Aegis

The Idea: Absolute Return v. Relative Return… What’s the difference?

Absolute return strategies are much less discovered than their more widely known and more practiced counterparts due to the fact that they typically provide more modest returns. Relative return strategies typically offer more return potential in any given year along with more volatility.

v.

In favorable market environments relative return strategies have the ability to significantly outperform absolute return strategies. In volatile or down markets absolute return strategies tend to do better by not losing and adding to their gains incrementally year in and year out; tortoise vs. hare.

The Process: The Three Legged Stool

ACM’s approach to absolute return is a three legged stool. Each leg is in and of itself subject to price risk and volatility. However, the combination of the three provides a smoothing balance/counterbalance experience that attempts to inoculate price movements in order to collect cash through dividends and option premiums in a steady and consistent manner.

The first leg is a basket of dividend paying ETPs (exchange traded products) that provide income; currently around 4.5% per year. We like the dividend; we don’t like the price risk attached the investments that provide the dividend so now we need the second leg of the stool.

Ying & Yang The second leg of the stool is short the broad stock market to inoculate the price movement of the first leg. Ying and Yang, balance and counterbalance, Abbot and Costello, Laurel and Hardy, Sonny and Cher, you get the ideal. This leg of the stool does not provide income. However, it is necessary to offset potential market price losses in the first and even the second stools. When the price of the first stool goes down the price of the second goes up and vice versa.

The third leg of the stool is where the bulk of the return potential lies but also where there is the most risk. This leg uses a covered call strategy to generate additional income to the account above and beyond the fixed amount that the first two legs of the stool can provide.

This leg selects stocks based on how much premium (cash) can be received in hand today to purchase sufficient downside protection and still have some money left over for a modest short-term gain. In essence we sell future potential upside appreciation on the underlying stock for cash in hand today for an agreed upon price. Our gains are capped, however, the money we receive to cap our gains provides downside protection. In technical terms a covered call is a contractual agreement we have with another party to sell our stock at an agreed upon price for cash in hand today to be terminated at an agreed upon date in the future. The contracts are called options and are standardized, regulated, and traded every second of every trading day.

Together the three legs make up the ARS:

ARS Pie Chart

Long High Dividend Stocks 13%
Long High Yield Bonds 10%
Long Short Term High Yield 9%
Long Income Index Fund 13%  Total Longs = 45%
Short Positions 25%
Covered Calls 30%
Total 100%

The above percentages are for illustrative purposes only and are subject to change.