Total-return approach

The total-return approach generally describes an investment strategy primarily used in professional stock exchange trading. Most private investors are only superficially familiar with the total-return approach, if at all, even though it forms the basis for trading in the world of asset management and hedge funds.

Target

The total-return approach essentially pursues two objectives. On the one hand, it strives to achieve positive absolute returns in every possible market situation. It does not matter whether the markets are generally rising, falling, stagnating, or even crashing. The goal of building a total-return investment portfolio is always to generate a profit, regardless of what the market does. The second objective is that of building the portfolio independently of the overall market. After all, this is the only way to realise profits in any market situation. Independence from the market as a whole has one major advantage: protection against losses triggered by crashes, natural disasters, or events such as 9/11 and Fukushima. All of these share one element. They have or had a massive, mostly negative impact on the market as a whole. However, the negative impact on a solid total return portfolio is minimal at best.

Concept: total return

How can an investment portfolio be built independently of the overall market and be largely protected against extreme events? Let us first look at a typical investment fund. A typical investment fund is long-only, i.e., it can only buy securities. It can only go long or do nothing at all. A typical investment fund cannot short-sell shares, for example. In this respect, such a fund only generates a positive result if the overall market and the individual stocks purchased rise. However, the investment fund will also suffer losses because it cannot or can hardly hedge against price losses if major price losses occur.

The decisive advantage of a total return portfolio is that such portfolios are not only built up long, but also long-short. Using shares as an example, this means that the ratio between long and short traded shares is always balanced. Simply put, long stocks will make a loss if the market as a whole drops sharply, but such loss will be offset by the short stocks, or at best overcompensated, causing the portfolio as a whole to make a profit. In most cases, each long value is simultaneously assigned a short value as a counterpart. Both positions are opened simultaneously and form a kind of tandem. These are referred to as spread trades. We will cover this in greater detail later.

Building a total-return portfolio

The decisive factor for the success of a total return portfolio is, on the one hand, diversification across all essential asset classes. The focus here is on the equity market. At about 10,000 shares tradable worldwide, this is by far the largest market with the most extensive selection of individual stocks. The second-most important asset class is currency pairs. Bonds and commodities can also be added, however. Diversification is vital to protect the portfolio from extraordinary movements within a single stock. A portfolio that comprises 20 different shares and one of them performs significantly below expectations, the damage to the entire portfolio is negligible. However, if a portfolio comprises only three individual securities, each security has such a large share that strong fluctuations can jeopardise the entire portfolio and lead to large losses.

Buying or selling off (longing or shorting) the right stocks at the right time is the big trick in addition to diversification itself. Macroeconomic factors, company-specific factors and technical chart factors are considered for the specific selection of individual stocks and the timing. As already mentioned, opening a position is not mandatory. However, it usually involves spread trades. The individual values of such a spread trade are not considered in isolation, but always relative to each other. This principle is applied to currency pairs in the same way. Once again, there are two currencies involved that are set in relation to each other, thus forming the currency pair. Just as in the currency sector, this principle can be applied to the stock market or all other markets. The basic idea is to buy relative strength and sell relative weakness. This means that a share that is expected to be strong is bought and a share that is expected to be weak is sold in the scope of a spread trade. If the plan works out, the share bought rises while the share sold falls. Both shares will then earn money. If both shares rise, money will still be made while the expected strong share performs better than the expected weaker share – and vice versa.

Portfolios constructed in accordance with this scheme deliver such good results because it is assumed that strong shares tend to rise more strongly in boom phases than weak shares. Similarly, it is assumed that strong shares will drop less sharply than shares that are already weak if a crash does occur. This means that the sum of the two individual values of a spread trade theoretically produces a profitable result. In practice, the selection of the “correct” individual values is decisive for success.