The total return approach is a general term for an investment strategy used mainly in professional market trading. While total return strategies form the basis of trading for many asset managers and hedge funds, most private investors know the approach only superficially, if at all.
Objectives
The total return approach essentially pursues two objectives. The first is to achieve positive, absolute returns in any market environment – regardless of whether markets in general are rising, falling, stagnating or even crashing. A total return portfolio is always built with the aim of generating a profit, whatever the market does. The second objective is to build the portfolio so that it is independent of the overall market, since this is the only way to make profits in every market environment. This independence brings a major advantage: protection against losses triggered by crashes, natural disasters or events such as the terrorist attacks of 11 September 2001 and the Fukushima nuclear disaster of 2011. All these events have one thing in common: they had a massive, mostly negative impact on the market as a whole. The negative impact on a solid total return portfolio, by contrast, is ideally small.
The total return concept
But how can an investment portfolio be built so that it is independent of the overall market and largely protected against extreme events? Consider first a traditional investment fund. A traditional investment fund is long-only, meaning it can only buy securities: it can go long – or do nothing at all. It cannot go short, for example by short selling shares. Such a fund therefore only produces a positive result when the overall market and the individual securities it has bought rise. If prices fall significantly, the fund also makes losses, because it cannot hedge against falling prices, or can do so only to a limited extent.
The decisive advantage of a total return portfolio is that it is built not long-only but long-short. In the case of shares, this means that the ratio between shares held long and shares sold short is always balanced. Put simply: if the overall market falls sharply, the long positions lose value, but these losses are offset by the short positions – ideally more than offset, so that the portfolio as a whole makes a profit. Usually each long position is paired with a short position as its counterpart. Both positions are opened at the same time and form a kind of tandem. These are known as spread trades – more on them below.
Building a total return portfolio
A key factor in the success of a total return portfolio is diversification across all essential asset classes. The focus is on the stock market, because it offers by far the widest choice of individual securities – many thousands of shares are traded worldwide. The second most important asset class is currency pairs; bonds and commodities can be added as a supplement. Diversification matters so much because it protects the portfolio against unusual moves in any single holding. If a portfolio consists of 20 different shares and one of them performs well below expectations, the damage to the portfolio as a whole is negligible. If, however, a portfolio consists of only three holdings, each one carries so much weight that strong price swings can put the entire portfolio at risk and lead to large losses.
Beyond diversification itself, the real art lies in buying or short selling the right securities at the right time (going long or short). Macroeconomic, company-specific and chart-based technical factors are all used to select individual securities and to time the trades. As mentioned, positions are usually – though not necessarily – opened as spread trades. The two components of a spread trade are never viewed in isolation but always relative to each other. The same principle applies to currency pairs: each pair consists of two currencies whose values are set in relation to each other. Just as in the currency market, this principle can be applied to the stock market or any other market. The basic idea is to buy relative strength and sell relative weakness. Within a spread trade, a share that is expected to be strong is bought and, against it, a share that is expected to be weak is sold. If the plan works out, the share bought rises while the share sold falls, so money is made on both. Even if both shares rise, the trade still makes money as long as the share expected to be stronger performs better than the one expected to be weaker – and the same applies in reverse when both shares fall, as long as the stronger share falls less.
The rationale behind portfolios built on this pattern is the assumption that relatively strong shares tend to rise more than weak shares in boom phases, and that in a crash, strong shares tend to fall less than shares that were already weak. In theory, the two legs of a spread trade therefore add up to a profitable result. In practice, success depends on selecting the "right" securities: if the share bought performs worse than the share sold short, the spread trade loses money – whichever way the market moves.