Why absolute return funds are our preferred diversifier for passive portfolios

Two common options are:

• Factor-based funds – These funds tilt towards specific market factors like value, momentum, quality, and low volatility to seek enhanced long-term returns. However, they remain highly correlated with equity markets.

• Absolute return funds – These strategies aim to generate positive returns independent of market direction, using techniques like long-short equity, market-neutral investing, managed futures, and global macro strategies.

At Brigantia, our preference for this diversifier allocation is clear: absolute return funds are the superior choice for dampening volatility and reducing drawdowns compared to a fully passive portfolio.

While factor investing can enhance long-term returns, it does not fundamentally alter a portfolio’s risk exposure. Absolute return strategies, on the other hand, provide meaningful diversification benefits by reducing correlation with equity markets.

Why factor-based funds are not the best diversifier

Factor investing tilts equity exposure towards segments of the market that have historically provided excess returns. While this can be an effective way to improve returns within equities, it does not significantly change portfolio risk during market downturns.

The major factor styles include:

• Value – Invests in undervalued stocks. While value stocks have a long history of outperformance, they often experience deep drawdowns during crises.

• Momentum – Buys recent winners and avoids (or shorts) losers. Momentum strategies can produce strong returns but are vulnerable to sudden reversals in market trends.

• Quality – Targets stocks with strong financials and stable earnings. This factor provides some defensive benefits but remains correlated to the market.

• Low volatility – Focuses on stocks with lower price swings, reducing downside risk but also capping upside potential.

The key issue: factor funds still behave like equities.

Although factor-based strategies can shift risk exposure within an equity allocation, they do not provide true diversification. Their correlation to traditional equity indices often exceeds 0.9, meaning they still experience significant losses during market downturns.

For example, during major market crashes:

• Dot-com bust (2000–2002): Value and low-volatility stocks outperformed, but momentum strategies suffered heavily. However, all equity factor strategies still faced drawdowns.

• Global financial crisis (2008): Quality and low-volatility stocks provided some cushion, but value stocks - often overweight in financials - underperformed. Factor-based funds did not prevent significant portfolio losses.

• COVID-19 crash (2020): Most factor funds suffered along with the broader market, demonstrating their inability to act as true hedges.

While factor investing may boost returns over the long term, it is not an effective tool for reducing portfolio risk when markets decline sharply.

Why absolute return funds are the best choice for diversification

Absolute return funds take an entirely different approach. Instead of tilting towards certain market factors, they aim to generate returns with low or negative correlation to traditional asset classes. This makes them the ideal diversifier for dampening portfolio volatility.

Key absolute return strategies include:

• Equity market-neutral: These funds take long and short positions in equal proportions, aiming to profit from stock selection while minimizing overall market exposure. With near-zero beta, they can smooth returns without relying on market direction.

• Long-short equity: By dynamically adjusting their net market exposure, long-short funds can reduce volatility compared to long-only equity strategies.

• Managed futures (CTA): These funds use trend-following models to take long and short positions in equities, bonds, commodities, and currencies. Historically, they have delivered strong positive returns during major bear markets.

• Global macro: These funds take positions across asset classes based on macroeconomic trends, often performing well when market dislocations occur.

How absolute return funds perform in downturns

Absolute return funds have demonstrated their value across multiple crises:

• Dot-com bust (2000–2002): While the S&P 500 lost 37%, the absolute return index gained 9%. Many long-short and market-neutral funds posted positive returns.

• Global financial crisis (2008): The S&P 500 fell -37%, while equity absolute return funds lost -19% on average - substantially reducing downside exposure. Managed futures funds, meanwhile, posted strong double-digit gains.

• COVID-19 crash (2020): While the sudden V-shaped recovery made it a challenging period for diversifiers, many market-neutral funds held steady while managed futures strategies adapted quickly.

• 2022 bear market: With stocks and bonds both falling, traditional diversification failed. However, managed futures strategies had their best year on record, returning 20–30% as they profited from rising interest rates and falling equities.

The impact of absolute return funds on portfolio construction

By incorporating absolute return funds into a passive portfolio, investors can reduce overall volatility and limit drawdowns in ways that factor investing cannot.

For a 60/40 portfolio

A standard 60/40 portfolio already has some risk mitigation from bonds, but absolute return funds can provide additional protection:

• Replacing 5-10% of the portfolio with absolute return funds (such as managed futures or market-neutral strategies) can lower volatility and improve drawdown resilience.

• Studies have shown that shifting part of a 60/40 portfolio to alternatives reduces overall risk while maintaining similar long-term returns.

For an 80/20 portfolio

With 80% equities, the portfolio is far more exposed to stock market risk, making diversifiers even more critical:

• Adding 5-10% in absolute return funds can reduce drawdowns by 30% or more in major market crashes.

• Managed futures and global macro strategies provide non-correlated returns that help stabilize performance in periods of heightened volatility.

Cost and implementation considerations

• Factor funds are cheap but don’t provide true diversification. Many ETFs charge 0.2–0.5%, making them cost-effective but still highly correlated to equities.

• Absolute return funds tend to have higher fees, but some liquid alternatives, such as managed futures ETFs, charge 0.5–1%, making them more accessible than hedge funds.

• Liquidity is key - many absolute return strategies are now available in mutual funds and ETFs, ensuring daily trading flexibility and easy rebalancing.

Conclusion: absolute return funds are the superior diversifier

At Brigantia, our goal for a minority allocation within a predominantly passive portfolio is not to chase excess returns, but to dampen volatility and improve downside resilience.

• Factor-based funds tilt equity exposure but do not provide true diversification. They remain highly correlated with the broader market, limiting their ability to protect portfolios in downturns.

• Absolute return funds, particularly managed futures, market-neutral, and global macro strategies, provide genuine diversification benefits. They have a proven track record of delivering positive or uncorrelated returns when equities decline.

For investors seeking a smoother ride through market cycles, allocating a portion of the portfolio to absolute return strategies is the most effective way to enhance resilience without sacrificing long-term performance.

By focusing on true diversification rather than incremental return tilts, we believe absolute return funds are the best choice for investors looking to strengthen their passive portfolios against volatility and market shocks.