The COVID-19 pandemic has brought many things into focus, reminding investors of the shock of a market crash. With bond and equity prices already back at levels that seem to belie the harsh economic reality, Peter Fitzgerald and Mark Robertson believe it could be time to reconsider absolute return multi-strategy investing once more.
10 minute read
It is a familiar story. Markets rally, a long bull run ensues, and investors forget the value of downside protection in their portfolios. Those that do hold firm begrudge the performance drag on their overall returns; most, however, either succumb to short-term financial amnesia or get swept away with the buying herd – either way, they sell out of defensive positions and strategies.
That explains one side of the multi-strategy story of recent years. The other side, of course, is one of a sector marred by underwhelming performance and missed return objectives. Who can blame the sellers, some might ask? It’s a reasonable question. And then a global pandemic hits and the ensuing market rupture offers a chance for redemption.
For end clients, the future of the multi-strategy sector really matters. This is not a theoretical debate. As more and more individuals have control of their own retirement destiny with defined contribution pensions as opposed to defined benefit pots, the risk of them crystallising losses at inopportune moments is significant and growing. In this article, we assess the outlook for multi-strategy investing and explore where and how it might need to evolve.
A shock to the system
Part of the explanation for the severity of the sell-off in March was the widespread belief that, having exhausted all their ammunition, central banks would be powerless to prevent the pandemic from inflicting deep damage on the global economy. And although there are tentative signs of economic recovery for some economies, the outlook remains highly uncertain – especially with the unintended adverse consequences of negative interest rates becoming ever more apparent.
Leading economies could be in for a prolonged period of sluggish economic growth
Even if signs of a pick-up in activity can be sustained, once the initial recovery phase is completed, leading economies could be in for a prolonged period of sluggish economic growth, weighed down by excessive levels of debt.
For now, most investors appear to believe the worst is over and that the ‘Fed put’ remains firmly intact; central banks appear to have regained control of government bond markets, pinning yields at record lows. Over the longer term, however, investors will inevitably speculate as to whether central banks can extricate themselves from their current monetary policy stance ahead of the next downturn.
Government bonds: A golden age that won’t be repeated
Just six weeks after the UK sold three-year debt at a negative yield for the first time, the US sold ten-year bonds at a record low yield.1,2
However, it was a new 100-year issue from Austria at the end of June that really caught investors’ attention. The auction provided a vivid example of how desperate investors are to snap up highly rated securities with any kind of positive yield. Strong demand from pension funds and insurance companies, looking for ultra-long assets to match liabilities, resulted in the issue being ten times oversubscribed; the bond offers a yield of just 0.88 per cent and Austria sold €2 billion worth of them.3
This collapse in government bond yields is a double-edged sword for investors. For the past four decades, government bonds have made an important contribution to the performance of multi-asset portfolios.
First, they have provided one of the few reliable means of diversifying a portfolio of risky assets. Better still, they have delivered consistently positive performance. One hundred dollars invested in a basket of US Treasuries at the start of 1980 is now worth nearly $1750. That is equivalent to an annual compound return of 7.3 per cent. Even allowing for inflation, bonds have returned 4.3 per cent a year.4
The collapse in government bond yields is a double-edged sword for investors
While there is little prospect of yields rising in the foreseeable future, such a golden age for bonds is not going to be repeated. A bond’s yield to maturity is the most important determinant of how much it is expected to return over its lifetime. With nominal yields negative in many cases, and real yields even lower, it is mathematically impossible bonds will return anything like as much in the next 40 years as they have over the last 40.
Secondly, as Figure 1 shows, nominal interest rates have also been steadily declining around the world. Overall investment returns have been augmented by capital appreciation. With no room for most central banks’ main policy rates to fall any further, this return foundation can no longer be relied upon.
Figure 1: Long-run decline in main policy rates
The collapse in government bond yields has profound implications for investors. When a country like Austria, which is not even AAA rated, can issue 100-year debt for less than one per cent, investors in traditional fixed income products face an inescapable choice: accept much lower returns than they have been accustomed to, or take more risk.
This could mean accepting greater credit risk, by buying junk bonds for example, reaching for ever longer duration, or a combination of the two. Those prepared to do this have in recent weeks been handsomely rewarded. For example, corporate bond prices have surged in response to collapsing government bond yields and as central banks snapped up record amounts of corporate debt. By June 30, the yield on the Bloomberg US Corporate Investment Grade Index had fallen to a record low of 2.2 per cent.
Figure 2: Investment grade yields plummet
Just as with government bonds, however, this rebound in credit valuations diminishes prospective returns – once again, potentially for a long time to come.
Similar arguments apply to equities, which have risen sharply from their March nadir at the same time analysts slashed their earnings estimates. As Figure 3 shows, this has pushed forward price: earnings multiples on US stocks up appreciably. They now stand at their highest level since the dot.com bubble.
Figure 3: P:E ratios at highest since dot.com bubble
A world starved of growth
The rise in P:E ratios is arguably justified given how low interest rates are. After all, the value of risk assets is partially determined by applying a relevant ‘risk-free’ interest rate to expected future cash flows. Moreover, in a world starved of growth, some investors will understandably re-rate large, solid multinational businesses with stable and healthy cash flows.
At the same time, however, corporate profits are under pressure from several directions, particularly the uncertain economic environment. Even if economies can recover quickly, future levels of growth are likely to be constrained by the need to reduce debt, which is already at record levels.
Economic growth on its own does not explain equity market performance. As Figure 4 shows, over the past half century the US stock market has risen seven times as fast as economic output. In part, this is explained by corporate profits taking an ever-bigger slice of the economic cake. However, companies will be unable to continue growing their share of the economic spoils indefinitely.
Figure 4: US stock market has risen seven times as fast as GDP
The stock market’s performance is also explained by the inexorable decline in interest rates, which has boosted the net present value of those earnings. As with bonds, this windfall is not going to be repeated.
Interestingly, the bulk of the outperformance relative to the economy took place after the global financial crisis. During this time shareholder returns have been propped up by share buybacks and companies increasing dividends thanks to record debt issuance. In the US, big tax cuts in November 2017 provided a further boost to firms’ profitability.
The investment conundrum
Once again, it is doubtful either of these tailwinds will be repeated. The current pandemic has highlighted the dangers of over indebtedness, and corporation tax rates seem more likely to rise than fall as governments confront skyrocketing deficits.
The challenge of where to find attractive investment opportunities is clear. While equities may at least hold the prospect for potential capital appreciation, unlike the majority of bonds, most multi-asset investors are unlikely to want to re-allocate significant capital away from bonds into shares. Equities are already a big driver of risk in a typical 60:40 portfolio. They may be 60 per cent of the assets but they constitute more like 90 per cent of the risk.
Multi-asset investors are unlikely to want to re-allocate significant capital away from bonds into shares
Moreover, whereas an investor may be prepared to tolerate the risk of a ten per cent drawdown to secure a 20 per cent return, taking on that level of risk suddenly looks far less appealing if the return on offer is significantly reduced.
Aware they are not going to get very much, if anything, from allocating to bonds, not wanting to take more equity risk, and in need of diversification against the rest of the portfolio, investors are running out of options.
Ultra-low bond yields have prompted many multi-asset investors to shift some of their bond allocation into infrastructure investments and other types of real assets in an attempt to find steady real rates of return and portfolio diversification. Demand for these investments could continue to grow, especially if governments try to reignite economic growth by encouraging privately funded infrastructure projects.
However, there are limits to how much capital investors will be prepared to allocate to real assets – lack of liquidity being the most obvious factor. Boosting risk-adjusted performance could therefore mean looking further afield and absolute return products offer a viable alternative.
The appeal of downside protection
Absolute return strategies that offer downside protection at the same time as delivering a real rate of return in line with pensioners’ or other end investors’ objectives, ought to have appeal for many investors, so long as they can deliver on their performance objective.
How realistic are those objectives if prospective returns from traditional asset classes are diminished?
All of which begs the question: how realistic are those objectives if prospective returns from traditional asset classes are diminished? After all, while absolute return funds are designed to rely far less on market beta than traditional long-only funds, historical performance data shows the vast majority are nonetheless exposed to the performance of underlying markets to varying degrees.
Our multi-strategy portfolios contain a variety of strategies that we split into three ‘buckets’, each with different drivers of returns, which we label ‘market’, ‘opportunistic’ and ‘risk reducing’.
Under normal circumstances, the bulk of each of the funds’ performance would be expected to come from the market returns bucket. However, with prospective returns from equities diminished, and those from bonds even harder to come by, it will likely be harder to make as much money from holding long positions in either asset class.
That it not to say it will be impossible as even fixed income contains a diverse opportunity set. Historic tables of annual returns show there is almost always one segment of fixed income capable of doing well, whether that is short-duration high yield, long-dated sovereign bonds, or bonds denominated in a particular currency. That is especially true where managers have the leeway to home in on very specific market segments.
Nonetheless, in the current environment we anticipate no more than 30 to 50 per cent of overall performance coming from market returns, which is appreciably less than before.
Focusing on relative-value strategies
Given potential challenges for market returns, opportunistic or relative-value strategies that don’t take a lot of directional risk will have an increasingly important role to play. For example, whereas our flagship target return strategy would have rarely contained no more than two relative value equity strategies, it now has ten.
Since it is harder to generate money from relative-value trades than market directional ones, the decision to strengthen the company’s equity capability at the end of 2017 was vital. Relative-value trades tend to have little beta and are almost wholly reliant on manager skill instead. So, it makes sense we invested in our people and our investment platform to try to generate the best investment ideas.
Making sure there is little commonality to the underlying investment rationales underpinning each strategy helps to diversify exposure
Obviously, there is a risk that by increasing the number of equity relative-value strategies, expected returns will simply be diversified away as losing strategies cancel out winning ones. However, while some of these strategies may give us a small amount of beta exposure individually, we aim to ensure as a whole they give us very little. Beyond that, making sure there is little commonality to the underlying investment rationales underpinning each strategy helps to diversify exposure.
Of course, the ability to take non-market-directional positions potentially offers an important advantage of absolute return funds relative to conventional long-only funds. For example, uncertainty over the outlook for inflation, as central banks print record amounts of money, is currently offering up attractive opportunities within fixed income that long-only managers cannot exploit so effectively.
Just like long-only funds, we can buy inflation-linked bonds. But crucially we can simultaneously go short conventional debt against them. That protects the portfolio in a world where inflation does come back, for limited cost in the event it doesn’t.
The income challenge
Income-hungry investors are likely to find life every bit as hard. In addition to bond yields falling, dividend yields have declined as scores of companies cancelled or cut pay-outs to conserve cash during the pandemic.
Strategies that aim to generate stable levels of income by tapping into diverse streams offer a compelling proposition
With investors in traditional equity and bond funds again facing an unenviable choice of either accepting less income or taking more risk, strategies that aim to generate stable levels of income by tapping into diverse streams, while simultaneously attempting to protect capital, offer a compelling proposition.
Although our multi-strategy income fund can gain exposure to a broad array of assets capable of generating income in all market conditions, such as equities, credit and emerging-market debt, there is an equal emphasis on managing downside risk. For instance, the fund currently has strategies in place to protect investors from big drawdowns in the event markets go into reverse once more.
Similarly, it makes sense to sacrifice some upside potential in order to improve the chances of securing the income objective, for example by selling out-of-the-money’ options on shares the fund already owns. While that admittedly caps the fund’s potential upside from owning the shares, it offers a fair degree of downside protection while at the same time boosting income. That is because we get to book the call-option premium, on top of any dividend received on the shares, as income.
In the event the shares rally above the strike price and we have to deliver the stock to the purchaser of the call option, there is nothing to stop us replacing them. We estimate the strategy delivered between 80 and 90 basis points of incremental income in 2019.
Refining the investment process
A frequent criticism of the absolute return and multi-strategy sectors has been the sacrifice of investment returns in order to manage volatility. We accept that in the past our funds have on occasion spent too much time trying to hedge out too many risks. While that helped preserve capital, it meant giving up potential returns. In future, while we will still hedge out risks, we will only do so when we believe they could be truly destructive to potential performance.
However, while we recognise the need for funds to try to hit their objectives over any given three-year period, it is equally important managers do not end up blindly chasing returns. Our funds have been resilient and done a decent job of protecting clients’ capital from big drawdowns and it is important this continues. Clients can rest assured we will not simply be taking more risk to try to hit their fund’s return objectives.
Despite a difficult couple of years in 2017 and 2018 when our flagship fund failed to capture as much of the strong rally in asset prices as we would have liked, we have taken various steps to address this.
We have improved our investment process, most crucially in terms of the monitoring of individual strategies
Aside from investing in the equity business, we have improved our investment process, most crucially in terms of the monitoring of individual strategies. Now, where a strategy is not performing well, managers are more ruthless in questioning whether the original investment thesis still holds or if there are any new potential drivers. Similarly, where strategies have done very well and hit their upside target, capital is being recycled into other strategies more quickly.
As with any aspect of life, improving an investment process only happens if you are prepared to learn from your mistakes. Multi-strategy funds may well have limited appeal to investors who think markets are going to deliver strong returns over the next two to three years. But for others, who are less certain about the prospects for financial markets, it might not be a bad idea to allocate some capital to a fund that at least has the potential to generate a satisfactory outcome, is fairly uncorrelated to the rest of the portfolio and above all offers downside resilience.
We saw markets crash in March. The bounce back has been almost as rapid. But this crisis looks far from over. And even if it is, long-only investors need to accept they will have to take a lot more risk than they have been used to generate an acceptable return.