Most institutional investors are searching for strategies to improve risk-adjusted returns (Sharpe ratio) without sacrificing return. Two approaches dominate: pursuing a portfolio’s desired rate of return with less volatility or seeking to increase returns without a significant boost in volatility. Investors have in recent years made progress towards these goals by refining the optimal asset allocation mix.
We believe a more powerful tool for further improvement comes from adding a new layer of diversification with absolute return strategies. In our investment research and practice, we find that absolute return strategies, which we define as unconstrained, benchmark-agnostic strategies that focus on more efficient returns with less systematic risk (beta), can help improve the overall efficiency of an investment plan.
Recent studies, by contrast, demonstrate a reliance on traditional asset classes. A Towers Watson study, analysing the 2012 asset allocations of 556 Fortune 1000 US pension plans, revealed a focus on traditional asset classes. Though there is a small allocation to alternative asset classes, such as REITs, private equity and hedge funds, the vast majority of the allocation consists of stocks and bonds.
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