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January 2011 » White paper

Absolute return strategiesoer modern diversifcation

Over the past 30 years, investors have embraced investing in stocks and bonds topursue their fnancial goals. However, many have been disappointed by the stockmarket’s lost decade since 2000, and bonds may now be vulnerable to similarsetbacks given the inationary potential o Fed policies and government debt.Absolute return investing oers something dierent or investors who have ollowedtraditional stock and bond strategies. Absolute return strategies, by defnition,pursue returns independent o a traditional benchmark index like the S&P 500 Indexor the Barclays Capital Aggregate Bond Index. Absolute return is unconstrained andcan “go anywhere” as well as use modern tools, such as hedging strategies, in seekingto reduce risk or investors.This paper explores the eatures o absolute return unds that dier rom traditionalstock or bond unds:

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A ocus on providing positive returns over time with less volatility than moretraditional unds

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Potential or positive returns in at or declining markets

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Flexibility to pursue global investment opportunities

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Diversifcation across newer and alternative asset classes

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Progressive risk management with tools or hedging to choose which risks, andhow much, to take

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Absolute return diersrom traditional stockand bond investing.

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Absolute return seeksto reduce marketvolatility or investors.

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Modern tools,investment fexibility,and managementskill are keys toabsolute return.

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Putnam oers a choiceo absolute returnunds to help diversiytraditional portolios.

Absolute return is a modern strategy thatpursues positive returns with lower volatilitythan traditional unds, to help diversiyportolios or all kinds o investors.

January 2011 |

Absolute return strategies oer modern diversication

Traditional stock and bond unds ollowbenchmark indexes

Investors turn to stocks and bonds as a way to buildlong-term wealth because these asset classes have ahistorical track record o positive perormance over thelong term. While stocks and bonds have greater risksthan short-term securities such as Treasury bills, overthe long haul investors have been historically rewardedor taking these risks by earning higher rates o return

(Figure 1)

Perormance is measured againsta market index

Most traditional mutual unds task the portoliomanager with outperorming a stock or bond bench-mark such as the S&P 500 Index or Barclays CapitalU.S. Aggregate Bond Index. The manager is usuallyconstrained to invest only in the domestic market orin a specifc asset class. According to the InvestmentCompany Institute 2010 Fact Book, 94% o mutual undassets are in unds ocused on a specifc asset class —stocks, bonds, or money market securities. Hybrid undsare an exception. These traditional unds have greaterexibility to invest across global asset classes. However,only about 6% o industry assets are invested in hybridunds. Furthermore, some traditional unds have eventighter constraints, such as bond unds that invest onlyin government bonds or high-yield bonds, and stockunds that invest only in small companies or growthstocks. Such constraints beneft investors in that theydiscourage a money manager rom taking a rangeo unintended risks, and they ocus eorts onsecurity selection.

Traditional unds take market risk

At the same time, constraints carry a disadvantage aswell. In a general market decline, when securities all inprice or systemic, rather than specifc, reasons, there islittle that a constrained manager can do to avoid anegative result. In act, a manager may do what isconsidered a good job — by outperorming the marketbenchmark — yet, during a bear market, the und mightpost a signifcant decline or shareholders.

Bear markets can be devastating

There have been 12 bear markets in stocks sinceWorld War II, with prices declining 22% over 14months, on average. Bear markets pose substantialrisks. For younger investors, a downturn interruptsthe compounding o returns, and this delays wealthaccumulation. For investors who have already built upsavings and may be relying on them to generate income,the impact o a bear market can be devastating. Forsaety, such investors typically avor more conservativeinvestments, which, with lower rates o return, requirea number o years to recover rom a downturn

(Figure 2)

.Since their time horizon is shorter, older investors cannotreallocate enough money to stocks to potentially beneftrom a recovery in prices and restore their wealth.

Retired investors are vulnerable

For retired investors, a bear market poses special risks.Withdrawing money during declines locks in the lowstock prices and leaves investors with a smaller posi-tion or when the market recovers. In short, retireesare particularly vulnerable to bear markets, which canshrink savings and reduce the potential or generatinga uture income stream, because retirees are unable toadd to their portolios rom occupational income.To understand the heightened bear market risk orretired investors, consider the example o the stockmarket decline o 2000–2002. Figure 3 compares two

Source: Morningstar, 2010. Stocks are represented by the IbbotsonS&P 500 Total Return Index, bonds by the Ibbotson U.S. Long-TermGovernment Bond Total Return Index, and cash by the Ibbotson U.S.30-day Treasury Bill Total Return Index. The indexes are unman-aged and measure broad sectors o the stock and bond markets. Youcannot invest directly in an index. Past perormance is not indicativeo uture results.

Figure 1. Relative return unds invest intraditional asset classes

Cash

3% Inﬂation

Bonds Stocks

9.9%5.5%3.6%

Annualized returns (12/31/25–12/31/10)

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investors, one who retired in late 1999, at the start o abear market, and one who retired in late 2002, near thebeginning o a recovery. The frst investor’s portoliodeclined during the bear market and remained wellbelow its original value even ater the market recovered,leaving the investor with less fnancial security. Theother investor benefted rom market perormance,and the portolio even appreciated or several years.The dierence highlights the damaging impact o abear market.For more inormation on the importance o stable returnsin retirement, visit theretirementsavingschallenge.com.

Absolute return strategies are lessconstrained

An absolute return objective removes many constraintson managers and allows them to implement morestrategies or addressing market volatility. More tradi-tional strategies can have similar types o exibility,but are generally more constrained. For example, atraditional bond und manager may be allowed toinvest in all sectors, but is likely to be inuenced by thesector weightings o the benchmark index becausediverging rom them can cause risk. This generallycompels traditional unds to take on market exposure.

Figure 2. Retired investors cannot take the risk o a bear market because it can take years to recover

Rate of returnSize of bear market downturn-10-0-30-0-50

yearsyears77yearsyears7years

7yearsyearsyears7years7years

7years7yearsyears8yearsyears

years7yearsyearsyears87years

%

yearyearsyearsyears7years

This hypothetical illustration is based on mathematical principles and assumes monthly compounding. It is not meant as a orecast o uture eventsor as a statement that prior markets may be duplicated. Recovery periods are rounded to the nearest quarter o a year.

Figure 3. Reducing volatility is a key to retirement success

Ending balance

$586,212

Ending balance

$140,740

Taking withdrawalsampliﬁes market losses

$500,000$0

22222242262728292

Annual withdrawals

$25,000 $25,750 $26,523 $27,318 $28,138 $28,982 $29,851 $30,747 $31,669 $32,619 $33,598

(5% in year 1, increased by 3% thereafter)

$25,000 $25,750 $26,523 $27,318 $28,138 $28,982 $29,851 $30,747

This illustration depicts two hypothetical $500,000 investments in stocks, as represented by the S&P 500 Index. One investor starts on 12/31/99,withdraws 5% in year one, and increases that amount by 3% each year to adjust or ination. Another investor takes the same approach, but startsthree years later, thereby missing the market decline o 2000–2002. Past perormance is not indicative o uture results.