Back to the future: the return of total return investing

During the speculative bubble of 1999, investors began to believe that diversification was merely a way of reducing returns. The bear market of 2000 has brought a welcome return to reality. As a result, investors are looking for additional ways to increase diversification while maintaining market exposure. Total return investing (often referred to as hedge funds) has become one such alternative though they are difficult to analyze in traditional ways. While often viewed as presenting new problems to fund sponsors and consultants, total return investing is really a return to the period before Modern Portfolio Theory (MPT), and Markowitz mean/variance efficiency became the standard.

Defining hedge funds is problematic by itself. Essentially there are no rules in total return investing. Strategies that are considered imprudent by institutional investors are considered standard and essential in hedge funds. These include using leverage and shorting securities. But the strategies are attractive. They offer high returns, low volatility and excellent diversification with traditional investment styles.

However, there are many methodological and cultural problems for institutional investors. Methodological problems are concerned with investment methods that, in isolation are considered imprudent, though used together actually reduce risk. Because of their nature, using mean/variance analysis to position such strategies in a fund may not apply.

There are no benchmarks for the strategies since they are based upon achieving high total returns. Cultural problems come from the fact that the hedge fund industry is largely unregulated and used to dealing with wealthy individuals who are responsible only for themselves, not for other people's money. There is little client service. Hedge fund managers are notoriously secretive about their investment process--making it difficult to perform due diligence analysis.

For these reasons (especially the problem of benchmarking), conducting a strategic asset allocation using hedge funds is problematic. Many have advocated avoiding total return investing for this reason.

ASSET ALLOCATION
It is important to remember that there was a time before MPT, when all investing was considered total return investing. MPT and the Capital Asset Pricing Model (CAPM) brought us the concept of benchmarking, which simplified performance measurement as well as strategic asset allocation. Prior to CAPM, strategic allocation was largely done by intuition--looking at the individual managers in the fund. Benchmarking allowed us to simplify the asset allocation process. We could now use the benchmark for stocks and bonds, or other asset classes, and feed them into a mean/variance optimizer as proxies for the underlying managers.

Unfortunately, hedge funds do not lend themselves to this convenient shortcut.

Both institutions and hedge funds must adapt if institutional investors are to benefit from this attractive style of management.

For institutions and consultants, it means a return to full mean/covariance analysis of the fund using candidate hedge fund managers themselves rather than a market proxy. This means additional work, but no one said that long-term investing was easy. Funds will have to screen managers and then perform a full analysis to decide how much will be appropriate for investment.

Hedge fund managers will have to supply more transparency and client service. A statement of investment policy stating the amount of leverage which can be used, general guidelines used for shorting stocks and overall portfolio characteristics must be supplied to clients in order for them to perform their fiduciary responsibilities. Finally, long-run risk/return targets should be given as total return goals.

With these adjustments, a new diversifying style, which offers high returns, would become available to institutional investors.