“Absolute return strategies, by definition, pursue returns independent of a traditional benchmark index like the S&P 500 Index or the Barclays Capital Aggregate Bond Index. Absolute return is unconstrained and can ‘go anywhere’ as well as use modern tools, such as hedging strategies, in seeking to reduce risk for investors.”
—Investment management marketing brochure
Absolute return versus traditional investing translates into the flexibility to use a wide range of tactics across multiple asset classes versus limits on asset classes and performance measured against benchmarks. Proponents of absolute-return investing argue that with this flexibility they almost always achieve positive returns, usually with less volatility, than traditional investment managers. Such flexibility offers more opportunity than what traditional investment managers enjoy. Traditional investments usually come with benchmarks. The majority of ETFs track published indexes. While a substantial majority of mutual funds are not index trackers, over 90 percent have benchmarks and are restricted to a few asset classes. Among institutionally managed funds the pattern is similar—investment managers are restricted to a few asset classes and may be compensated by their performance against a benchmark. The best practice is for the plan sponsor to determine the benchmark and the asset class.
In the last few decades, absolute-return investing emerged to challenge traditional investment management. The issues posed by absolute-return investing are which asset classes are reasonable and whether going short is different from going long and if derivatives are foolish or evil (they’re neither). However, it is the agency relation between the investor/asset owner and the investment manager that really matters. An investor hires a manager and gives her discretion over how the funds are invested. This means that there is potential conflict in the agency relationship: Will the funds be lost? Will the risks be exorbitant? Will the investments be so timid that gains are missed? No matter what the investment, results won’t match expectations.
Agency relationships are everywhere. Early work goes back to the 1930s, with Berle and Means1 discussing managers in large corporations. As business moved from partnerships and proprietorships to stockholder-owned corporations where managers had little ownership and little of their own wealth in the business, were the stockholders sure that the managers wouldn’t embellish themselves at the true owners’ expense? Who wouldn’t like a palatial office or the use of a private jet? Anyone who thinks this problem has been solved hasn’t read a newspaper or a blog recently. Though less dramatic and maybe with less wealth at issue, the same relationship—and question—exists inside any organization: When a manager delegates a task to a subordinate, what assurances does the manager have that it will be done as well as possible?
Investors try to monitor the efforts and performance of their investment managers. Benchmarks, investment policy statements and limits on asset classes are crucial for monitoring investor/manager relations. Yet these tools for monitoring and understanding actual returns are missing in absolute-return investing.
The Prudent Man
In investment practice, there are generally three monitoring approaches: 1) the “prudent man rule;” 2) benchmarking; and 3) transparency. The prudent man rule goes back to a court case (Harvard College v. Armory) in 1830 in Massachusetts where a trustee was sued for mismanagement of funds. The court noted that the trust agreement instructed the trustee to invest “in safe and productive stock, either in the public funds, bank shares, or other stock, according to their best judgment and discretion” and then found that while the investments had not been completely successful, that trustees should “observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income as well as the probable safety of the capital to be invested… Do what you will, the capital is at hazard.”2