The Covid-19 pandemic has had an unprecedented impact on corporate earnings and has significantly increased correlation between traditional asset classes like bonds and equities. At the height of the outbreak in the first quarter of 2020, investors sold equities and bonds, including Treasuries, and rushed to the safety of cash.
A portfolio that combined both equities and fixed income would have provided little diversification benefits during this time. As a result, the current lack of a clear resolution to the crisis raises a key question: what, then, are the options for investors seeking to protect their portfolios?
“Diversification is easier to achieve in an up market than in a down market,” says David Elms, head of diversified alternatives at Janus Henderson Investors. “When things are going badly, the tendency is for everything to be dragged down together.”
His team uses six different strategies, including one specifically constructed with the aim of protecting portfolios from losses.
Limited benefits of bonds, for now
According to Elms, the traditional approach of buying bonds to protect against any downside and still achieve returns has its drawbacks.
“Ever since the late 1990s, you’ve had what’s called the ‘Fed Put’. It’s the idea in investment markets that if something goes wrong, the Fed will cut rates aggressively and bonds will rally, and this will protect investors portfolios,” he explains. However, as bonds are sold off and sovereign yields go to zero, or lower, capital gains from bonds can no longer hedge against losses from stocks.
The notion that long-duration exposure to bonds provides protection “is not valid indefinitely”, he stresses, adding that the outlook for bonds is “difficult over time”.
Even as interest rates moved into negative territory, Elms believes there is limited upside to duration. “We think the policy response to the crisis of supporting financial assets and effectively injecting massive quantities of money relative to GDP, particularly in the US, is ultimately bad for bonds.”
While holding bonds, particularly short-term Treasuries, can still preserve capital, historically low interest rates mean their potential to generate both income and capital gains is reduced. This is the case even if the negative correlation environment of last 20 years – bonds rising when stocks fall – continues.
Delivering for investors
A criterion for success is delivering diversification in a down market. “Our strategies are designed not to be directional,” says Elms, adding that they can help to produce positive returns when the equity market, typically the biggest risk driver in portfolios, is down. According to Janus Henderson's analysis, since 2000, the S&P 500 has experienced a drawdown of 20% or greater in about a quarter of all rolling one-year periods.
The six main strategies the team employs to mitigate risk are: convertible arbitrage; event-driven; equity market neutral; price pressure; risk transfer; and portfolio protection. These investing approaches seek to take advantage of pricing inefficiencies that often occur in turbulent markets.
For instance, the event-driven approach performed strongly in April 2020, Elms explains, when risk-taking opportunities that had become significantly dislocated due to pricing differentials began to price a more normal outcome. The merger arbitrage spread – the difference between the price of a company being acquired and the terms for the acquisition – widened during March 2020, amid concerns that deals would not complete due to the pandemic.
“We've been running our portfolio for some time, and the March quarter was the biggest test. We're satisfied with the way it performed to protect our investors' portfolios at a time when they needed it most,” Elms adds.
Portfolio protection strategy
A critical differentiator is the sixth strategy – portfolio protection. This is designed to help generate positive returns when the market goes down. “Think of it as an embedded tail risk strategy,” explains Elms. “This is the differentiator that enables us to deliver our objective of producing robust returns when the market is down.”
Within the strategy are three distinct sub-strategies, each of which provides protection in different market scenarios: systematic long volatility; systematic trend following; and discretionary macro, which takes advantage of shifts in macroeconomic trends.
While large market swings bring difficult trading conditions, many alternatives strategies thrive on the opportunities created by higher volatility.
“A difficult environment for us is when volatility is low and the rewards for taking risks are low,” says Elms, referring to the period of subdued volatility through most of 2019 and into early 2020 before the pandemic. “Many traditional strategies gear up in a low volatility environment. We do not and that was difficult for us, as we were running at the low end of our risk budget for a long period of time.”
Lack of a playbook
Even as the current market conditions provide a fertile ground for alternatives strategies, Elms says these are implemented with caution.
His team runs different scenarios on how the markets will unfold to ensure the strategies are effective. “This is because there is no playbook for what we're experiencing,” he explains.
With Covid-19, there isn't any historical data the market can use to predict the future. “The absence of relevant history is one of the reasons many quantitative strategies that rigorously model themselves on history have not performed as people would hope and expect in recent times,” adds Elms.
As the financial world continues to grapple with uncertainty, Elms is cautiously optimistic about the outlook for risk-taking. He notes that while the pandemic will continue to affect financial markets in the short term, the unprecedented liquidity injections by governments and central banks will lead to two significant consequences in the longer term: inflation and a weak US dollar.
“The current policy in isolation is incredibly negative for the dollar,” he says. “What this means for us, is that the currency world is likely to be an interesting place to deploy risk.”
Elms points to diversification as an overused axiom of financial markets, and as the first quarter of 2020 highlighted, true diversification can be hard to deliver. During periods of increased market stress, price movements from seemingly uncorrelated assets can often synchronise.
The question for alternatives managers in 2020, he adds, is whether or not they can match the promise of delivering truly diversified returns for investors.
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