Absolute Results.

Playing it safe for right now

For years everyone has been talking about the advantages gained from the Bull Market. Such confidence even led to a complacency to accept negative periods if overall returns brought in double-digit numbers.

But that time may be coming to an end. Nonprofits should focus more on minimizing those negative periods, according to experts at the We Love New York Day 2001 event held recently by the New York Society of Association Executives.

"The investment cycle may be changing, especially with last year's volatility," said Thomas W. Strauss, managing member of the Ramius Capital Group, LLC, in New York City. "The growth rate of our economy may not be sustainable, and past trends could be reverted."

Such caution puts pressure on asset management of endowments that could force a change in thinking. The new guideline might aim at trying to get the best percentage over a basic safe strategy.

Look at alternative investments, Strauss warned. "You can't spend relative returns," he said. "The past has been a period where underperformers didn't matter because an S&P up to 20 percent meant your underperformer could rake up a figure like 12 percent -- and that would be all right."

But last year, that approach didn't work so well. He pointed to a dichotomy in which returns are measured. Most securities and even fixed income returns are benchmarked to some market index. But financial institutions and insurances need absolute returns. "We're in the early stages of the S&P running into problems of continuing its level," he said. "So nonprofits do not want all assets linked to that performance driver."

Strauss pointed to an alternative class of investing, where 5,000 to 6,000 managers handle a market of $500 to $600 billion in areas such as private equity, venture capital, real estate, real assets, oil and gas. Within that market, approximately 2,000 managers handle a low volatility absolute returns sector in the neighborhood of $150 to $200 billion.

The absolute return method looks at the basic historical return over 75 years. Equities in the United States have hit 11.3 percent while United States Government Long Bonds brought in 5.2 percent. A risk-free aim would be to take all the nonprofit funds and invest them in Treasury Bills four times a year for 90-day periods to obtain around 5.5 percent.

The philosophy then tries to add as much as possible on top of that figure by managing the portfolio to reduce negative periods in the equities markets.

"We have to consider absolute returns as the absolute investment not tied to any market index or stock," he said. "We want to separate the returns from a high overall volatility."

The absolute return uses a series of lower volatility, arbitrage and hedge-oriented strategies to gain the extra percentage. Arbitrage and hedged positions are used to exploit mispricings and capture inefficiencies. In large sizes such as endowments, the figures add up.

"This is an alternative to the ways nonprofits manage funds today because it looks for predictability to increase the income," said Morgan B. Stark, a managing member of Ramius Capital Group, LLC.

All of the returns come from abilities of the manager, according to Stark. "Your rebound recovery is very quick -- you can achieve that premium or return in multiples of the risk-free rate," he said.

Stark contrasted the historical performance of five indices against the S&P 500 and the Lehman High Yield Credit Bond Index over the past 10 years -- convertible arbitrage, distressed securities, the equity market neutral index, the fixed income arbitrage and the merger arbitrage.

During that period, the S&P drew an annualized return of 16.67 percent while Lehman produced 9.48 percent.

However, the high standard deviation of more than 15 percent in S&P and more than 7 percent in Lehman failed against the alternative approaches. The five alternatives ranged from as low as 3 percent to only 6.5 percent.

The standard deviation helps organizations predict that a one month performance will fall within the percentage. The higher the standard, the less predictability.

Another category called the Sharp ratio measures volatility with a desired number above one, according to Stark. Historically the S&P listed at .78 while the Lehman ranked at .62. However, Stark's five alternatives ranged from .80 to a high of 1.90.

A decision to devote 20 percent of a given portfolio to each of the five strategies provided even better results. "By putting all of these strategies together, the number of positive months is greater than any one of the five components," he said. "The losing periods are only 1 out of 119."

Results can be obtained using this approach that show a specific fund that recorded only three down months since 1996. That fund brought in an average return of 10.8 percent with a standard deviation of only 2.01 percent and a high Sharp of 2.74.

"A market cycle includes a period of dislocation," he said. "We just don't know when it will occur -- but it will happen sometime."

An organization needs assets of at least $8 to 12 million in endowments to make use of these techniques, according to Stark.

More organizations should take note of the absolute concept to strengthen the financial basis. "This could be a watershed year," said Strauss. "We'll trade off any negative performance to insure we don't have losses."

Tom Pope is a New York City-based journalist who writes about management issues.