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The Only Constant 5

Large Large Large

Cap Cap Cap
Growth Core Value
Mid Mid Mid
Cap Cap Cap
Growth Core Value
Small Small Small
Cap Cap Cap
Growth Core Value

FIGURE 1.2 Typical U.S. equity styles.

individual managers were performing relative to the market, and relative

to each other. Consultants initially used broad markets indices to gauge
performance. However, as more and more specialty managers began to ap-
pear, benchmarks began to evolve and, as with all change, these evolutions
became increasingly complex. Specialized market indexes were employed
to gauge performance. Categories were formed so that managers could
be compared against their peers. Consultants pigeonholed asset managers
into distinct styles so they could more easily monitor their activity and
fire them (or not hire them) if they didn’t fit neatly into preconceived cate-
gories. Over time, this forced many money managers to become highly spe-
cialized, focusing on individual styles like growth or value, which in turn
were further broken down into large-cap, mid-cap, and small-cap strate-
gies, as well as a host of other variations.
Throughout the Great Bull market that began in 1982 and ran for al-
most 20 years, managers that attempted to be creative and innovative
sometimes found that their ability to raise assets diminished—even if they
had stellar track records—because they no longer fit within a convenient
category.
The perceived institutional need to compare performance to peers and
market benchmarks resulted in most of the focus being on relative perfor-
mance, rather than absolute performance. (In short, “relative return” has
to do with how an asset class performs relative to a benchmark, such as
the S&P 500. “Absolute return” speaks to the absolute gain or loss an asset
or portfolio posts over a certain period.) The relativistic approach to eval-
uating performance proved to be a boon for asset managers, in that they
could now focus on constructing portfolios that had only to equal or per-
form marginally better than market benchmarks—regardless of whether
performance was positive or negative.
Relativism provided a windfall for asset managers, in that it often
masked poor absolute performance; an asset manager with a negative
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6 MARKETS IN PROFILE

return could still win the Boeing pension fund simply by outperforming
peers and benchmarks! As long as performance was measured on a rela-
tive basis, the money management industry continued to raise significant
assets (upon which fees could be charged). While this wasn’t so detrimen-
tal during the rising markets of the time, the relative-performance crutch
did little to prepare managers to compete in the less certain markets that
followed the end of the great bull market in 2000.
The tide would soon turn: Once it was clear that the market was no
longer going up, clients would begin to demand that their managers do
more than simply match the market.

THE FALL OF THE GREAT BULL

Coupled with an extended bull market, the enactment of ERISA had the
effect of codifying modern portfolio theory (MPT) in the eyes of the major-
ity of investors and investment managers. (In a nutshell, MPT emphasizes
that risk is an inherent part of higher reward, and that investors can con-
struct portfolios in order to optimize risk for expected returns.) For fidu-
ciaries, the concept of controlled risk through diverse asset allocation is
certainly appealing. When markets are “behaving” (as they were for nearly
two bullish decades) the return, risk, and correlation assumptions used to
generate asset allocation analyses tend to sync relatively well with market
activity; a trend is predictable as long as it continues. In this environment,
modern portfolio theory became the comfortable thread that held the fi-
nancial markets’ complex patchwork quilt together. Within this model, as-
set managers that performed well on a relative basis within a single, easily
identifiable style could consistently raise assets. Once they stepped away
from their advertised style, however, their opportunities became limited.
An unfortunate result of this phenomenon was that this narrow, restrictive
environment tended to limit the growth of asset managers’ skill base. It’s
difficult to understand how talented, competitive individuals allowed them-
selves to remain locked into one specific management style for so long,
especially when that style had clearly fallen out of favor. I saw managers
literally go out of business rather than change their investment approach.
As the great bull began to show signs of strain and the equity markets
began to behave with far less certainty (no longer trending up). It became
apparent that the relativistic, MPT-driven business model embraced by tra-
ditional asset managers—one in which money was managed on a relative
basis, track records were marketed based on relative performance, and
performance was measured in relative terms—was plagued by significant
weaknesses.
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The Only Constant 7

Alexander M. Ineichen of Union Bank of Switzerland (UBS) estimated

that total global equity peaked at a little over $31 trillion at the top of the
bull market, falling to approximately $18 trillion at the 2002 low—a decline
of approximately 42 percent. As during the 1974 period, the investment
community reluctantly began to embrace change in order to cope with the
divide that opened between the objectives of traditional money managers
and the needs of their clients.
One of the prime causes for this divide was that MPT depends on “rea-
sonable” assumptions for each asset class. Implicitly, this requires a very
long-term view; investors must plan on holding their investments for a long
time in order to reap the desired rewards. Unfortunately, when markets
failed to cooperate toward the end of the bull market, it became evident
that most individuals and institutions have a vastly different perspective of
what “long-term” means, especially when short-term performance is on the
line. During times of market stress, the correlations between asset classes
often fall apart, which often results in unexpectedly poor performance.

THE RISE OF ABSOLUTE RETURN

There appears to be a dearth of insight into how investors respond when

the shorter timeframe delivers significantly different results than was ad-
vertised and expected for the longer term. But there is no lack of evidence
that long-term-minded investors, when confronted with unexpectedly
poor short-term results, tend to liquidate their holdings at precisely the
wrong time.
As the markets became more volatile and uncertain, traders and
investors who had broken free of the relativistic herd, embracing an
absolute-return philosophy, continued to produce positive returns at a
time when the majority of traditional asset managers were posting consis-
tently negative returns (along with the market). Because absolute-return
investors measure themselves against the risk-free rate, rather than rela-
tive to a market index, they must be more flexible and nimble. They must
have the ability to employ a much broader arsenal of investment strate-
gies in order to achieve their goal of delivering consistently positive per-
formance. This group can employ all styles across all capitalizations. They
can also short securities, which creates even more opportunities and en-
ables portfolio managers to exploit both overpriced as well as underpriced
securities.
The end of the great bull served as the catalyst for a much more adven-
turous and entrepreneurial environment. In today’s atmosphere, it’s harder
for the traditional money management firms to hold on to talented traders
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8 MARKETS IN PROFILE

and portfolio managers, as the financial rewards for stepping out solo can
be extremely large for truly capable individuals. The firms that want to sur-
vive and prosper in the absolute-return milieu must adapt and find new in-
centives for attracting and retaining such innovators. An article in a leading
U.K. newspaper, the Observer, reported that Dillon Read Capital Manage-
ment, the new hedge fund unit established by UBS in 2005, earmarked $1
billion in bonuses for its first three years in business to ensure that it con-
tinued to attract and retain successful traders. When the article appeared,
there were only about 120 employees in that unit, which would work out,
on average, to about $3 million per employee. It’s no wonder that we con-
tinue to see a steady exodus of portfolio managers from the traditional
asset management firms toward those organizations that offer more chal-
lenging opportunities in the new world of absolute return.

SUCCEEDING IN AN ABSOLUTE RETURN

MARKET ENVIRONMENT

Following a strong rise or bubble, markets historically remain within

bracketing ranges for many years. As most equity markets peaked in early
2000, we are in the fifth year of a bear market at the time of this writing.
Although the term “bear,” in this context, is misleading, it is more useful to
think of current conditions as indicative of a “consolidating,” “trading,” or
“bracketing” market. The high-to-low range of a consolidating market of-
fers excellent opportunities for traders who are adaptable enough to trade
them. John Mauldin, in Bull’s Eye Investing: Targeting Real Returns in
a Smoke and Mirrors Market (Hoboken, NJ: John Wiley & Sons, 2005),
states that the shortest bear on record is eight years, with the average be-
ing 16 years. During these periods, it seems as if the market’s actions are
guided by some shrewd NFL offensive coordinator—just when it looks like
the market is going long it pulls up short, jukes left and rolls right, leaving
a pile of stunned investors in its wake.
Consolidating markets are tricky. Just when you think you’ve got them
figured out, you end up the wrong way on a big move and you feel like
you’ve been betrayed by everything you know. Many traders begin to think
of the market as a cunning adversary who tries to foil their best-laid plans,
or perhaps a tempting siren, bent on luring them to the bottom of their
bank accounts.
In a long-term bull market, or a “relative-return market,” you can suc-
ceed by simply staying fully invested and matching the market’s steady
rise. In a bear, or consolidating market, such as the one we’re in now,
savvy traders seek to identify and profit from mispriced securities, both on
the long as well as short side of the market. Achieving “absolute returns”
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The Only Constant 9

S&P 500 Large Cap Index ($SPX) INDX

1550
1500
1450
1400
1350
1300
1250
1200
1150
1100
1050
1000
950
900
850
800
750

Relative return market 700

Absolute 650
600
return 550

market 500

450

400

350

300

250

200

150

Absolute return market

100

50
61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

FIGURE 1.3 Absolute vs. relative return market conditions: S&P 500, 1965 to
2004.
Source: Chart courtesy of StockCharts.com.

(returns that consistently exceed the risk-free rate, regardless of market

direction) requires skill, self-knowledge, an understanding of market and
investor behavior, and trading maturity. The point here is that the relative
and absolute approaches exist at opposite ends of the spectrum, and brack-
eting market conditions reward absolute-return investors—those individu-
als who are concerned with the value of their portfolios at every point in
time, not just at some predetermined maturation (see Figure 1.3).
If history continues to repeat itself, as it has for the past five years,
then the 20-year bull run will fade farther into the past, and a substantially
different approach to market understanding will be required to consistently
succeed.
It is worth noting here that Mind over Markets, the first collaboration
between these authors, was written in the middle of the great bull market,
when most investors had already climbed aboard the relative-return train.
The theories and practices prescribed in that book are as applicable to-
day as they were then—there is still unexpected volatility in bull markets,
and Mind over Markets provided a detailed treatise on taking advantage of
such volatility. Since the great bull, market mechanics and human behavior