The concept of relative returns may be useful for benchmarking traditional mutual funds, but may not be nearly as good for our money. Big, early losses destroy even the best plan for building wealth. Preventing disappointment in investing requires carefully evaluating return potential against the risk necessary to achieve it.
When traditional markets rally, alternative asset classes get punched. Is it justified?
Alternative Investments have somewhat of a black or white perception in the markets that seem somewhat correlated to economic cycles. Whenever traditional markets rally, the usual market pundits tend to enjoy pointing to the fact that stocks, bonds, gold, or crude oil, for example, are returning ‘more’ than the average Alternative Investment.
Let‘s set aside the argument whether some of those assets mentioned actually should be counted as alternatives: the tone of the discussion usually and suddenly changes as soon as markets reverse.
Confidence yields to the urge to explain why traditional stocks and bonds portfolios may have suffered a loss of 20 percent or more. Curiously (or brazenly?) enough, many wealth management professionals tirelessly point out that equities fund x in their portfolio outperformed equity index y by three percentage points. Which still leaves an investor with a 17 percent capital loss on the investment!
Non-professional investors tend to rationalize such losses by declaring themselves, long-term investors. This article aims to explain why this thinking is flawed, why absolute returns matter, and why the amount of risk taken per amount of expected return fundamentally changes the way investors ought to think about their wealth.
What is good for benchmarking may not necessarily be good for preserving and building wealth
Today, still most traditionally managed assets pursue so-called "relative return" strategies, which are measured against a benchmark index - e.g., the Swiss SMI or the US Dow Jones Index.
- Easily compare results between index and investment portfolio
- Large index risk (due to coupling)
Skill-based active management vs. active risk management
Measuring performance in relative terms is a relatively modern concept that became popular with the advent of mutual funds. The emerging mutual fund industry needed metrics to compare the various funds against each other and a benchmark.
In reality, this relative return concept clashes quite often with our lives, which seems to be mostly driven by absolute (return) needs. Ask anyone who has tried to accumulate wealth to fund a child’s education or the purchase of a property. Being short, say, 17% of such a funding goal can be painful, or even disastrous to our family harmony.
It also has consequences for the potential of (re-)building up wealth down the line.
Avoiding early losses is the key to compounding wealth
As Alternative Investments pundit Alexander Ineichen once explained, a 10-year investment of 100 that is flat in the first year and then compounds at what many would consider a boring 8% annually will end at 200. Contrast this to a 10-year investment of 100 that falls by 50% in the first year and then compounds at 8%. The second investment will end at 100.3.
Another way to look at it: if one loses 50% of the value of one’s holdings in a crash, it will take a performance gain of 100% only to recoup the losses! This brings us back to the concept of declaring oneself a ‘long-term’ investor. Some of us will simply run out of time in the process.
This understanding of compounding is why the best professional investors will do everything in their power to not only prevent losses but to be particularly careful not to suffer them early.
It’s time to return to the good old concept of absolute, risk-adjusted returns
The only thing Alternative investments benchmark against (if at all) is against the so-called risk-free rate, i.e., the return one would get from investing, for example into the London Interbank Rate (LIBOR).
Another metric used by many private equity investors is how many times the total of their contributions during the investment phase have multiplied after the proceeds have been distributed. You may already overheard the term “multiple” or TVPI (which is Private Equity speak for Total Value vs. Paid In) in locations where those types mingle.
Luck is a short-term proposition best left to gamblers
It may come as a surprise to some that a good hedge fund investor is not out for the quick win, and not nearly eager to take the risk often attributed to such investing. More often, the successful ones among them actually care about risk-adjusted absolute returns in the medium term. The focus being on ‚risk-adjusted‘ and ‚medium term‘. Why? Because the amount of risk taken per unit of return really matters. Anyone can occasionally have a lucky period putting their clients’ (and occasionally their own) fortune at risk. Having luck persistently (i.e. at least over the “medium-term”) is much less likely. Ask the majority of casino players.
Since the concept of weighing the risks for every activity where we expect some return is one we employ in any other domain of our lives, why not also in investing?
Stableton’s approach to Alternative Investments
Stableton believes that the proper implementation of an absolute return strategy does not only entail a significantly lower risk of a significant capital loss - as there is no rigid link to a benchmark - but usually also considerably more calculable investment results.
This article barely scratches the surface. If you are interested to learn more about Alternative Investments, and startup and venture investments in particular, and how to efficiently access them, please visit www.stableton.com.
About Stableton Financial AG
Stableton Financial AG is a Switzerland-based, rapidly growing financial technology company.
The company’s alternative investment Fintech platform is designed to be Europe’s leading gateway for qualified investors and financial advisors seeking simplified access to absolute return and alternative investment strategies such as hedge funds, startups, alternative lending, and real estate. Stableton was founded by entrepreneurs with decades of experience across the alternative investments value chain.