Investors hoping to replicate bond-like returns (low to mid-single digit, low volatility and drawdown) are facing an unenviable predicament. How can they generate acceptable, positive returns without simultaneously suffering illiquidity, valuation uncertainty, gap risk, and other hard to quantify risks?
- Carefully constructed portfolios of liquid and alternative strategies can form a credible substitute for traditional bond allocations
In a world full of return-free risk, and about $18trn (€15trn) of debt trading at negative yields, accounting for about 30% of the world’s investment grade debt, investors are facing tough choices. Investment committees worldwide are wrestling with bond maturity reinvestment and rotation out of negative yielding bonds to help offset the liability side of the equation.
It is therefore no surprise – with a flood of capital looking for a home – that the market has seen the creation of numerous private debt vehicles. These are trying to provide the return stream desired by institutional investors while filling a role that the banks formerly played in providing capital to corporates. The managers are promising insulation from market moves. This is achieved partially by not having to mark less liquid positions in longer-dated vehicles and promoting the more ‘attractive’ returns that public markets cannot.
Investors are faced with an embarrassment of choices when it comes to what these investment funds are willing to finance. These range from mundane mortgages and car loans, to point-of-purchase consumer loans, financing for beauty treatments, loans for domestic workers in Asia and loans for ESG projects. Even credit for manufactured housing or the latest recreational vehicles can be covered.
Some of these funds clearly have robust underwriting processes in place. They have teams of seasoned professionals, loan-to-value ratios that make sense and liquidity terms that match their portfolios. Others, however, are trying to capitalise on the current need for yield and are pushing the limits of prudence.
Much of what is happening today is reminiscent of the pre-2008 development of lending funds. Almost all of the current loan production, particularly from private-equity deals, is covenant-lite. It also has much lower coupons than would have been the case prior to the latest dearth of yield. Some thrived the last time this movie played. Many tried to pick up every last basis point of return by taking on more and more hard-to-quantify risks. Such moves in many cases led to significant investment losses.
The best of these funds clearly may have a place in investment portfolios. That is, provided investors are willing and able to lock up capital for extended periods of time. They should also be cognisant of the risks inherent in these strategies.
For investors not willing, or unable, to lock up capital, other choices are available. That is particularly for those with a preference for objective, real-time pricing of their holdings, and uncomfortable with the different sets of risks in private debt or lending funds. In such cases, liquid alternatives exist that do not require them to take traditional equity/fixed income/credit risks.
One such alternative is the creation of portfolios of daily liquidity products – such as pan-European UCITs funds, managed accounts and alternative risk premia (ARP). These can exhibit low market correlation and avoid the aforementioned traditional exposures. By construction and asset strategy they can provide good upside convexity during periods of crisis.
The first step in the construction of such a portfolio has to be top-down. It has to identify a range of historically uncorrelated strategies and assets to be traded in those. A forward-looking view, not necessarily directional, is an important element at this stage. Each market phase is clearly different. Identifying asymmetrical opportunities that have arisen from the current crisis not only adds return, but can also provide additional downside protection.
Of course, this part of the construction should be ongoing. The portfolio should be adjusted as new opportunities and known risks arise. Setting a reasonable expected risk-and-return target should then lead to desired allocation sizes. It should also determine the volatility and return characteristics of the strategies. It can combine a systematic bucket (updated trend-following, mean-reverting and newer 2.0 strategies/machine learning or artificial intelligence), further split up geographically as well as by trading time frame, a macro bucket (again with additional geographic specialists included), a dynamic-protection bucket (which includes relative-value volatility, as well as gold and treasury-focused strategies), an actively managed fixed-income bucket (with a focus on developed market sovereign rather than spread exposures), as well as ARP adjuncts. Together these tend to work well in creating portfolios that not only generate low volatility, all-weather returns but also provide good crisis convexity.
Cost, particularly in a portfolio aiming for single-digit returns, must be considered with a focus on not over-paying for relatively replicable risk premia. The higher the fee load, not just headline fees but total expense ratio, the bigger the obstacle to generating meaningful performance. This might result in some customised portfolios having a blend of funds like those outlined. In such cases the fees are justified by hard-to-replicate strategies and desired, although perhaps customised, risk premia with low expenses.
As these types of portfolios are liquid and daily priced, they will not be free of volatility, just like liquid fixed-income portfolios. However, if constructed properly they should not only exhibit low volatility but also low correlation to traditional markets. Crucially, they should provide returns and protection in periods of market stress.
Perhaps even more importantly, this approach is not reliant on further spread compression, or equity markets continuing their bull run. Instead, it aims to generate much more idiosyncratic returns which should be less dependent on market direction, and hence more durable in nature. This provides investors with an alternative to traditional exposures, a better option to locking up their capital for extended periods of time as a trade-off for return. If and when the broad markets have a meaningful adjustment, this more liquid and defensive component of portfolios can be complemented with less-liquid-risk positions with a palatable risk/return profile.
Patrick Ghali is managing partner and Jim Neumann is CIO at Sussex Partners