Absolute Returns

Abstract

The author focuses on absolute return strategies as the third paradigm of active asset management. He argues that the asset management industry is about to move from its second stage into its third. The first stage was a holistic approach as individuals and institutions sought to generate returns by balancing stocks, bonds, and cash in a single portfolio. This paradigm suffered two great weaknesses: mediocre returns due to the lack of specialization and lack of manager accountability. These weaknesses were the seeds that enabled a whole new investment management industry to grow, and a shift to the second paradigm: the relative performance game, the second paradigm, which fits nicely with modern portfolio theory (MPT) and seminal academic work on performance evaluation. Fostering as this does mediocrity as opposed to meritocracy, the second paradigm led to poor performance, a strong disincentive to use risk management techniques to preserve investors' wealth, and a focus on asset growth rather than performance. The absolute return approach, on the other hand, seeks to solve some of the issues of the relative return approach. The author then proceeds to analyze the critical feature of absolute return strategies and concludes that there is still a lot of mythology with respect to hedge funds, much of it built on anecdotal evidence, oversimplification, myopia, or simply a misrepresentation of facts.