Mark Nash, fund manager, fixed income explains the merits of an `absolute return’ approach in a reflationary environment which will be better for the global economy and worse for fixed income markets.
The post financial crisis era was marked by low growth and low inflation, due to errors of policymakers. The dominance of central banks in that environment proved very supportive for financial assets. In that falling yield and low volatility world, economic outcomes were poor as central bank liquidity flowed directly into financial assets.
As the global economy recovers from the pandemic, the policymaking landscape has dramatically changed. Fiscal spending is unlikely to disappear anytime soon as inequality and global warming issues are addressed. Central banks will remain supportive but will take more of a backseat, while ensuring that banking systems are in good health to support the recovery.
This reflationary environment will be better for the global economy and worse for fixed income markets. Higher growth and inflation will see yields rise and so a more ‘absolute return’ approach will be needed to achieve positive returns in fixed income space. Funds with the ability to take short positions either outright or for relative value investments will be required and the flexibility to invest across the fixed income universe to find returns is essential.
Worst start to the year for bonds since 2009 (global agg. USD unhedged)
Strategy for all seasons
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. This incorporates the amount of return achieved relative to the amount of risk used to achieve it.
Their purpose is to manage the cycle for investors and to smooth returns as the cycle progresses, outperforming in a bear market although they will often underperform in a bull market. Methods of downside protection are often incorporated to achieve this key goal. They tend to have high flexibility and make the most use of diversification avoiding pure directional market plays to achieve a low correlation to the broader markets. They are often unconstrained and have a full derivative usage to achieve this.
Absolute Return strategies typically use top-down fundamental research to identify the macro-economic environment to provide a framework for their core strategy. However, focussing solely on a fundamental approach to investing is not enough any longer to outperform in modern financial markets. Bottom-up macro analysis, a more technical approach involving the studying of individual market mechanics is becoming more common. Given the growth in markets size in the past decade, markets themselves can often become the story and be key drivers of the broader asset classes and potentially impact economic fundamentals directly. This has been critical to outperform in recent years.
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, and so can 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 relying on any one specific area of the market. The funds will come with varying degrees of liquidity and volatility. Investment time horizons will tend to be shorter as the strategy is continuously reinvented to fit the up-coming macro environment and achieve its positive return objectives.
In recent years the sector has suffered outflows as fixed income has been in a bull market and long only funds have dominated. This was supported by the financial crisis as all economies were hit, damaging macro volatility and proved a difficult environment for ARB investors to fund diversified returns.
More recently the sector has seen a revival as the low level of yields and credit spreads are seeing investors look elsewhere for return. Inflation fears have ignited concerns over fixed income markets as the cycle has turned higher. The extreme policy action has also raised opportunity as economies move at different speeds offering up diversified returns that ARB managers crave. A key issue for investors is, over this more difficult period for ARB funds, the number of viable funds has shrunk as investors closed funds, suffered underperformance or failed to stick to their true diversified ARB investment processes.
Our belief is that more traditional funds will struggle to make positive returns as the global economy recovers from the pandemic, monetary policy is tightened and as inflation is higher than in the last decade. The track record of sourcing returns from interest rates, spread and currency markets on both the long and short side puts the strategy in a good position to outperform in this environment. If the recovery falters and there’s a slide into deflation then the risk is more duration heavy funds would perform better.
The value of active minds: independent thinking
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