Absolute Returns are Absolute Nonsense

A recent article in Pensions & Investments (8/19/2011 pg 19) gives several reasons why absolute returns are just another Wall Street marketing gimmick: they didn’t work in 2008 and there are a wide range of strategies called Absolute Return Strategies.  There is only one return that pension funds absolutely have to focus on and that is the return they need to earn on their assets in order to meet future payouts  called liabilities. That is simply an internal rate of return calculation.  Every first year student in finance learns how to obtain that on their hand held calculator.

The claim that protecting against interest rate risk is a reason to employ an absolute return strategy is a ploy for getting pension fund committees to lock in historically low interest rates.  Why would anyone want to lock in 4% when they need more than 8% to fund their plans?  That is locking in a 4% loss!  As interest rates rise when Fed policy inevitably abates, the pain of losses in their bond portfolio will not be perfectly offset by a decrease in liabilities (because immunization never works perfectly) and they will still be underfunded.

The solution is to have their actuary solve for the IRR that discounts the future payouts to the present value of the assets, including contributions, instead of assuming the actuarial return calculated when the plan was fully funded is still meaningful.  This would allow their consultant to construct a portfolio designed to maximize the potential to exceed that IRR relative to the risk of falling below the IRR.  We now call that IRR the Desired Target Return® or DTR®.

The figure below demonstrates how we would construct such a portfolio for an 8% DTR.  The symmetric distribution (f) consists of sll passive indexes while distribution (g) is a combination of active and passive managers.  The names of the active managers are blocked out.

About Frank Sortino

Frank Sortino is finance professor emeritus from San Francisco State University and Director of the Pension Research Institute which he founded in 1981. For 10 years he wrote a quarterly analysis of mutual funds for Pensions and Investments Magazine and he has written two books on the subject of Post Modern Portfolio Theory. He has been a featured speaker at many conferences in the U.S., Europe, South Africa, and the Pacific Basin. Dr. Sortino received his Ph.D in Finance from the University of Oregon and has carried out research projects with many institutions like Shell Oil, Netherlands and The City and County of San Francisco Retirement System.
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