Relative Returns

Modern Portfolio Theory assumes that (i) investors rationally maximize their utility of wealth and (ii) portfolios composed of securities or assets with returns that are less than perfectly correlated with each other will diversify risk.  The less correlated the returns are, the more the efficient frontier will be pushed in a desirable direction (up for higher returns of a given level of risk, and left for a lower portfolio risk at a given level of return).  Such a basic result, along with the portfolio separation theorem, whereby investors will maximize their utility by choosing to split their total allocation [100% = w + (1-w)] among only a diversified portfolio of risky assets (w) and a risk-free asset (1-w) according to their individual risk tolerances, led to the widespread development of index funds  This results from finding the line that intercepts the risk-free rate and is tangential with the efficient frontier of all possible assets.

For those espousing the efficient market hypothesis, there is no need for active management.  One's risky portfolio need only consist of a passively managed, highly diversified fund that mimics the performance of the market as a whole.  Within the same relative return paradigm, for those believing that there are some inefficient markets or market segments or certain periods or degrees of market inefficiency, active management can lead to excess returns. 

Absolute Returns

Although hedge funds (and commodity trading advisors) have been around for decades, in the past ten years, they have attracted the attention of sophisticated investors, in part, because they offered positive absolute returns, especially in down markets.  One reason why hedge funds are able to credibly offer absolute returns (positive nominal returns) during times of equity market downturns is that they are able to go short.  In general, hedge funds are less constrained than traditional equity and balanced funds.  Talented hedge fund managers are also able to leverage their outperformance.  Additionally, this class of alternative investment strategies has been shown to exhibit returns that have low correlation with traditional assets (equity and fixed income).  When included in the asset allocations of institutional portfolios, the low return correlations of hedge funds with traditional asset returns could reduce portfolio risk without sacrificing returns.

Since the financial crisis began in 2008, it was clear that most hedge funds could not, however, credibly offer positive absolute returns in all economic environments.  Furthermore, across the globe the crisis required an unprecedented regulatory response and, as notably, an unprecedented monetary response.  While hedge funds remain viable alternative strategies, we are in a new economic environment replete with much uncertainty.  More recently, the debt crisis adds further uncertainty regarding country-specific inflation and lending rates, asset prices and relative currency valuations. The absolute return paradigm focuses on nominal returns, and may better address investor needs by focusing on real returns.

Real Returns

While many institutional investors state their return objectives relative to inflation in order to match their liability streams, most investment managers target and report their investment performance for a variety of strategies in nominal terms.  Today, investors whose objectives are expressed in real terms explicitly attempt to maximize real, not nominal, returns to preserve and increase real purchasing power. A focus on real returns is particularly important because expected nominal asset returns are at historical lows.