Key takeaways for your client conversations:

  • The "risk-on, risk-off" market mentality of recent years leads to poor risk management.

  • Serving investors with long-term goals means planning for durable diversification.

  • Modern all-weather allocation means including a broader set of asset classes and absolute return strategies.

Volatility may be the biggest challenge to investors in this or any other year. No matter the level of one's experience, investors must all confront the market's rapid transformations from euphoria to fear and back again. Amid a barrage of market-moving headlines, investors do not generally think about their risk management or act on measured analyses of fundamental data relative to specific companies' prospects. Many move with the herd.

Experienced financial managers and advisors know, however, that rapid-fire changes to an investment plan can lead to whipsawing performance and sacrifice the benefits of proper diversification. A well-diversified portfolio seeks to moderate short-term risk by taking advantage of low correlations among asset classes, thereby leading to better compound returns — one of the few "free lunches" still available to the average investor.

Seek a better balance with modern diversification for all kinds of market conditions

The classic diversification strategy of portfolio balance is a concept that Putnam has championed for nearly 80 years. But we have also taken it to new levels.

Stepping beyond tradition is valuable because of the high degree of equity risk that is still concentrated in a classic 60/40 balance, in which nearly 90% of the risk comes from the equity holdings. And, as we have seen too often, in a high-volatility regime, particularly one driven by systemic financial market stress, correlations within equities can rise dramatically.

That is why it is important to both globalize allocations and include a broader set of asset classes: domestic and international fixed income across the quality spectrum, as well as inflation-oriented securities — including commodities, real-estate-related securities, and Treasury Inflation-Protected Securities (TIPS).

But there is still more that modern diversification can achieve through an absolute return strategy. Taking advantage of the broadest possible toolkit, an absolute return approach can capture a portion of the upside potential of any market rally while consistently seeking to mitigate market volatility.

Independent of traditional equity and fixed-income benchmarks, an absolute-return manager has no motivation to follow the market's herd mentality. Instead, the manager's foremost concern is risk-adjusted performance, a look-before-you-leap mentality. It works by constructing portfolios with a variety of strategies uncorrelated with each other, and with the goal of greater independence from market direction. Absolute return provides an active form of tail risk management valuable for any portfolio charting a long-term course.

Absolute return funds combine many tools to manage risk

All funds involve different levels of risk, have different fees and expenses, and have different objectives that you should consider before investing. Absolute return funds have fewer limitations on where they can invest as compared with traditional funds. They have the ability to move among security types (i.e., stocks, bonds, cash, and alternatives), capitalization ranges, styles, durations, credit qualities, and geographic regions. This flexibility in terms of asset allocation offers the advantage of improved portfolio diversification as compared with many traditional funds. Absolute return funds also may have additional risks that traditional funds might not incur such as investing in derivatives and commodities, and from the use of leverage. Absolute return funds are not intended to outperform stocks and bonds during strong market rallies. Draft - content not finalized. Thursday, May 12, 2016 at 11:28:04 AM. Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio.

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