There are very few silver linings in the horror show of the Bernie Madoff story. However, I am hoping that this episode marks the end of the term, “absolute return” when referring to investment strategies.
Since the dot-com bust, “absolute return” has become a buzz phrase that I have always found misleading. The marketing teams of countless asset managers have used that phrase to promote their product or strategy. In theory, “absolute return” has been used to indicate that investment returns are not dependent on or correlated with general market returns. In practice, it has often meant that portfolio managers are taking on whole different types of risks — and often these are risks for which these managers are inadequately prepared.
Closely related to the “absolute return” issue is the habit of many of these managers to discuss their “target returns,” as in “we target returns of 400 basis points above t-bills,” or “we target returns of 8-10%.” This is a ridiculous practice. I can “target” winning the lottery, but making that a target doesn’t make it any more achievable.
In general, over time, these “absolute return” managers and their “targets” eventually fall apart as their quantitative strategies either eliminated the available opportunities, or simply failed as conditions changed. But then there was Bernie Madoff. His predictable, solid returns seemed to be the exception that proved the rule. His track record always was evidence of the viability of the absolute return story — the record seemed to say, “it is achievable, if only you get the model right, or get the right person managing the money.” Like a flame before moths, the Madoff track record attracted others to absolute return strategies.
This bitter end of the Madoff story can provide some small good if it serves as a reminder that there truly are no free lunches on Wall Street. Let’s do away, once and for all, with the concept of “absolute return” investing. The only absolute that comes with investing is the absolute certainty that returns come with risks. It is truly tragic that this lesson cost so much for so many good people, endowments and professional reputations.