As discussed in “Why an Absolute Return Strategy,” most investors, knowingly or not, rely on long-only passive strategies. These investors may shift between stocks, bonds, and cash at various intervals, but generally, their portfolio returns mimic those of well-known stock and bond indices. Alternatively, active or absolute return investors rely on many different strategies not dependent upon a positive market direction to generate positive returns. To continually build wealth through good and bad markets, absolute return investors require a diverse, alternative set of strategic tools. This article describes several strategies absolute return investors use to help them achieve their goals.
Global macro
By far the most complex and difficult of strategies, managers use a fundamental assessment of global economic dynamics to establish long or short positions in every asset class.
Deep Value
This strategy seeks to invest only in heavily discounted opportunities and/or significantly out of favor, thus appearing to have minimal downside risk. This strategy tends to have longer holding periods than most.
Option Strategy
Managers employing this strategy predominately engage in the exchange-traded options market (put/calls) and/or over-the-counter options (swaptions). Sometimes, options are combined with long or short positions in the underlying securities to create the desired profile.
Event-Driven
This is a strategy where managers attempt to identify specific catalysts related to a company, a sector, or an economy and position for the ultimate realization of that event.
Arbitrage
In this approach, managers look for pricing anomalies among related instruments and seek to extract risk-free profits by simultaneously being long or short.
Volatility
This strategy uses long or short positions and options to produce opportunities through low (and rising) or high (and falling) price swings in those instruments.
Long/Short
Predominantly used by managers in the equity markets to pair a long position in one stock against a short position in another with the intent of limiting market risk while taking advantage of perceived richness and cheapness in selected securities.
Trend Following
This strategy is generally a technical approach that relies upon the momentum of price action in a security or an index to generate profits. Managers use long or short positions as a trend establishes itself, then take profits and reverse positions as the trend weakens or reverses.
Fund of Funds
Firms with expertise in identifying talented investment managers look to diversify investment dollars among many managers and strategies, including those listed above.
The strategies listed above represent a subset of strategies commonly used by those seeking returns that are not highly correlated with market returns. Like any strategy, those summarized above tend to go through periods where they are effective or ineffective; therefore, selecting strategies based on the current or anticipated market environment is essential.
It is important to stress that the strategies detailed above are typically beyond the scope of amateurs. We highly recommend speaking with a knowledgeable investment manager and conducting extensive due diligence before investing in such strategies.