Retired investors are particularly vulnerable: If a retiree’s portfolio suffered a 30% loss, then it would take him 3.5 years to recover the losses, assuming a 10% rate of return. But if market returns are much lower in the future, as many analysts project, then recovery from losses of more than 30% could be unachievable. With a 2% rate of return, it would take a retiree nearly 35 years to recover from a 50% loss, and most retirees don’t have 35 years.

Modern Strategy

This is why Putnam Investments argues that absolute return is a “modern strategy” that may provide benefit to “all kinds of investors.” Fund managers need the flexibility to go wherever the potential returns are, which includes asset classes other than stocks and bonds, and companies of national origin other than the United States.

Putnam’s own approach to absolute return involves prudent hedging to reduce market risk, and investments across asset classes, including REITs, commodities, and foreign currencies, in addition to U.S. and international stocks and bonds. Putnam’s funds also employ futures, forwards, and options for downside protection and the possibility of gains during bear markets.

Putnam’s Funds

Putnam’s absolute return strategies were previously available only to institutional investors, but now they’re available to retail investors as liquid alts. Each of the funds pursues positive returns above the returns of Treasury bills, with lower volatility than the broad markets.

All four funds also strive to produce lower volatility over time. As of March 31, PARTX had generated three-year returns of 1.23%, while PTRNX, PJMDX, and PDMAX had produced respective returns of 2.62%, 3.91%, and 6.72%.

For more information, download a pdf copy of the whitepaper.

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