Higher inflation, exacerbated by geopolitical conflict, rising rates and recession fears have converged to create a challenging time for investors. And for traditional 60% stock/40% bond investors it amounts to a perfect storm.

For the past 20 years or so, bond and equity returns have enjoyed a negative correlation; when one goes up, the other goes down. This relationship has helped traditional 60 / 40 investors to reduce portfolio volatility and risk during times of market uncertainty. During an equity correction, for instance, investors could fall back on the value of their bond portfolio for protection.

Lately though, this combination simply has not worked with both equity and bond markets falling meaningfully in tandem. And with no signs of difficult current market conditions abating, this has fuelled fears that we could witness a reappearance of the positive equity / bond correlation last seen in the 1970s and early 1980s.

As a consequence, many investors are recognising the need to look beyond a traditional 60 / 40 structure in favour of a more modern approach. In particular, the concept of achieving diversification via uncorrelated strategies rather than across asset classes is gaining ground.

The growing adoption of absolute return bond (ARB) strategies is one such example. Absolute return funds typically seek to achieve positive returns in all market environments. They have no benchmark and so should be measured by manager skill through their level of risk-adjusted returns, or the return relative to the amount of risk used to achieve it.

In ARB Funds, the goal is to construct a portfolio that has appropriate characteristics in terms of its duration, yield curve, credit, country and currency exposure. The fund should utilise a full derivative overlay to help achieve positive returns in a rising yield environment. The process should look to achieve diversified returns across the fixed income and currency spectrum, and not rely on any one specific area of the market. The funds come with varying degrees of liquidity and volatility. Macro themes will often last a reasonable period. However, investment time horizons will tend to be shorter as the strategy is continuously reinvented to fit those longer macro themes and achieve its positive return objectives.

In recent years many ARB strategies have suffered outflows as they struggled to deliver the uncorrelated returns they promised investors as long-only dominated investor flows against the backdrop of falling interest rates. This was supported by extraordinarily loose central bank policy in the wake of the financial crisis, damaging macro volatility and proved a difficult environment for ARB investors to find diversified returns.

More recently ARB investing has seen an increasing level of interest as portfolios have experienced challenging markets for the 60 / 40 investment weighting and investors seek diversification elsewhere. Inflation fears have ignited concerns over fixed income markets as the cycle has turned higher. The extreme policy action by central banks has also created opportunity as economies move at different speeds offering up diversified returns that ARB managers can take advantage of, something traditional fixed income funds struggle to access. The absolute return asset class is definitely attracting attention.

However, investors are scrutinising funds more intensely after previous experiences, making sure these strategies truly offer diversified exposures to traditional fixed income investments.

More traditional 60 / 40 portfolios will likely struggle to make positive returns as the global economy continues to recover from the pandemic, monetary policy is tightened and as inflation continues to rise. In this context we believe Absolute Return Bond funds should form part of a permanent allocation of well-diversified, multi-asset portfolios thanks to their ability to generate uncorrelated returns and therefore to improve the overall risk profiles of portfolios.

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