Benchmark-Relative and Absolute-Return Are the Same Thing: Conditions Apply

Abstract

Recent market turmoil and the prospect of higher interest rates will have reminded many investors of the benefits of an absolute-return investment strategy, which aims to avoid losses when markets turn down. Some, however, are constrained by investment guidelines that force them to use a market benchmark. This chapter sets out a framework for relating absolute-return and benchmark-relative portfolio construction and demonstrates that, under certain conditions, these two very different strategies can actually result in identical portfolios. This is of particular use for public institutional investors who must stick to a benchmark-relative approach for governance reasons, but would like to have the capital protection in bear markets that an absolute-return strategy seeks to provide.

Appendix: Simulation Details

Imagine a simple 60/40 stocks bonds portfolio where the stock component of the benchmark has a beta of one, meaning the benchmark has a beta of 0.6 (60% × 1) and the bond component is a simple 0–10-year universe of government bonds with a duration of 5, giving a benchmark duration of 2.0 (5.0 × 40%). We could simply describe this as a two-factor portfolio, and the decision for the portfolio manager is what the appropriate beta and duration are for the investment. There is a risk for each asset class (assumed to be 21% for the equity component and 3% for the bond component), and an expected return component. For equities, we have assumed an expected excess return over the risk-free rate of 7% and for bonds, 3%. Furthermore, we assume a correlation of 25% between stock and bond returns. It is important to note that the comparative results of this simulation are not sensitive to the actual expected returns, risks, or correlations (so long as they are not extremes, such as perfect positive or negative correlation, etc.). In an active process, the expected returns would change as the portfolio manager’s views change, as well as possibly the expected correlation and volatilities. This information represents the minimum necessary to construct the best possible portfolio given a set of market views.

Under the absolute-return scenario, the possible portfolios are created using the highest expected return subject to a target or maximum portfolio volatility. The frontier of available portfolios then is the set of best possible portfolios assuming different levels of target risk. The simple benchmark-relative positions are the sensitivities that give the highest possible expected excess return over the benchmark (alpha), subject to a tracking error limit. It is important to point out here that these portfolios are based on the same market views. It is not feasible to have equities deliver 7% over cash for an absolute-return manager, and some other amount for a benchmark-relative manager. The market only has one outcome, although it can be measured against differing reference points. The constrained benchmark-relative simulations are based on the same framework and set of views as the unconstrained simulation but with the addition of beta = 1 in the first case and portfolio volatility ≤ benchmark volatility in the second case.

The simulation was repeated for five risk factors to ensure that the results were not unique to a two-asset portfolio, which produced similar results and identical conclusions.