Absolute return evolution
Category: Japan, Global, Europe, U.S.A., United Kingdom
Building more certain investment outcomes
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“In this world, nothing can be said to be certain except death and taxes.”
US founding father Benjamin Franklin’s famous quote may date from 1789 but it still holds true today, as those investing in financial markets will attest. Over the last few years, investors have had to contend with extensive economic and market uncertainty, starting with the financial crisis and subsequent recession in 2008. Last year we had events including natural disasters in Japan, uprisings in North Africa, the unfolding euro-zone debt crisis and a downgrading of US debt. It is therefore no surprise that equity and credit markets reflected the uncertainty of the modern world with their volatile behaviour.
As a result, investors are seeking investment portfolios with better balance – those that still allow them to achieve their long-term investment objectives but with less volatility and less reliance on equity beta. Some are turning to less liquid investment strategies in order to achieve greater portfolio diversification. While these should add some diversification to existing traditional investment strategies, they also bring further challenges in terms of price discovery and portfolio cashflow management, and may not necessarily improve the portfolio’s risk/return characteristics.
Significant market volatility and negative returns from equities over a number of years is a challenge we have had to contend with in the UK for some time. Ten years of volatile investment returns have left many pension schemes in deficit and looking to reduce portfolio risk without sacrificing returns. To help address this, absolute return funds have evolved, aiming to deliver a positive return to investors regardless of underlying economic conditions.
Taking an absolute approach
Absolute return funds offer the potential for consistent, positive returns as they give investment managers more scope to diversify and deliver returns from a variety of strategies. They normally use cash as a benchmark with a target return over and above this. This gives managers the freedom to invest in different geographies and markets, investing wherever they see the best prospects.
Furthermore, from the investor’s perspective, the fund manager has a clear mandate to deliver positive returns and not just beat a market index. Few things have infuriated investors more in recent times than fund managers being pleased when they have only lost 15% of their clients’ monies because markets have gone down 20%! With an absolute return mandate, the fund manager cannot use equity bear markets or credit crunches as reasons for not delivering positive performance.
At Standard Life Investments, we have been at the forefront of the development of absolute return investing. In 2005, we created an absolute return portfolio as part of a ‘liabilities plus’ strategy for the pension scheme of our parent company Standard Life. Our success in helping the scheme achieve a lower-risk framework in which to meet its performance objectives is demonstrated in the significant reduction of the pension accounting deficit during some of the most turbulent markets in financial history. The attraction of this multi-asset strategy led to the launch of a standalone absolute return investment vehicle for third-party investors.
Our absolute return vehicle embodies a multi-asset, multi-strategy approach with a target return of cash* +5% (gross of fees) over a rolling three-year period. This level of return is a broad proxy for the long-term return available from equity investment. However, we aim to meet this target with less than half of the investment risk associated with equity markets. To achieve this, we employ a diversified portfolio containing 25-35 diverse and liquid strategies.
Achieving genuine diversification in a world of many possible futures
In building a genuinely resilient portfolio that can provide stable and positive performance in an uncertain world, our chosen set of investment strategies have to reflect:
- a fragile global economic recovery
- continuing high levels of market volatility
- a further surge in commodity prices
- a collapse in commodity prices
- inflation becoming a major problem
- deflation fears growing
- emerging markets growing ever faster
- the emerging markets bubble popping
… and many more.
While events such as Germany walking away from the euro or the US deciding to become self-sufficient in energy production (with a subsequent collapse in oil prices) are unlikely, they are not impossible. And these are some of the extreme scenarios we think about when deciding on the balance of investment risks within our absolute return portfolios. As you can imagine, building a portfolio to provide stable performance for this potential range of eventualities is no easy task!
As a result, our chosen investment strategies reflect a wide range of investment themes. These include traditional asset allocations as well as those that seek return in the interest rate, inflation, currency and volatility markets. We also give ourselves the extra challenge of ensuring that all of our investment strategies are highly liquid. To achieve this, we combine physical investments in large equity and bond markets with conventional derivative contracts. This allows us to implement our range of themes as efficiently and with as much liquidity as possible.
The time horizon for each of our strategies is important too. We have a long legacy of multi-asset investment management and managing large amounts of money. Therefore we have expertise in understanding longer-term macroeconomic changes and each of our strategies is assessed with the aim of delivering a positive return on a two-three year timeframe. While we constantly monitor markets, our value comes from having placed monies prudently rather than through the highly competitive world of high-frequency trading.
In building a multi-asset, absolute return portfolio, we first add market returns from traditional asset classes, including equities, bonds and listed property, which are expected to provide long-term returns superior to cash. We actively manage weightings among these asset classes depending on the macroeconomic outlook. We can seek to enhance returns from these asset allocations through our in-house security selection capabilities – also known as seeking alpha. Taken together, traditional exposures combined with fund manager alpha gives us a quite traditional multi-asset fund. These two sources should be enough to produce a positive return in a number of economic scenarios. However, during extreme economic circumstances, such as 2008 and 2011 when the markets sought safety, a number of these traditional strategies fail and diversification benefits are significantly reduced.
Therefore, to achieve true diversification and the potential for positive returns in all economic conditions, we add more advanced strategies, which we term directional and relative value.
Directional strategies are based on cyclical market opportunities relating to our views on asset classes such as foreign exchange, interest rates and inflation. For example, we are positioned against the euro, which we believe will weaken as the European economy continues to struggle with the fiscal strains of numerous euro-zone members. We therefore hold a short position in the euro versus the US dollar. This type of strategy is often unavailable to traditional funds as these asset classes do not offer a long-term reward for being held continuously. However, we expect this strategy to deliver a profit over our two-three year time horizon, and to provide diversification against other strategies we are running.
Relative value strategies allow us to exploit differences in behaviour between two normally similar markets. For example, we currently hold a position preferring large-cap companies in the US to their small-cap counterparts. The rationale behind this is that since 2003 US small-cap stocks have broadly outperformed larger companies. As a result, they are now significantly more expensive, which we believe is unsustainable and should start to unwind. This strategy will be profitable as long as large caps outperform, regardless of whether equities are going up or down. Consequently, such relative value strategies can provide further levels of diversification as they are not directly exposed to the underlying market.
The breadth of strategies available to absolute return investors ensures that diversification can be achieved even in the most demanding investment conditions. In addition, constructing a portfolio of liquid, diversified investment opportunities allows us to aim to deliver positive returns for relatively low risk in all investment conditions. This is because if one strategy fails to perform at any given time, it should be offset by positive performance from other strategies held.
For example, in recent times owning both high-yielding corporate bonds and Australian government bonds has rarely been simultaneously rewarding on any one day, week, or even quarter. However, on a multi-year view we have been well rewarded for both these positions, as the market has come to appreciate the value of assets with reliable yield in a low interest rate world and the wisdom of lending to solvent governments or corporate entities with strong balance sheets. It is strategies such as these that have allowed our absolute return approach to provide some stability in volatile markets.
Playing the long game
It is this stability that makes absolute return investment such an enticing investment for many investors. If you were offered a deal now where in three years time you would potentially have annualised returns of cash +5% for less than half the volatility of equity markets, would you take it? In the current environment, with continuing swings in market sentiment likely to cause more unrest for investors, an absolute return portfolio that offers more certainty over future return outcomes while still achieving long-term investment objectives seems like quite a good deal. While investors have traditionally hoped that equities will provide them with the increased wealth that they seek, the ability to rely on a portfolio that delivers consistent returns in all market conditions makes for greater certainty in financial planning for whatever future we find ourselves in.
*Cash is measured as 1-month US LIBID
The value of investments can fall as well as rise and is not guaranteed - you may get back less than you pay in. Absolute return portfolios may use derivatives to meet their investment objective. The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.
For more information, please contact
Bonds, Absolute Returns and LDI Solutions
Standard Life Investments
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