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 is a reasonable question. And then a global pandemic hits and the ensuing market rupture offers a chance for redemption.
Government bonds: A golden age that won’t be repeated
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.
The subsequent and structural 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 1 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 forever 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.
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, with earnings multiples on US stocks now at their highest level since the 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.
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
The challenge of where to find attractive investment opportunities is clear. 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.
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.
All of which begs the question: how realistic are those objectives if prospective returns from traditional asset classes are diminished?
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 is 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.
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 10.
Relative-value trades tend to have little beta and are almost wholly reliant on manager skill instead. 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 diversify exposure.
Furthermore, 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.
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, though we will still hedge out risks, we will only do so when we believe they could be truly destructive to potential performance.
Managers should never 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.
Instead, 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.
Peter Fitzgerald is the chief investment officer of multi-asset & macro at Aviva Investors; and Mark Robertson is head of multi-strategy and portfolio manager at Aviva Investors