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Designing a successful absolute return solution in eight steps

Designing a successfully absolute return investment solution is not as easy as it may seem. Very often the investor’s needs are not adequately understood, and the proposed solutions fail to meet the promises made. Following the proposed eight steps, will significantly increase the chances that a future absolute return solution will regain the investor’s trust.

Absolute return investment solutions, also known under the names of total return or target return solutions, have seen bad lights over the recent years. In many cases this is due to failing to meet the promises made, partially because of poor expectation management or otherwise said, poor understanding of the investor’s needs. But it was also often a consequence of the unavailability of adequate skills to meet the promises made.

By following these eight steps, investment managers will significantly increase the probability that their future absolute return solutions will regain the investor’s trust.

STEP 1 – UNDERSTAND THE INVESTOR’S NEEDS

The first step in designing an absolute return solution is to understand the investor’s needs. What does the investor want to achieve? It is important to distinguish between wants and needs. Investors may want to achieve 4% return per year, but their need is to match the interest payments on their mortgage.

Determining the investors’ needs also requires understanding their balance between return expectations and risks.

  • Some investors want to achieve a decent return under the conditions that no money is lost
  • Others tend to focus on return maximization, accepting from time to time small losses
  • Again, other investors aim at maximizing the probability of satisfying their needs, without aiming at exceeding them

STEP 2 – DETERMINE THE INVESTOR’S RISK PROFILE

Especially with respect to absolute return solutions, investors exhibit different risk profiles. For some, absolute return means, no loss whatsoever. Others want to avoid frequent losses or large losses. And even others define risk as strong correlation with equity markets or interest rates.

Risk profiling should capture the three dimensions:

  • Risk capacity, that is, the objective amount of risk the investor can accept,
  • risk tolerance, that is, the subjective perception of risk that allows the investor to still “sleep well”, and
  • risk requirements, that is, the minimal level of risk needed to be taken to satisfy the investor’s needs.

STEP 3 – IDENTIFY THE INVESTOR’S INVESTMENT HORIZON

Although very often not explicitly formulated, most investor needs have an associated time horizon. This may be financing college for their children, buying that eagerly anticipated Ferrari at retirement, or just being able to afford that Christmas present. Therefore, objectively, absolute return solutions only need to satisfy the investors needs at maturity.

But more often than not, the investment horizon includes and emotional component. For example, the investors assess their wealth at the end of each month, quarter, year, and want their expectations met at that time. Others again expect from an absolute return solution positive return at any given moment in time.

STEP 4 –ASSESS THE FEASIBILITY OF THE INVESTOR’S EXPECTATIONS

Very often investors want to have the egg and the chicken, which is not possible. Before stating the design of the absolute return solution, the feasibility of satisfying the investor’s needs must be reviewed. This means answering the question: Is it possible to achieve the targets derived from the investor’s needs, risk profile, and investor horizon?

STEP 5 – IDENTIFY THE AVAILABLE SKILL SETS

After having assessed the feasibility the investment managers should identify the skill set available. What are they good at? Do they have financial engineering skills? Is their expertise in econometric modeling? Or are they gifted in analyzing complex causal relationships in real-time? Only real skills will allow to turn somebody could achieve the targets into you could achieve the targets.

STEP 6 – DEFINE THE INVESTMENT APPROACH

There exist three types of approaches to produce absolute return solutions. They distinguish themselves in the needs satisfied and, more importantly, in the skill set required to producing them. Investment managers should choose the one that best matches their skill set without losing sight of the investor’s needs.

ALGORITHMIC APPROACH

In an algorithmic approach, a one-time defined algorithm describes how the investment portfolio is to be managed over time. For example, the CPPI (Constant Proportion Portfolio Insurance) algorithm, guaranteeing no loss at maturity, falls into this category. Algorithmic approaches allow designing solutions that guarantee their result.

STATISTICAL APPROACH

Statistical approaches assume that given statistical properties hold. These properties are usually based on econometric or economic models. One such model could be that there exists an equilibrium price which any stock will achieve eventually. Under the assumption that the statistical property holds, absolute return targets can be achieved.

FORECASTING BASED APPROACH

In contrast with algorithmic and statistical frameworks are forecasting based approaches build on market expectations developed over the lifetime of the absolute return solution. These forecasts, which may be of quantitative or qualitative nature, are in real-time translated into investment portfolio positions. With a majority of correct forecasts absolute return targets can be achieved.

STEP 7 – Develop an investment process

Developing an investment process means defining how the absolute return solutions will be managed. A generic investment process is comprised of the following steps:

  • Collect and generate market data and, depending on the approach, formulate forecasts
  • Construct an investment portfolio based on step one
  • Structure the constructed investment portfolio so that it satisfies the investor’s risk profile
  • Derive transactions based on the structured portfolio in step three and execute them in the open market
  • Review and monitor the results achieved

STEP 8 – TEST THE DEVELOPED SOLUTION

Before launching the newly developed absolute return solution, the investment managers should thoroughly test it. If they based their solution on quantitative models, they should have the modes reviewed and validated by an independent expert. Testing should not only be done under normal market conditions but should also apply scenario and extreme event analysis. Are the results in-line with the investor’s risk profile?

The investment managers should review the results from the tests and adjust their investment process accordingly. Eventually improving upon existing skills is needed.

Once all eight steps have successfully been completed, investment managers can start digging in the dirt, that is, launch the new solution. And always remember, the result will be only as good as the combination of its design and their skill set.


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