When the stock market's doing well, as it has recently, it's easy to become complacent. And that's not a good thing. After all, complacency led to massive losses in the 2008 market meltdown.

Is another annus horribilis awaiting us? Well, we've learned one thing from the last one: having all one's assets tied to the vagaries of the stock market — or the bond market, for that matter — is a dangerous business.

The purveyors of absolute return (AR) strategies are keen for you to keep that thought foremost in mind. You remember AR, don't you? In a March 2009 article (“Positive Returns Hard to Come By? Absolutely!”), we examined several mutual funds that trade the components of an absolute return portfolio.

Always Positive?

If you're not familiar with AR strategies, they're assets designed to generate threshold returns without regard to the performance of typical market benchmarks, such as the S&P 500 Composite or the Barclays Capital Aggregate Bond Index. “Positive returns — all the time” would be the AR radio tagline, if their proponents advertised.

Institutional portfolios throw a lot of money at AR strategies. Most famous among them is the Yale endowment which has devoted 23 percent of its assets to the class over the last half-dozen years. No wonder, that: in the past decade, Yale's absolute return managers produced average annual gains of better than 11 percent, a return on par with a conservative equity portfolio but earned with the risk of an investment grade fixed-income play. The Elis set rather aggressive targets for their AR strategy: a real return of 6 percent per annum with a standard deviation of 12 to 13 percent. Many institutional managers have more modest objectives. A 300- to 500-basis point return above three-month Libor is typical.

So what does it take to produce these returns? And what kinds of investments are made by AR managers?

There are myriad approaches. Among them are market neutral plays, long/short tactics, and hedged trades utilizing short sales, futures, or options. At their core, AR portfolios are made up of trades that exploit market inefficiencies. Whatever the internal gizmos and methods employed, an AR portfolio is expected to exhibit low correlation to the overall market.

In our 2009 article, we examined the returns and risks of the 10 largest funds in the Morningstar universe that are the building blocks of AR portfolios. Individually, only three funds, representing 26 percent of invested capital, earned positive returns in 2008.

The weighted average return for the funds in 2008 was a negative 11.3 percent which appears rather disheartening until you consider the contemporaneous negative 37.7 percent loss of the S&P 500 Composite. Back then, absolute returns weren't absolute. That loss pretty much jives with the Yale endowment's experience. The Elis took a 9.1 percent hit on their AR allocation in the wake of the market's deep swoon.

So, how have AR strategies done since then?

Since our last look, six of the funds — 72 percent of invested capital — earned positive returns.

Collectively, a modest positive average annual return of 3.7 percent was attained for the entire portfolio with only 40 percent of the broad market's risk. While the market-weighted return doesn't come close to the recent rebound performance of the S&P 500, it is more than 300 basis points above the period's average three-month Libor (see Table 1.)

All of the other portfolio metrics — Sharpe ratio, beta and correlations to market proxies — improved since our last look. You might say 2008 was something of a “bad hair day” for AR strategies. They're looking pretty well-groomed now.

Yale and other institutions use AR strategies as portfolio diversifiers, but such big investors enjoy an economy of scale few advisors or investors can hope to attain. Swinging a $17 billion portfolio around, as Yale does, certainly gets the endowment a lot of commission concessions. For more plebian investors, market neutral, long/short and arbitrage funds tend to be very expensive, limited to institutional-sized buy-ins and/or require the execution of dealer agreements. You have to wonder if there's an inexpensive way to create an AR allocation with low-cost exchange-traded products.

Wonder no more. There is.

AR strategies are, by their nature, actively managed. There aren't very many actively managed exchange-traded products, but there are products that track so-called “smart indexes” — portfolios that aren't exactly passive, but are not truly active, either. A number of these provide access to the investment styles used in AR strategies.

Not many have long histories, though. Only a half-dozen have year-long track records. Several products have been recently introduced and still more are in registration, so there'll soon be a lot more seasoned ETPs (exchange traded products) for investors to use in their AR strategies.

Right now, pickings may be thin, but there are still enough for investors to gain immediate access to AR strategies (see Table 2.)

Hedge Fund-Like Investments

The IQ Hedge Multi-Strategy Tracker ETF (NYSE Arca: QAI) is a fund-of-funds that exhibits the risk-adjusted return characteristics of hedge funds pursuing long/short equity, global macro, market neutral, event-driven, fixed income arbitrage and emerging markets plays.

The IQ Hedge Macro Tracker ETF (NYSE Arca: MCRO) is geared to an index mimicking a combined portfolio of macro and emerging markets hedge funds.

The index methodology underlying the IQ ARB Merger Arbitrage ETF (NYSE Arca: MNA) mandates the purchase of securities issued by companies which are announced takeover targets. The resulting equity market risk is then hedged with short exposure.

Absolute Return

Through long and short exposure to a broad array of asset classes affected by inflation — equities, fixed income, commodities and real estate — the IQ Real Return and Inflation Hedge ETF (NYSE Arca: CPI) seeks a real return above the inflation rate reflected in the Consumer Price Index.

Long/Short

The iShares Diversified Alternatives Trust (NYSE Arca: ALT) is designed to capture returns from a mix of long/short plays in interest rate and equity index futures, together with currency forwards. The fund exploits arbitrage opportunities on the yield and futures curves, engages in momentum trades, and mines relative values for profits.

Managed Futures

Managed futures strategies are proxied by the ELEMENTS CTI ETN (NYSE Arca: LSC) with a methodology that captures market momentum — short or long — within a universe of 16 commodity futures.

What's It All Cost?

The market-weighted cost of the six ETPs catalogued above is 96 basis points per annum, considerably cheaper than many mutual fund portfolios. No dealer agreements need be executed to trade in the ETPs and they're completely portable. Neither is there a minimum investment threshold beyond one share.

Of course, one needn't buy into all six funds to create an AR strategy, nor does one have to use market weighting in the portfolio. A mix can be created to suit any budget or risk tolerance level.

All of the products listed above are funds, with one exception. The ELEMENTS CTI product is a note, so investors should be aware of the credit risk assumed when building their AR strategies with this component.

As time goes by, investors may not have to worry about credit risk, though. A number of hedge fund-like products are in registration now, most particularly from the IndexIQ family, including funds based on managed futures as well as event-driven, market neutral, convertible arbitrage and relative value trackers.

Soon, individual investors and their advisors will have as much access to low-cost AR exposures as the big endowments.