Dancing to a different tune
Hear more on absolute returns strategies with Insight’s Andrew Cawker
The overriding characteristic of today’s financial markets seems to be uncertainty. Fear and greed drive financial markets: with so much uncertainty with regards to the contrasting economic prospects around the world over the next 12 months, fear currently has the upper hand. Sonja Uys, portfolio manager at Insight Investment, looks at the challenge of limiting the effects of market direction on returns.
Previously when investors were thinking about where to invest they would open the traditional investment playbook and relate the performance of different asset classes to the evolution of the business cycle and the outlook for growth and inflation. But these are different times. With unpredictable business cycles, lacklustre growth and areas of the developed world overshadowed by the threat of deflation, this is far from a ‘normal’ recovery. Highly unorthodox policy responses have led to highly unusual financial market conditions. Indeed, almost a third of eurozone government debt – across maturities – now trades at negative interest rates. A new playbook is required.
An additional complicating factor is that the ongoing weak global economic recovery contrasts with the strong performance of individual asset markets. Developed equity markets and global government bonds have made significant double-digit returns since March 2009. While the economic benefits of quantitative easing are likely to be debated in academic journals for many years to come, it is clear that the cheap money era has been extraordinarily kind to investors.
A guessing game
In equity markets, valuations seem to be discounting future growth yet the underlying economic picture has become more mixed and policy is diverging. The threat of deflation in Europe has pushed the European Central Bank closer to its own quantitative easing (QE) programme; in Asia, the regional growth locomotive, China, has sputtered of late; while the Bank of Japan has thrown yet another QE-shaped kitchen sink at solving its continuing economic woes.
Trying to forecast future market returns will always be at very best an inexact science. But the current investment landscape is particularly difficult to navigate. Bonds and other interest-rate sensitive assets seem particularly vulnerable. With yields at or near record lows the risk now is clearly asymmetric: any future gains from yields falling further are likely to be outweighed by losses when yields rise.
The outlook for equities is also uncertain for the coming years. With QE in the US concluded and a recent marked shift in the Fed’s tone about labour markets, rising US policy rates are now on the agenda for 2015. Equity markets have benefited most in the QE era, but a rising cost of capital will increase the cost of borrowing for both individuals and corporations, with knock-on effects for consumption and investment.
The volatility spike that rocked markets at the beginning of fourth quarter of 2014 may have been just one manifestation of prevailing investor uncertainty. Against this backdrop, attempting to second-guess what is an unknowable future is likely to be even more prone to error than is usually the case. Long-only, buy-and-hold investment strategies which make an underlying assumption on upward market direction seem potentially ill-suited to the current environment.
In the driver’s seat
As absolute return strategies focus on an outcome, regardless of market conditions and direction, they can be focused on assets that might benefit from rising rates; make use of relative value trades; and utilise the freedom of relatively flexible investment guidelines, in particular the use of a cash benchmark.
In an environment of rising interest rates, investors may be well-served by strategies that are either insensitive to interest rate moves or will benefit from rising rates. Derivatives can be used to hedge out interest rate risk, making the value of a portfolio immune to changes in interest rates. Whether to take interest rate risk or not therefore becomes an active decision of whether or not to hedge the exposure. Other strategies may have high cash balances – for example those that use derivatives rather than physically buying securities – and would typically benefit from a rise in cash rates, or suffer if rates were to fall.
Some strategies invest using relative value trades. For example, an absolute return manager might express a view that large cap equities will outperform small cap equities, or that Italian bonds might outperform German Bunds. The driver of returns will therefore be for the one asset to outperform the other, rather than being driven by the general direction of the market.
Having a cash benchmark and a high degree of investment flexibility means that an absolute return manager can start with a blank sheet of paper – only investing when there are attractive opportunities. The ability to take both long and short investment views on markets or individual securities gives an absolute return strategy the ability to perform well in both rising and falling markets.
Economics is often called the dismal science. Market forecasting is its guessing cousin. Attempting to predict market direction is never easy, even when economic and market trends are clear. Increasing fears over growth and the threat of deflation in some major economies, the likelihood of US rate rises and the impressive returns seen across asset classes since 2009, combine to make the current outlook unusually hazy. Strict outcome-orientated absolute return strategies are designed to limit the role of market direction in their overall return profile; in these uncertain times that’s a valuable tool to have at your disposal.