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Wellington: The case for uncorrelated returns

12 Mar 2019

Vanessa Barrett, Investment Director, Wellington Alternative Investments.

Over the past 10 years, extreme monetary policy has distorted capital markets. Asset prices are defying investment fundamentals: equity markets are no longer driven by growth and profitability, while bond yields are abnormally low or even negative. Meanwhile, political risk has grown, and populism has raised concerns that protectionism may reverse three decades of globalisation, leading to subdued capital market returns and further volatility. Investors are therefore seeking returns that have little or no correlation with traditional markets. Here, we look at some potential absolute return solutions.

Solution 1: Absolute return fixed income

With fixed income making up a large part of many portfolios, investors are naturally keen to guard against duration and credit risk. That is particularly true now, as current reflationary trends exert upward pressure on interest rates and as the credit cycle matures. Absolute return fixed income strategies can aim to mitigate such risks in portfolios by shorting fixed income assets via liquid derivative instruments (for example, government bond futures).

Proper due diligence is essential to ensure that a strategy exhibits low correlations to various market betas while incorporating prudent downside controls. This is particularly important given the proliferation of absolute return and other unconstrained fixed income strategies. Evidence of high correlations to credit or other fixed income markets may indicate that a given strategy really depends on market beta. True absolute return fixed income strategies are structured not only to preserve capital in periods of market stress but also to take advantage of the mispricing that typically occurs at such times. We believe they are a potential solution for investors seeking both return and diversification.

Solution 2: Multi strategy

Multi-strategy approaches seek to capitalise on the ability of various active alternative strategies to capture dislocations created by market gyrations. Their success rests on three central pillars:

  • Strong risk-adjusted returns generated through the active management of the underlying strategies
  • Low correlations between each strategy
  • No reliance on structural beta at the strategy level

Typically, they will combine eight to 12 strategies to provide investors with meaningful yet steady performance, while limiting drawdowns and, crucially, correlation to equities and rates markets.

They offer two advantages over a portfolio of alternative strategies. First, the timing decision for each strategy is determined by a team that is close to the markets. Second, netting the performance fee across strategies can lead to significant cost benefits – if the approach’s performance is below a specified level, no performance fees are due, even on underlying strategies that have done well.

We believe it is important to look for a multi-strategy manager that has a wide range of differentiated, highly specialised strategies with significant track records, as well as risk management that can monitor for any unintended position, sector or factor concentration at the portfolio level.

Solution 3: Multi-asset alternative risk premia

Given the challenging investment outlook, many investors have turned to alternatives, such as hedge funds and private equity – only to be disappointed by often lacklustre returns, illiquidity and high fees. For them, alternative risk premia strategies may be an attractive option. Investors may use these lower-cost, liquid strategies as a core alternative holding, freeing up the fee budget for allocations to truly differentiated, high-quality hedge funds.

Four strategies, which account for the bulk of hedge fund returns, provide the key building blocks for alternative risk premia:

  • Momentum – identifying trends that are likely to persist
  • Relative value – buying one asset (or interest rate, time frame, etc.) you like while selling another you don’t like
  • Carry – capturing the difference in yield between two assets
  • Equity styles – exploiting one or more of the characteristics that drive share prices

Alternative risk premia strategies generally take long and short positions. So whether markets rise or fall should be irrelevant; what matters is whether the assets you buy perform better than the assets you sell short. Investing in these non-directional strategies can help to reduce overall portfolio volatility and smooth returns. And, because the dynamics behind alternative risk premia are unrelated and have different drivers, they can offer powerful diversification benefits.

Until recently, access to alternative risk premia was limited, but systemised investing has made such strategies widely available. Their rules-based systemised processes analyse vast volumes of market data and make objective, emotion-free investment decisions, which can lead to more consistent results – particularly at times of severe market stress.

Conclusions

As concerns grow about stretched asset valuations and rising volatility, many investors are looking for uncorrelated sources of return to help them achieve their long-term objectives. Absolute return strategies are a potential solution and can also be accessible, liquid and cost-efficient. The precise choice will depend on your existing investments, risk tolerance and any investment constraints, but may include fixed income, multi-strategy or multi-asset alternative risk premia strategies.

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