The Inflation Plus / Absolute Return Approach
This approach to investing has become popular since the mid-’90s, and its product category has grown in terms of asset size as well as the number of products available. The rationale for this approach is easy to understand, in that the Absolute Return approach to managing money differs from the more traditional approach in three ways:
- It aims to produce a return that will beat the inflation rate (CPI) by a certain percentage every year,
- It aims to do so in a more consistent or less volatile manner over clearly specified measurement periods,
- It also aims to have no negative returns over rolling periods like 12 or 24 months.
The challenge to this approach lies not only in the level of return above the inflation rate a fund aims to achieve from year to year but over what time frame this objective is measured for both return and volatility purposes. The higher the return, the more a portfolio is reliant upon more risky and volatile assets.
This intersection between taking just enough risk to meet the return objective but without introducing excessive volatility is, of course, the holy grail of investing.
To achieve more certain outcomes with less volatility, a manager philosophically needs to decide on a few fundamental factors when designing a return profile:
- Will the portfolio rely on a broadly diversified asset base with smaller allocations to each of the asset classes OR will the manager rely extensively on a more concentrated allocation to seemingly consistent return asset classes like high yielding fixed-income assets?
- Will the manager make tactical allocations around a strategic asset allocation framework using cheaper passive indices to produce returns or reduce risk, OR will they rely more on the active, high conviction, alpha-seeking skills within the asset classes to produce that alpha?
- What specific range of and size allocation to instruments do they use to provide the promised return outcome more optimally over time; do they rely extensively on high yielding credit instruments as the default option, do they make extensive use of derivatives, do they use something like gold, or a combination of these?
Guidance: Fundamentals of Investing
- Diversification By investing across various asset classes and geographies, the correlation between the various asset classes and currencies is reduced and thus the outcome over time is more volatile with more sources of return.
- Active (alpha) versus Passive (beta) skill conundrum Active managers believe they possess more skill than the average market participant and therefore place less emphasis on the true value of diversification by taking more concentrated positions in fewer assets. Commonly referred to as an unconstrained approach or benchmark agnostic; this factor is important to consider in any balanced fund type solution and is demonstrated by looking at the empirical evidence found in the market indices and competitor surveys.
- The Return Dispersion number This number has extremely important implications when constructing strategic asset allocation frameworks, as the long-term return assumptions are based on actual market index returns. If the underlying manager under-performs the Index by as much as the Index return itself and the Index constitutes a large allocation of the portfolio, this meaningfully detracts from meeting the objectives and leads to sub-optimal returns over time unless the manager can compensate through very good tactical asset allocation.
- Minimising costs All empirical analysis is conducted using market indices that do not account for any costs. Academic portfolio theory assumes minimal to no costs in the models, however in analysing the full range of expenses incurred in managing regulated products, it quickly becomes clear that costs can reduce the outcomes materially over time. A careful assessment of the entire value chain is critical in order to optimize this drag on performance, and ongoing enhancements and reductions are a key part of the Alusi solutions.
Empirically Sound Strategic Asset Allocation Frameworks
Any sound portfolio construct needs to be very clear as to what the sustainable value add is at the critical decision-making steps.
For an absolute return mandate, we would argue three key areas are:
- Optimizing the initial asset allocation framework as the core building block. Various studies have shown that this decision determines up to 90% of the eventual outcome.
- Define clear and sensible deviation limits when doing tactical allocations around the core asset allocation framework. Reducing the fatal human flaw as demonstrated in numerous behavioural finance studies.
- Use a low-cost, passive building block approach, as there is insufficient evidence and hence low confidence in further risk being introduced to add alpha by allowing active stock-picking at this level.
- The one exception is that of flexible fixed-income assets, where the ability to add value relative to cash without introducing excessive capital risk or volatility is empirically compelling.
The actual application of these beliefs is what all the Alusi solutions are built upon, and the Alusi Regulation 28 and Alusi Regulation 30 Compliant Funds are testimony to this philosophy.