Wellington: the case for uncorrelated returns

Wellington: the case for uncorrelated returns

Extreme monetary policy since the global financial crisis has distorted capital markets such that asset prices are defying investment fundamentals. Equity markets are no longer being driven by growth and profitability while bond yields have in many instances turned negative. Nearly a decade of quantitative easing (QE) has provided a tailwind for traditional asset classes, leading to elevated valuations, but it has done little to boost either growth or inflation. To add further complexity, populism has had a dramatic effect on recent referendums and elections around the world, raising concerns that protectionism may reverse three decades of globalisation.

We now see signs of a reversion to a more favorable environment for relative value or market-neutral absolute return strategies. The recent collapse in cross-asset correlations (see chart) suggests that this change may already be underway.

Stretched asset valuations and a rise in volatility are concerning enough for investors to look for uncorrelated sources of return to help them achieve their long-term objectives. Many are seeking to adopt more of an absolute return approach relying on a range of return drivers that have little correlation to traditional markets.

Below, we outline some uncorrelated absolute return solutions across fixed income, equities, and multi-asset alternative beta allocations. 

Solution 1: Absolute return fixed income

Absolute return fixed income strategies are a potential solution in the joint search for return and diversification. Fixed income makes up a large part of a typical insurer’s portfolio and therefore exposures to duration and credit remain the dominant risks. As a result, many insurers seek to embed diversification against these risks, particularly as current reflationary trends exert upward pressure on interest rates and as the credit cycle matures. True absolute return strategies are structured not only to seek to preserve capital, but also to take advantage of mispricing in periods of market stress.

A challenge facing insurers is to identify appropriate and cost-effective hedges. Government bonds, traditionally a go-to hedge in many core fixed income portfolios, remain highly vulnerable to sell-offs (as seen at the end of 2016). Absolute return fixed income strategies can help insulate portfolios because they have the flexibility to short fixed income assets via liquid derivative instruments (for example, government bond futures). This helps mitigate the risk of adverse market developments, such as a sell-off in credit markets or a prolonged rise in interest rates.

We believe the key to any absolute return fixed income allocation is to conduct proper due diligence to ensure that the strategy under consideration embeds the characteristics needed to deliver the desired outcomes. Such careful scrutiny is all the more essential given the proliferation of absolute return and other flexible, unconstrained fixed income strategies. Correlation analysis can help uncover the style and nature of a strategy. True absolute return strategies should exhibit low correlations to various market betas while incorporating prudent downside controls. By contrast, evidence of high correlations to credit or other fixed income markets may indicate that it is really just a levered market-dependent strategy. 

We believe that true absolute return strategies can meet insurers’ objectives, and that investors who have carried out proper due diligence on process and characteristics should be rewarded for their conviction and patience through any short-term cycles. Additionally, absolute return fixed income strategies continue to play a structurally vital role in insurers’ portfolios due to their low Solvency II charge and the diversification, transparency, and protection against rising rates they offer. 

Solution 2: Equity thematic market neutral

The macro challenges outlined in the introduction have been clearly evident in equity markets, leading to sharp periodic sell-offs. This backdrop often makes it hard to generate returns by timing market direction. Yet, with interest rates set to rise and equity valuations appearing stretched, insurance investors could benefit from steadier sources of return generated through market-neutral strategies. For insurers, market-neutral strategies have the additional potential attractions of being less constraining than traditional equity from a Solvency II perspective (as the downside hedging may reduce the equity market risk charge) while offering diversification to an insurer’s predominantly fixed income approach.

Substantial dislocations in equity markets have occurred due to political events and changing equity market factor exposure creating dispersion both between sectors and companies within those sectors. Market-neutral strategies look to capitalise on such dislocations in order to generate absolute returns, while seeking to avoid exposure to broad market movements. Not surprisingly, such strategies have proved popular in the current environment.

We believe a thematic approach is particularly suited to absolute return strategies. It is important to distinguish between more general market trends and market themes. Trends tend to be long-term shifts, such as the rise of the middle class in emerging markets, which is leading to increased consumer spending. They tend to be well grasped by markets and can generate outperformance provided investors are willing to extend their investment horizons to multiple years, or even decades. In contrast, themes are research insights on specific companies within a sub-sector that have been significantly mispriced, for example companies that we expect to benefit from the underappreciated shortage of trucking capacity in the US. Once identified, such themes can be isolated by hedging out unwanted exposures (such as market direction, sector exposure, commodity prices, or other factor drivers).

By investing in companies exposed to a given theme and then hedging these positions through investing in companies that are either not exposed or have a negative correlation, a portfolio can be built that is market neutral by design. Implementing several themes in a portfolio can create uncorrelated streams of return, offering investors an absolute return experience that is typically uncorrelated to general market movements and has lower volatility than any individual theme.

Solution 3: Multi-asset alternative beta

Given the challenging investment outlook, many investors have turned to alternatives, such as liquid alternatives, hedge funds, hedge funds of funds, or private equity. However, for some, these solutions have proved unattractive. Hedge funds have often posted underwhelming returns, with hedge funds of funds at times compounding the problem by layering on incremental costs, while private equity inherently suffers from high illiquidity. In addition, most alternative approaches incur high fees.

“Alternative beta” strategies seek to provide a more appealing solution, with returns that are truly diversified and uncorrelated to traditional markets. They are commonly associated with multi-strategy hedge funds, although alternative beta strategies are now accessible through more readily available and more liquid instruments. 

Sources of alternative beta include relative value, momentum, equity style factors, carry, and market-neutral strategies. What makes these positions “alternative” is their implementation, which requires both long and short positioning to potentially capture their returns. Examples include:

  • Merger arbitrage seeks to earn a premium for taking on deal risk. In a merger arbitrage strategy, the objective is to short the acquirer and go long the potential target. Typically, the target’s stock price tends to rise toward the takeover price as the likelihood increases of the deal closing, whereas the acquirer’s stock price tends to fall. This trade attempts to capture the spread between the price offered for the target and the target’s market price.
  • Carry seeks to capture a yield differential, which is the spread between high-yielding and low-yielding assets. Positions are typically implemented by shorting the low yielder and using those proceeds to go long the high yielder. A common example of this strategy is currency carry. 
  • Momentum strategies aim to exploit market trends. For example, behavioral biases can cause investors to panic and sell securities in times of volatility. As the selling intensifies, a trend can develop. When such downward trends are identified, momentum models can take short positions to seek to benefit from the price movement.

We believe that an allocation to alternative beta strategies can offer the potential benefits of both diversification and transparency at a lower cost than other alternatives approaches. Insurers may therefore wish to consider some of the wide range of possible investment approaches based on alternative beta.

Conclusions

As concerns grow regarding stretched asset valuations and a rise in volatility, many investors are looking for uncorrelated sources of return to help them achieve their long-term objectives. 

At Wellington, we believe that absolute return strategies are a potential solution that can offer both stable returns and reduced volatility. These strategies can also be accessible, liquid and cost-efficient.

The most favorable choice for you will depend on your existing investments, risk tolerance, and constraints imposed by Solvency II. Portfolios can be structured for uncorrelated market-neutral returns using fixed income, equities or multi-asset alternative beta strategies.

To discuss how an uncorrelated strategy could benefit your portfolio given the challenging market outlook, or to learn more about how Wellington Management can help you achieve your overall investment goals, please contact:

Bob Sharma, Insurance Relationship Manager, London (44-20-7126-6068; bssharma@wellington.com)

Susanne Ballauff, Business Development Manager, Frankfurt (49-69-677761-502; sballauff@wellington.com)

Ray Helfer, Director Global Relationship Group, APAC, Hong Kong (852-2846-6006; rehelfer@wellington.com) 

Eric Tanaka, Director Financial Reserves Management, Boston (01-617-263-4040; emtanaka@wellington.com)

Any views expressed herein are those of the authors, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. The material and/or its contents are current as of the most recent quarter end, unless otherwise noted. Certain data provided is that of a third party. While data is believed to be reliable, no assurance is being provided as to its accuracy or completeness.

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