Protection and fixed income strategies have had to adapt in recent years to the extraordinary economic environment and investors’ reluctance to miss out on returns, but that doesn’t mean the foremost experts in portfolio construction and blending strategies aren’t worried about how some portfolios are positioned.
“It’s no secret, right, that there’s just more equity exposure, there’s more credit exposure in portfolios. And that just means that the world is taking more and more risk,” Paul Britton (main picture, far right), founder and chief executive at Capstone Investment Advisers said during Investment Magazine’s recent Absolute Returns conference.
Britton and other multi-strategy and portfolio construction experts used the forum to delve into the way fixed income and downside protection strategies have evolved to accommodate record low interest rates, sporadic volatility and hot equity markets.
“The average portfolio has gone from 60/40 per [per cent equities and bonds] towards a 70/30 portfolio. And you can make a strong argument that even the 30 [per cent] doesn’t look like a traditional sovereign bond portfolio; there’s lots of credit-style strategies in there, which have an awful lot of equity participation as well,” Britton went on to describe.
The structural changes in fixed income portfolios started some five years ago when the key building blocks – government bonds – were becoming less useful, Vimal Gor (main picture, middle), head of bond, income and defensive strategies at Pendal described.
“We started doing volatility as an asset class and in the last few years we have been doing equity vol and crypto, so we are broadening out the base of what we use,” Gor said during a separate session at the Absolute Returns Conference.
As traditional fixed income has found itself challenged, thinking about portfolio construction implications has required different thinking about pathways to managing risk and outcomes, Gor noted.
“That’s certainly the impression we get as we go out and speak to super funds is that they’re looking to navigate this period where the 60/40 portfolio is no longer as relevant as it was in the past… it is about building strategies, sub-strategies that can contribute to the performance of the portfolio at certain times,” he said.
“And so it comes to this point of [asking] – how much are you willing to pay to make sure that your downside is covered?,” Gor continued.
“The answer is not very much. And so you’re coming to this point where you have to do market timing,” Gor said.
“There’s no question if you want to get coverage… you need to market time, but it’s too difficult to market time, or time correctly. That’s why we need a balance of portfolio of strategies which have the characteristics to perform at certain times of the cycle. And that’s what a multi strategy is,” he said.
Gor and also Steve Cain (main picture, far left), portfolio manager at Janus Henderson talked about volatility strategies as an important downside protection component in current portfolio construction discussions.
“We really think of volatility as the third rail… volatility is a third asset class that we can incorporate in the current environment which gives us interesting ways both to hedge the portfolio but also incorporate into our alpha strategies,” Cain noted.
The problem with using protection strategies like volatility is that they can be very difficult for funds to carry through market cycles for funds, Cain said.
“When we think about positioning volatility, we have to say ‘let’s be honest about where we are in this cycle. How long can this element of the cycle exist?’ And this gives us the opportunity to tilt towards long volatility, defensive convexity,” Cain explained.
“Market timing, unfortunately, has become something that one can’t avoid, there isn’t a static allocation to these strategies that make sense at all times during all cycles,” he said.
Cain noted that in periods like now with very benign markets and low volatility there is an extra focus on the cost of the insurance.
What funds are prepared to pay for protection in markets where valuations continue to rise as loose monetary policy fuels asset prices is a very live conversation, Capstone’s Britton highlighted.
“Fifteen years ago, the conversations would surround typically what volatility we have in our portfolio. That’s really changed. And it’s changed to now the conversation really starts with the returns that investors expect from their portfolio,” Britton said.
“It’s extraordinary loose [US Federal Reserve driven monetary] policy within the system, it is very difficult to be able to truly understand the fair value of any asset class,” he said.
“And there’s been a lot of fatigue set in when investors or investment committees look at [protection] as an individual line item… when you really look at it, the whole of the portfolio has benefited from taking more risk because you’ve been prudent in deploying a strategy that you know will defend against a market pullback and ultimately lower the volatility of that portfolio,” Britton said.