Investors have faced an extremely challenging environment in 2022, with factors such as the return of war in Europe and spiking inflation leading to widespread losses for traditional asset classes.
While global equity markets witnessed strong downside pressure, many historically defensive areas – such as developed market government bonds – also suffered over the period, calling into question the role of the asset class in providing much needed portfolio diversification.
With expectations of continued market uncertainty for the remainder of 2022 and beyond, investors seeing true diversification may need to consider dedicated strategies with proven uncorrelated characteristics.
Utilising risk premia
Asbjørn Trolle Hansen, head of the multi assets team at Nordea Asset Management
Stability and risk mitigation have not been the most in-demand investment qualities in recent years, as the sole focus of many investors has been to maximise returns. This has now changed, and it is understandable that many investors now do not know where to turn.
Investors look to balanced strategies for consistent returns over a cycle, as well as the ability to protect precious downside. A focus on capital preservation over a three-year time horizon undoubtedly helps when encountering a period of fear and panic in markets, like we have seen on a number of occasions over the past two years.
We do not adopt a typical method of asset class investing, such as making a top-down call or allocating to directional/beta investments. In our view, making major asset allocation decisions based on macro calls has repeatedly been proven to be a flawed investment approach.
In our view, efficient diversification is not just allocating to different asset classes, but about identifying a select number of truly uncorrelated positions able to deliver through all market environments. This is why we look at a broad and diversified set of 20-30 risk premia spread across strategy types and asset classes. The concept of risk premia is well known, but experience and the right toolkit are vital when looking to capitalise on this segment of the market.
Within a multi-asset portfolio, equities offer the highest return potential, but also contain the greatest source of risk. To counter this, we seek exposure to stable/low risk equities, which have repeatedly demonstrated an ability to perform better through periods of heightened volatility. These stocks display a greater degree of solidity in stock price, earnings, dividends, EBITDA and cash flow than the broader market. Not only are the defensive qualities appealing, but these stocks have also proven to participate relatively well on the upside.
Ability to short
Barry Norris, manager of the VT Argonaut Absolute Return fund
‘The party’s over now, the dawn is drawing very nigh,’ once sung Noel Coward. Central banks who were supposed to take away the punchbowl before the party was in full swing forgot. A lot of people did and said a lot of silly things. Remember that Tesla price target of $22,000? Now the band still need to be paid, and the economy’s got a dreadful hangover.
And it all used to be so easy. Everything used to go up. Central banks and governments handed out money in a panicked response to Covid. Now nothing works in the global economy or financial markets. If you are lucky, your wealth is only dying slowly. Worst still, although interest rates have been rising, they remain below the inflation rate to an unprecedented degree. No central bank in recent memory ever tamed inflation with negative interest rates. Until central banks turn dovish, there will be no respite for any financial assets.
Bonds were supposed to be defensive but not with high inflation. Equities have earnings and interest rate risk. Property is just a play on cheap money. Cash is locking in a real return loss. Don’t even get me started on crypto, the biggest Ponzi scheme of all time.
VT Argonaut Absolute Return has been delivering uncorrelated annualised average returns for over a decade. Our best month ever was during the Covid crash. It is not a typical ‘absolute return’ fund which charges a high fee for going nowhere – would rather not have the moniker, but there is no other place for us to go.
Our ability to short, awareness of style risk in portfolio construction and an overall valuation discipline has meant that the fund has powered on to new highs, whilst the market crashed, and most growth funds blew up. During a bull market for everything, it is easy to overlook the value of an uncorrelated return. Not so much in a bear market, particularly one that might last years.
Unique structural returns
Toby Hayes, portfolio manager, Trium Capital
There simply is not enough exposure to truly uncorrelated returns. This is something underlined by the recent acute volatility; as the tide has been drawn, the asset classes without real diversification have been found, as Warren Buffett famously said, to be swimming naked. Fortunately, many allocators have been building their exposure to liquid alternatives that can act as fixed income replacements and provide sources of uncorrelated returns. For example, structural returns are not only unique, but their idiosyncratic nature and fundamental underpinnings make them one of the purest forms of diversification.
Their defining characteristic is that their return profile is independent of traditional risk factors such as Federal Reserve policy, macroeconomics, the pandemic response, or corporate earnings. Instead, they are driven by quite esoteric factors, such as the weather, taxation policy, regulation, seasonality, index rebalancing, congestion, and credit rating slippage. These factors are specific and unique to the market in question.
The steepness of curves, the volatility regime, and the inflationary regime can amplify or dampen the magnitude of structural returns. Some structural returns require volatility and inflation to perform, while others prefer calm environments. Certain structural premia exhibit long periods of performance, followed by periods of dormancy. We map structural premia against their preferred environment and the prevailing economic conditions – be it inflation, deflation, or high and low volatility.
There is no one ‘event’, pandemic, global depression nor Federal Reserve policy pivot that hurts structural returns at the same time. Their ability to diversify is fundamental, not just statistical. In this regard, they are unique in finance and should have an essential place within a balanced portfolio. Not only are they truly uncorrelated, but structural return strategies can be geared towards the prevailing economic outlook. Whether deflationary or inflationary, high or low volatility conditions, structural returns offer the rare quality of certainty in an uncertain environment.
Seb Jory, manager of the TM Tellworth UK Select Fund
Our UK Select equity strategy sets out to be uncorrelated as a core principle. When we started out in 2019, we designed a fundamental stock-picking product that we thought could be genuinely market neutral. This does not mean ‘zero net cash’ or contorting the portfolio into an arrangement of stocks to arithmetically produce a zero ‘beta’ – the ex-ante modelled sensitivity to the stock market. It means being able to perform in all market conditions: up, down and sideways markets and particularly protecting capital during equity market ‘rotations’, where headline index levels are not so volatile, but sectors and other stock groupings disperse wildly.
Our framework rests on two approaches to risk that are distinct. The first depends on our knowledge of the stocks in our UK Mid & Large Cap universe – we need to find longs and shorts that are ‘loose pairs’. This means they may not be perfect pairs in the same sub-sector – this is not possible in a relatively small equity market like the UK – but we make sure that all of our stock ‘clusters’, whether it’s Travel, RMI, Banking or Growth TMT, have no significant net exposure. It relies on our judgement of whether the market views certain stocks as in the same ‘category’ – we think this is a good, common-sense starting point.
The second is totally objective – we use regressions on all stocks in the universe to determine the key factors driving the share prices. The obvious ones are ‘market’, ‘value/quality’, ‘cyclical/defensive’ and we would also add the ‘domestic’ factor. But it’s also important to check in on thematic risks like ‘oil price sensitivity’ or ‘lockdown/re-opening’. When we aggregate these scores up to our portfolio, we can make sure our fund is not particularly biased to any one factor, insulating our investors from macro risks.
The proof of the pudding, in terms of a strategy that claims to be neutral or ‘all-weather’, can only be in the eating. We’ve been forced to rule nothing out in future – and the best way to approach this is to magnify the portfolio towards risk investors actually want to take and not those they don’t. For us – that’s the stock picking, not the macro.