Written By: Suzanne Hutchins
Suzanne Hutchins of the Newton Real Return team contends that the flexibility of absolute return strategies enables access to different return sources within one portfolio and helps clients to overcome challenging market conditions
Strategies which have as their benchmark non-investable, cash-plus targets, such as absolute-return and diversified growth funds (DGFs), have in recent years become part of the institutional investment landscape, gaining particular popularity in the wake of the 2007-08 global financial crisis.
Such strategies encompass a disparate range of approaches. Some are managed more like hedge funds; others are relatively complex vehicles with derivatives and synthetic exposures; and others are more akin to traditional balanced portfolios. They typically share an objective of seeking to participate to some extent at times of rising asset prices, while limiting drawdowns and volatility.
In considering why, in the aftermath of the financial crisis, investors thought that absolute return strategies were a useful addition to their asset distribution, one needs to recall that, a decade ago, it looked as if the investment world had changed irrevocably. Future expected returns appeared likely to be more muted, with clients no longer able to rely on the equity market trend being “their friend”. This seemed to necessitate an active, flexible approach to investment management, and a focus on an upward-only target rather than a relative benchmark in relation to which capital preservation is typically not an aim.
As it turned out, the credit crisis was in fact the catalyst for a historic bull-market run. Low (and sometimes zero) interest rates, negative interest rates and quantitative easing (the introduction of new money into the supply via bond buying by central banks) have suppressed the yields of traditional safe-haven bond investments, encouraging investors to migrate into riskier assets, with policymakers hoping that this would reflate the real economy.
Against this backdrop of a relentless hunt for yield, and despite a number of subsequent scares, investors in risk assets have enjoyed one of the longest economic cycles in history, with strong returns available from a portfolio of global risk assets, particularly when viewed from a weak currency base such as sterling. For example, the MSCI All Countries World index has returned around 13% per annum in sterling terms over the last decade1, but such asset-price inflation has not been limited to equities. High-yield credit has experienced similarly robust returns over the same period, while various bubbles have formed in assets such as property, commodities, and even cryptocurrencies. Given this recent “super-normal” return experience, it is perhaps not surprising that investors question the utility of strategies which aim to limit risk of capital loss and target a cash-plus return.
Where are we now?
However, in an investment environment that remains increasingly uncertain and distorted, can such super-normal returns be sustained? We would contend that the current backdrop has a late-cycle feel. This is generally the phase when vested interests pronounce that “this time is different”. Well this time is certainly unusual, in that monetary support for markets has become a permanent feature. If the zeitgeist of the bubble of two decades ago was the potential for a technological revolution, and a decade later it was the finance sector’s mastery of debt, the current boom is based on central-bank policy always being on hand to support asset prices on any signs of market distress.
Our thesis remains that it is highly unlikely that the cycle has been abolished, and that the persistent stimulus over an extended period has magnified the feedback loop between the economy and the financial system. A combination of ever-increasing debt levels (and the misallocation of capital that this implies), high valuations (implying low expected returns), investors who have been encouraged to take on too much risk, and constrained underlying liquidity suggests that even a relatively mild cyclical downturn could have an oversized adverse impact on financial markets. At the present time, major economies around the globe are facing significant headwinds, particularly with regard to global trade, in relation to which frictions, and pressure on supply chains, are intensifying. Meanwhile, the benefit of cyclical improvement in employment has already occurred.
The case for absolute return
In our view, the challenge for all investors is understanding how this cycle ultimately unfolds. As already noted, we strongly believe that persistent cheap money has costs in terms of distortions. This throws up the prospect of much lower (or even negative) returns in the short term, but would also present opportunities and significantly improve the longer-term expected return for those investors who can preserve capital and be patient.
The challenge for the absolute return strategy is to beat an upward-only target (which, importantly, is not investable in passive terms) over the longer term. Where relative investors will tend to be fully committed at all times, the absolute return strategy will attempt to balance participation (in a whole range of asset classes) and capital preservation in a dynamic way through the cycle. The key aim is to create an asymmetric return profile by capturing some upside and dampening the drawdowns that are so damaging to the arithmetic of longer-term returns.
An unconstrained multi-asset, global and highly active strategy has the ability to be tactically flexible and opportunistic in a way that those strategies that rely principally on passive diversification cannot. Structuring a portfolio around a stable core of predominantly traditional return-seeking assets and an insulating layer of stabilising assets can help to set a balance between participation and capital preservation, with the aim of maximising the upside potential when markets rise, while limiting the downside risks when they fall.
The tools in the toolbox
In addition to global equities, a dynamic absolute return strategy can be exposed to a broad range of assets in the risk space, including corporate bonds and emerging market sovereign debt. Alternative investments such as infrastructure, renewables, real estate investment trusts and aircraft leasing can provide uncorrelated return streams. Following a holistically-constructed single-portfolio approach, based primarily on holdings of individual securities, means there is no obligation to invest in all asset classes at all times. Instead, one can take a selective and specific approach to investment in different asset classes on the basis of their underlying investment characteristics. It is possible to alter the style or characteristics of positions in an asset class as the backdrop changes, rather than just the weights. Likewise, wish lists of attractive securities can be activated when price levels change.
Stabilising assets in a portfolio can be used to either dampen or increase the volatility and perceived equity risks, based on the stage of the market cycle. Derivative positions can be used as a direct hedge, and can enhance returns in periods of market stress. Government bonds can be positioned as an indirect hedge to falling equity markets, while precious metals such as gold could provide a safe haven during tough economic times.
In summary, we would contend that the flexible nature of such a strategy enables clients not just to access different return sources within a single portfolio, but also to benefit from the ability to navigate a challenging market backdrop as the potentially toxic combination of deteriorating fundamentals and lofty valuations threatens major drawdowns in asset prices. Such a strategy could be used as both an insurance policy and a diversifier, and could also have a tactical role as part of an overall portfolio allocation to adjust risk levels, without giving up the prospect of sizeable capital growth through the cycle.
1. Source: Bloomberg, 30 June 2019.
Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.
This is a financial promotion. These opinions should not be construed as investment or any other advice and are subject to change. This article is for information purposes only. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell investments in those countries or sectors. Issued in the UK by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No. 01371973. Newton Investment Management is authorised and regulated by the Financial Conduct Authority, 12 Endeavour Square, London, E20 1JN.