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Absolute return: buyer beware

For the modern family office, the need to preserve past generations' achievements for future generations' benefit makes the need for capital preservation strategies immediate. Encouraged by their experiences with foundations and endowments, trustees have broadened the family office investment universe to include absolute return strategies.

Encompassing a wide range of strategies, absolute return has come to refer to investment approaches designed to deliver positive performance in all market environments, maintain low correlation to other asset classes and have lower downside risk than their relative return cousins.

However, investors have been lulled into a false sense of security about the risks inherent in absolute return strategies. Detailed manager research is needed to identify manager talent, the use or abuse of leverage and, finally, manager credibility. Hedge fund and private equity managers' sales promises of absolute return sounded convincingly reassuring to family offices whose strategic asset allocation plans began to more and more resemble those of foundations and endowments. What has happened to those promises?

Do absolute returns exist?
The simultaneous bursting of multiple asset bubbles proved that absolute return strategies absolutely could lose money. In fact, the term "absolute return" clouds the fact that there are a large number of strategies that target positive returns regardless of market movements. Detailed manager analysis is required to distinguish manager skill from hidden betas, leverage bets and fraud – all sources of poor performance in 2008.

Any portfolio return consists of a market component (beta) and non-market component (alpha). Beta returns are relatively inexpensive because they provide an expected risk premium (that of the benchmark) without requiring skill and are easy to achieve via index trackers. Positive expected alpha, or excess return, requires manager skill and comes at a higher price.

Differentiating between the two sources of return is critical, particularly in alternative asset classes, which remain opaque in comparison to traditional funds. It is the responsibility of the trustees of investment boards to determine what sources of beta should be included in the portfolio.

Absolute return strategies claim to have low market risk - ie,  their returns (negative or positive) are not driven by market performance but by the skill of their managers. However, the bad performance of private equity and hedge funds in 2008 demonstrates that manager skill is elusive and the tide of the market is difficult to resist.

Leverage return, leverage risk
Several factors have contributed to this underperformance. The deleveraging of global financial markets has hurt all but a few investors. Private equity funds, for instance, are threatened by the defaulting or bankruptcy of firms they bought. Hedge funds faced with unprecedented redemptions have been forced to unwind highly levered and complex strategies at fire sale prices.

The abuse of leverage is indicative not of a manager's conviction in their investment bets but the need to generate higher returns in a low return environment. The prevailing fee structure of 2% management fee and 20% of profits was sustainable when higher interest rates prevailed, but created the unintended consequence of gross leveraging to maintain high returns as they fell (see page 19).

Poor communication on the heightened risk investors were being exposed to is another failure of the absolute return model. Leverage was also abused to compensate for a low interest rate environment, rather than managing client expectations.
Risk and fraudulent returns
However, the absence of high fees is not an indication of best practices either. Many manager selectors, particularly those of feeder funds, were seduced by the unconventional fee structure of Bernard Madoff's funds. Madoff did not charge any management fees at all, claiming to be happy to collect only transaction commissions. This apparent free lunch blinded fund advisors to the conflict between Madoff's two roles of fund manager and broker dealer. This was made clear when it was revealed that no trades had actually taken place.

Investors were long impressed by the enviably stable and positive returns Madoff's funds produced. Even in difficult markets, Madoff's funds reliably produced single-digit positive returns. According to Madoff, this was possible because of an esoteric strategy he coined the "split-strike conversion". However, he refused to divulge details of the strategy and its performance was never successfully recreated by any other investors.

Madoff failed to observe basic conventions of investment management. The lack of a clear separation of key functions, such as portfolio management, trading and custody, created the opportunity for abuse. This inadequate governance structure allowed Madoff to act as his own broker-dealer and custodian that in turn enabled his fraud, in which little to no trading actually took place. He also used obscure audit and accounting firms rather than one of the "big four". With no third-party looking over his shoulder, Madoff was able to simulate investments and returns for years.

The Madoff scandal has highlighted the overly close relationship between some investment managers and consultants. In the case of a number of American pension funds, they have discovered that their consultants have been on the payroll of investment funds seeking mandates, which sets up a clear conflict of interest.

Madoff's unconventional firm management, vague investment process and secrecy should have been picked up during thorough due diligence investigations of his funds and firm and alerted potential investors to danger. It is clear that very basic due diligence reviews were not carried out by numerous investors. Bottom-up due diligence that focused on understanding the manager's investment and valuation processes and risk monitoring, was clearly lacking when it came to Madoff's firm.

Instead, investors were persuaded by personal recommendations, the appeal of exclusivity and performance. Some basic questions would have thrown up a flurry of red flags to a thorough manager selector. Standard, yet key questions may include how independent a fund's custodian and auditor are from the asset manager, or who the fund's service providers are and what agreements are in place?

Avoiding the pitfalls
Investors have been lulled into two traps. First is the belief that absolute returns exist; all investment strategies that seek to deliver returns above the risk free rate take on risk, whether this be beta or alpha risk. The second trap is that when an investment opportunity looks too good to be true, it likely is. It is the investor's duty to understand those risks, the beta drivers and active risks undertaken.

Investment fraud, fallout from over-leveraging and an inability to distinguish between manager alpha and market beta teaches us that for some manager selectors, due diligence and fund analysis are simply marketing-speak masking an inadequate investment process. The tools and methods of due diligence are not new but require systematic and impartial application.

Ultimately, it is the responsibility of the investor to verify that his consultant or advisor has done the necessary homework, even if it is simply to see the results of due diligence.

The heavy losses at major financial institutions with reputations for prudent and conservative investing demonstrate that they have taken huge risks with client money through inadequate vetting. The redemption of $500 billion by high net worth individuals from hedge funds in 2008 bears out the assertion that investors were unclear on the risks they were facing and the very real potential for loss (Brewster, 2009).
While having strategies targeting capital preservation and absolute positive returns is certainly desirable, the term "absolute return" should be put to rest as it confers a false sense of security to the investor. Rather, more focus should be placed on those return drivers the investor feels offer the best value.
Difficult choices
Family officers and trustees must now make some difficult investment choices in order to preserve and grow their clients' wealth.

Successful fund investing requires that manager selectors have a clear understanding and commitment to their fiduciary duty, putting the interests of the client first. This in turn demands a transparent selection process whose logic and methods can be easily understood by outsiders.

Manager selectors have a multitude of tools at hand; good manager selectors know how and when to use them and succeed at distinguishing between manager skill and the market, identifying the over use of leverage and uncovering implausible returns.

Understanding the client's needs, manager screening, returns analysis, holdings analysis and manager due diligence are the fundamentals that lie at the heart of investment success.

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