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Two Pair Trades for Absolute Returns

MINNEAPOLIS ( Stockpickr) -- One of the hottest trends in investment management involves the concept of absolute returns. In a volatile market that can swing violently in any direction, absolute returns hold out the promise of protecting capital while making money at the same time.

Wall Street of course is catching on to the trend, with many new mutual funds offering exposure to both the long and short side of the market. Looking at Morningstar's list of top-performing funds over the last three years and you will find absolute return managers at the top of the list.

My question is: Does the promise of absolute returns deliver? Knowing the financial industry as I do, I am naturally skeptical.

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In 2005, I launched a now-defunct publicly traded mutual fund that offered investors an opportunity to buy stocks that were undervalued and sell over valued stocks short. I think I was a bit ahead of my time. My old prospectus and marketing material for the fund read like a playbook of how investors should have been positioned over the last several years. If I'd had the capital to properly incubate the fund, the returns would have been fairly spectacular.

Instead of a fund, I now do all of my money management in the form of writing articles about stocks and making my recommendations in print. I've had a remarkable track record of successful recommendations, including my own personal favorite, " Why It's Okay to Sell."

My approach in obtaining absolute returns includes a concept known as pair trading. With pair trading, investors take a position on the long side and match that position with a short sale of a different position. If both stocks go up, one would expect the long stock to outperform the short stock, and vice versa.

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For example ,at the beginning of the year I offered five pair trades for 2010. One of the trades was to buy Apple (AAPL - Get Report) and sell short Palm (PALM). At that time, Apple was rolling out its iPhone, while Palm was struggling to survive. So far this year, Apple has continued its quest for global market domination, while Palm meekly accepted a low-ball buy-out offer from Hewlett-Packard (HPQ).

A portfolio made up of these trades in equal amounts netted investors approximately 3% year to date. That amount falls far short of the near 10% gains in the market, but it does deliver on the promise of absolute returns: make a small gain while protecting capital from downside risk.

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