In the past, investors used to prefer diverse portfolios consisting of bonds, cash, stock and other financial instruments, to single assets (Ineichen, 2002). They believed that diversification was the best way to maximise their returns and mitigate risk; however, such a holistic approach had two main drawbacks, namely modest returns and insufficient transparency (Ineichen, 2002). This resulted in the emergence of a relative performance-based approach whose main purpose was to help measure investment managers’ performance against one or more benchmark indices (Ineichen, 2002). Simply put, while absolute returns refer to the returns generated by a certain asset, investment portfolio or strategy without comparing their performance to any indices, relative returns make it possible for investors to determine whether fund managers / investment managers / brokers are actually protecting their interests by comparing their returns with those of the benchmark index. It follows that an investor who wishes to determine the amount of return achieved by a security or portfolio over a certain period of time should pay attention to the absolute return of that security or portfolio; on the other hand, an investor who wishes to determine whether a security or portfolio is performing well compared to the overall market should focus on the relative return of the security or portfolio. It is also worth mentioning that relative returns represent a highly reliable and widely appreciated indicator for assessing the performance of investment managers.
In a world where investors are primarily interested in outperforming the market, relative returns represent a highly reliable and useful measure that helps determine whether and by how much investment managers have beaten the performance standard/s for their assets or portfolios. Since investment managers manage their clients’ portfolios in exchange for a management fee, it is no surprise that investors expect investment managers to make effective decisions so as to ensure their returns exceed the benchmark index. Relative returns are calculated by deducting the return achieved by the benchmark from the absolute return (Chambers et al., 2015). For instance, if one holds a fund that has generated an absolute return of 20% over a certain period of time while the benchmark index only provided a return of 10%, they will have achieved a relative return of 10%.
With that being said, Pankin (2008) observed that even though most investors aim at achieving high relative returns, absolute returns are associated with less risk as well as less volatility when portfolios are managed properly. As undesirable as risk and volatility may be, investors’ desire to achieve outstanding returns prompts fund managers to design portfolios in such a way to ensure that they beat the benchmark, even if this entails more risk. After all, if fund managers advertised a portfolio that promises to generate an annual return of 10% when the related market has grown by 15% over the previous year, it is highly likely that investors will look for a mutual fund that offers higher returns – ideally above 15% annually (Pankin, 2008).
As explained by Ineichen (2002), what distinguishes absolute return managers from their relative return colleagues is their approach to risk management. Specifically, absolute return managers strive to protect their clients’ capital by using speculative financial instruments as a hedge to minimise their risk exposure. As a result of their reliance on speculative instruments, investors who hold hedge funds are often labelled as speculators; however, most critics fail to understand that speculative financial instruments are not always used for speculative purposes: in fact, they represent an excellent way to manage conservative portfolios – hence the reason why absolute return managers consider themselves to be much more prudent and conservative than relative return managers (Ineichen, 2002. It is relative return managers who are more willing to take risk and speculate in order to increase their clients’ wealth and achieve returns that exceed the benchmark (Ineichen, 2002). This is also because while relative return managers tend to deal with other people’s money, absolute return managers usually invest their own capital in the hedge funds they manage, which means that their interests and needs coincide with those of their clients (Ineichen, 2002). Consequently, absolute return managers are more reluctant to make unnecessarily risky decisions that have a negative impact on their own capital (Ineichen, 2002).
Alpha and Beta are two risk indicators that investors can use to assess risk and evaluate how rewarding and risky a certain investment is (Chambers et al., 2015). As reported by Setten (2009), during the past few years numerous investors have begun distinguishing alpha performance from beta performance in an attempt to improve their portfolios’ risk-return ratio. Alpha may be defined as a superior return performance measure that allows investors to determine the extent to which the investment manager’s experience, skills, knowledge and information contribute to the generation of “superior risk-adiusted returns” (Chambers et al.. 2015. p. 176). While alpha returns depend on the investment manager’s expertise, beta refers to returns achieved as a result of favourable market conditions (Chambers et al., 2015). It follows that while beta is linked with systematic risk – i.e. the risk associated with investing in any security that is affected by the overall market -, alpha is linked with idiosyncratic risk, which depends on the characteristics of the single security in which one invests. Considering that a portfolio with a high alpha is a portfolio whose performance exceeds that of the overall market, it is no surprise that most investors pay more attention to alpha than beta. With that being said, it is worth mentioning that a mixed portfolio is an excellent solution that allows investors to achieve their desired returns whilst maintaining their chosen exposure to both alpha and beta (Chambers et al., 2015). While a lower beta is associated with less volatility, investors may still be willing to invest in a portfolio with a higher beta, hoping that more volatility will result in higher returns and a higher alpha. It is important to consider that even though neither alpha nor beta can predict the future due to their reliance on historical data to produce accurate risk ratios, both measures can assist investors and investment managers in assessing investments over a certain period of time (Chambers et al., 2015).
Overall, as Hou et al. (2011) pointed out, investment decisions should not be based primarily on investors’ desire to achieve absolute or relative returns, investment portfolios should be designed in view of their current financial situation and expectations; once investors’ needs and goals have been evaluated, one may decide whether to pursue a high alpha and/or a high beta.
Figure . Four bonds issued by two large British companies, the British government and the French government have been chosen to perform a fundamental analysis of their potential, attractiveness to investors and duration. The two chosen corporate bonds are issued by Unilever, a world-renowned Anglo-Dutch multinational corporation, and Transco, which has merged with other gas and utility providers and currently operates under the name of National Grid plc. The government bonds chosen for this analysis are issued by Électricité de France (henceforth EDF), an electric utility company that is partly owned by the French government, and the British Government, whose “gilts” are known to be low-risk bonds. First of all, it should be noted that government bonds are widely regarded as being a lot safer than any other type of bonds due to their high quality and low risk. Government bonds, also referred to as sovereign bonds, enable governments to raise capital so as to support their expenditure. When investing in government bonds, investors should assess the various risks associated with the country that has issued said bonds, including political risk, country risk, overall creditworthiness (which is measured by rating agencies) and inflation risk, to name but a few. On the other hand, corporate bonds are issued by organisations that need capital to support their operations, to undertake mergers and / or acquisitions and to expand their business. These bonds are considered to be less safe than government bonds due to their higher risks; however, it is because of their uncertainty that corporate bonds offer higher interest rates to investors.Figure . Four bonds issued by two large British companies, the British government and the French government have been chosen to perform a fundamental analysis of their potential, attractiveness to investors and duration. The two chosen corporate bonds are issued by Unilever, a world-renowned Anglo-Dutch multinational corporation, and Transco, which has merged with other gas and utility providers and currently operates under the name of National Grid plc. The government bonds chosen for this analysis are issued by Électricité de France (henceforth EDF), an electric utility company that is partly owned by the French government, and the British Government, whose “gilts” are known to be low-risk bonds. First of all, it should be noted that government bonds are widely regarded as being a lot safer than any other type of bonds due to their high quality and low risk. Government bonds, also referred to as sovereign bonds, enable governments to raise capital so as to support their expenditure. When investing in government bonds, investors should assess the various risks associated with the country that has issued said bonds, including political risk, country risk, overall creditworthiness (which is measured by rating agencies) and inflation risk, to name but a few. On the other hand, corporate bonds are issued by organisations that need capital to support their operations, to undertake mergers and / or acquisitions and to expand their business. These bonds are considered to be less safe than government bonds due to their higher risks; however, it is because of their uncertainty that corporate bonds offer higher interest rates to investors.
As can be seen from Figure 1, Unilever and Transco’s bonds are short term (as their term to maturity is less than five years), whereas EDF’s bonds and gilts are long term (as their term to maturity is comprised between twelve and thirty years). Specifically, the YTM for both Unilever and ‘Transco is two years, while the YTM for EDF and the British Government’s bonds is twelve and seventeen years respectively. The current yield and YTM values displayed in Figure 1 also indicate that these bonds’ current yields exceed their respective YTM rates. Specifically, accurate calculations have revealed that the current yields for Unilever, Transco, EDF and the British Government’s Gilts are 4,43%, 5,49%, 4,94% and 3,47% respectively, whereas their Years to Maturity are 1,09%, 1,26%, 3,65% and 2,11% respectively.
If an investor put an equal amount of money into each of the previously selected bonds, the whole portfolio’s duration would be 6,605. This figure was obtained by calculating the Macaulay duration of a portfolio consisting of bonds issued by Unilever, Transco, EDF and the British Government (i.e. Gilts). Accurate information concerning each chosen bond’s duration was obtained online; the resulting figure (i.e. 6,605) indicates that the portfolio’s duration is equivalent to that of any medium-term bonds.
The workings displayed in Figure 3 show how a 1% increase and decrease in yield would affect the bond portfolio being analysed. The results clearly indicate that if market interest rates grew by 1%, the overall value of the bond portfolio would decrease by 6, 61%. On the other hand, if market interest rates fell by 1%, the overall value of the bond portfolio would increase by 6,61%. In the first case, lower market interest rates would have a negative effect on the portfolio’s attractiveness; in the second case, higher market interest rates would make the bond portfolio more appealing to investors. In view of these considerations, it can be inferred that similar changes in market interest rates lead to similar changes in portfolios’ prices – however, the direction of said changes depends on whether market interest rates rise or decline.
Barbell is an investment strategy that is executed by designing portfolios consisting of two equal parts: 50% of the portfolio is anchored in long-term bonds, and the remaining 50% of it comprises short-term bonds. As explained by Fabozzi & CFA (2001), portfolios designed using a Barbell strategy consists of bonds whose maturities are concentrated at two extremes (i.e. very short-term and very long-term maturities). On the other hand, portfolios designed using a bullet strategy consist of bonds that have a similar duration or maturities Fabozzi & CFA (2001). As can be seen from Figure 4, if a barbell portfolio was formed investing in an equal amount of Bonds A and C (whose maturities are five and twenty years respectively), the duration of the bond portfolio would be 8,31. Similarly, if a bullet portfolio was formed by investing exclusively in Bonds B, the portfolio duration would be 8, 36. It follows that even though the aforementioned portfolios are formed using different investment strategies and consist of different bonds with different maturities, their duration is actually similar.
The Macaulay duration provides information about the average cash flow associated with each bond, thus allowing portfolio managers to determine how volatile bond prices are and how vulnerable bonds and / or portfolios are to changes in interest rates. When the Macaulay duration for a bond is high, the bond is quite volatile due to the fact that long-term bonds are more vulnerable to yield risk than short-term bonds. As can be seen from Figure 5, Bond A has a shorter duration than Bonds B and C and its value is much less variable than that of Bonds B and C. On the other hand, Bond C has the longest maturity (twenty years) and is more exposed to price variations than Bonds A and B. As a medium-term bond, Bond B is in the middle between Bonds A and C. In light of these observations, it follows that any investor who has reason to believe that interest rates are going to decline should invest in the aforementioned Bullet portfolio (i.e. Bond B) as this would generate him / her a satisfactory return. On the other hand, if one has reason to believe that interest rates are going to rise, a Barbell portfolio consisting of Bonds A and C is the certainly the best option as the investor would probably succeed in achieving satisfactory returns. From an analysis of the returns associated with both portfolios (i.e. the Barbell and Bullet ones), it is found that the Barbell portfolio is likely to generate returns when interest rates are expected to rise, whereas the Bullet portfolio is likely to generate returns when interest rates are expected to fall.
Supposing that yield curve shifts are characterised by a flattening where for each change in Bond B, Bond A gets an additional 25 BP whereas B C loses 25 BP, the Barbell and Bullet portfolios appear to respond in slightly different ways to the yield changes in Bond B. As can be seen from Figure 6, nonparallel and parallel yield curves produce different results. Specifically, a parallel shift in the yield curve leaves both portfolios equally attractive in terms of returns; on the other hand, an nonparallel shift in the yield curve results in the Barbell portfolio generating higher returns than the Bullet portfolio. It is also found that the gap between both portfolios’ profits increases in the presence of a nonparallel shift in the yield curve. However, that does not change the fact that the Barbell portfolio is more profitable than the Bullet one.
References
- Chambers, D.R. et al. (2015). Alternative Investments: CAIA Level I. Hoboken, NJ: John Wiley & Sons. Fabozzi, F.J. & CFA (2001). Bond Portfolio Management. Hoboken, NJ: John Wiley & Sons.
- Hou, K., Karolyi, G. A., & Kho, B. C. (2011). What factors drive global stock returns?. Review of Financial Studies, 24(8): 2527-2574. Ineichen, A.M. (2002). Absolute Returns: The Risk and Opportunities of Hedge Fund Investing.
- Hoboken, NJ: John Wiley & Sons. Pankin, M. (2008). Stock Market Perspective: Absolute and Relative Returns [Online] Available at www.pankin.com/persp053.pdf> [Accessed on 4ª June 2016]. Setten, L.D. (2009). The Law of Institutional Investment Management. Oxford, UK: Oxford University Press.
