Perhaps you thought hedge funds were complex and difficult to grasp. But they are straightforward when compared with a plethora of new esoteric tools being developed by investment managers attempting to squeeze higher returns out of stocks, bonds and other instruments without necessarily adding risk.
Even the names reflect their complexity: Portable alpha, 120/20, global tactical asset allocation, credit default swaps, limited long/short, LIBOR-benchmarked products. The list goes on.
Right now, many of these aggressive strategies – which are proliferating rapidly – are being used only by large funds, or exist mainly on the drawing boards of researchers. But soon you are likely to hear more about them. Who knows, in years to come they might become household words.
The search for new strategies is being driven by a return to what appear to be “normal” market conditions. We became used to the period from 1982 to 1999 when stocks delivered nearly 14 percent real returns, measured by the Dow Jones Industrial Average, and bonds’ real returns were above 8 percent, as measured by long-term government bonds. We began to accept those returns as normal. They were not. A look back in time reveals that since the market crash of 1929, normal returns of stocks are closer to an inflation-adjusted 7 percent, with bonds returning about 2 to 3 percent, using the same measures.
The return to normal motivates managers to search more strongly for alternative ways to boost returns. After all, when stocks return 25 percent a year, as they did from Jan. 1, 1996 through Dec. 31, 1999, managers and researchers are unlikely to be motivated to seek out strategies designed to add 1 or 2 percentage points to the total return.
But when the U.S. stock market is returning an average 3.3 percent, as it has in the last five years (as of June 2 as measured by the Russell 3000 Index) – and is forecast to perform only marginally better over the next decade – managers are more likely to consider pursuing strategies aimed at adding an additional couple of percentage points to returns.
The return to normal not only sets managers in search of higher returns closer to those they came to know in the 1980s and 1990s, but it also puts pressure on those who determine the investment strategy for large funds. For example, many foundations require 9 percent return a year to meet minimum payout, cost and reserve requirements. These plans are turning to inventive researchers and investment managers to help them achieve above-normal targets.
In some cases, the new strategies might be incorporated into existing funds; in other cases they might be the stimulus for the creation of a new fund.
If these new strategies’ collective promise of greater returns shows traction, they are likely to prove increasingly popular as more and more are rolled out in the months and years ahead.
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Contributor Noel Lamb is Chief Investment Officer for North America for Tacoma-based Russell Investment Group. He is responsible for Russell’s funds and research in the United States and Canada. He joined Russell in 1997.
