The Case For Absolute Return by Axel Merk, Merk Investments
Talk about diversification comes cheap. Actually diversifying one’s portfolio is far more difficult.
We have been preaching for some time that in an era where both stocks and bonds may be expensive, investors may want to embrace alternative investments. I have been quoted saying that unless investors have at least 20% in alternative investments, they may not be truly diversified. While that quote made some headlines at the time, many college endowments have a far greater allocation to alternatives, at times more than half of their portfolio. There may be a good reason for that; let me elaborate and make a case why, in this context, investors may want to consider absolute return investing.
Goal of Diversification
Diversification is at times described as the one free lunch Wall Street has to offer: by adding a return stream with low correlation to other investments, risk-adjusted returns might be enhanced. While it’s theoretically possible to enhance risk-adjusted return with an asset that has negative returns, I have yet to meet investors embracing an investment with expected negative returns merely for its correlation attributes.
Not all alternatives are created equal. The simplest alternative investment may be gold. Maybe because it’s ‘merely’ an unproductive shiny metal, our analysis has shown that it historically has exhibited a very low correlation to equities and, as such, warrants evaluation as a good diversifier. The volatility in the price of gold tends to be closer to be that of equities (at times lower; at times higher). Yet gold may be the least volatile commodity; we believe that’s because of the comparatively low industrial use, making its dynamics less complex.
When we say investors may want to have a substantial portion of their assets in alternatives, much of that assumes that alternatives exhibit low volatility and, as such, a large allocation may be necessary to counter the swings of volatile equity positions. When it comes to commodities, their volatility can be rather high; as such, investors may be well served to justify a higher than usual gold or commodity allocation for reasons other than volatility.
Whereas volatility in commodities may be obvious, there may a lot of what one might call latent volatility in other investments. In today’s environment, this may apply to stocks and bonds as much as to alternatives. That’s because we believe central banks have ‘compressed risk premia’, i.e. taken perceived risk out of the market. Markets are, of course, still risky, but you wouldn’t know it if you look at what has been generally low volatility in stocks and bonds in recent years. When volatility does flare up, it can come back with a vengeance, as we have sporadically seen. In this context, we have referred to ‘taper tantrums’ akin to the Fed trying to gently take the lid off a pressure cooker, which – surprise, surprise, doesn’t work so well.
But latent volatility can also lurk in alternatives. Remember those emerging market local currency bond investments that appeared to offer high returns at low volatility (partially because their currencies were tightly managed); those strategies worked until, well, they didn’t anymore because emerging markets may ultimately be proxies for liquidity; and when there’s fear in the market, liquidity can vanish.
Or take investments in master limited partnerships; in a quest for income, such ‘alternatives’ had been embraced by many investors. That is, until the price of oil started to plunge and it became apparent just why those investments had yielded so much in the first place: they were risky…
Bubble, bubble, bubble?
Looking at the bond market these days, I have flashbacks to the dot com bubble of the late 1990s. It was December 5, 1996, that former Fed Chair Alan Greenspan gave his speech warning about ‘irrational exuberance’, yet it took the equity markets until 2000 to peak. What may have appeared to be sky high valuations became ever-higher valuations.
Similarly, while many of us have been scratching our heads about low to negative sovereign bond yields, we see ever more stunning bond prices, with both 50 year Swiss government bonds and 20 year Japanese government bonds now yielding negatively, i.e. investors paying governments to take their cash. Something within us can give a rationale explanation; another part of us says this is plain nuts. Years from now, with hindsight, it will be obvious.
It has been all about ‘Carry’?!
Most have heard of a carry trade, even if not everyone using that term knows what it means. A carry trade is one where one borrows money cheaply with the expectation of receiving a return higher than the borrowing cost. That is, assuming nothing goes wrong. Traditionally, one of the better known carry trades is to borrow in yen, a currency with low interest rates – also referred to as the ‘funding currency’, to buy Australian dollars, a high yielding currency. Such trades work well when ‘risk is on’, in the context of this discussion, I might say when ‘the world is right side up.’ However, when the yen rises versus the Australian dollar, any extra yield captured by the interest rate differential can turn a winning trade into a losing proposition. Because borrowing tends to be involved, moves tend to be exaggerated.
Carry trades aren’t limited to the yen. The euro with negative interest rates has also been employed as a funding currency; as such, when there’s fear in the market, the euro at times appreciate as carry trades are being unwound.
Let’s take it as step further: buying equities is a carry type of trade, as investors borrow cheaply (usually U.S. dollar cash) to buy a higher yielding asset (equities).
Negative carry carries the day?!
What if I told you that when the market turns, negative carry may carry the day. What the heck is that supposed to mean? Well, in plain English when the market turns, anything that’s gotten expensive might get cheaper; conversely, the stuff that people borrowed in might appreciate. That is, cash might suddenly get a hell of a lot more attractive. The yen and euro might appreciate (like anything, though, there are no guarantees, and this isn’t investment advice).
More abstractly speaking, it is negative carry that may shine. If you take it a step further, it means the types of investments that are expensive to hold might carry the day. Take gold. Gold doesn’t pay interest, and it costs investors to hold it, yet it might do well when the tide turns. Take shorting stocks. Shorting stocks is not suitable for many investors, not least of which because it can be expensive: you constantly have to pay the dividend yield rather than receive it.
Or shorting bonds. Think shorting U.S. government bonds – the one investment that – by regulation – is considered safe. Betting against bonds may cost you. Except, of course, that when bond rates are extremely low (or even negative), shorting such securities might not cost you much. There have been stories of some homeowners in Europe actually being paid for holding a mortgage, so the upside down world may indeed by arriving.
Here’s the problem: in the long-run, negative carry investments are an expensive proposition. At the same time, if indeed we see a bursting of a bond bubble; or if we see a sharp correction in equities, such negative carry investments might be the place investors wish they had been.
Gold is one of the less expensive ways to have a longer-term exposure to what is in the class of ‘negative’ carry. Shorting stocks may be a more expensive way.
Absolute Return: Alternative Investments for Today’s Markets?
Tying this all together, we believe investors may want to have a closer look at absolute return strategies. As a class of alternatives they have had a patchy track record, but we believe they deserve a second look.
Correlation: Such strategies tend to provide uncorrelated returns by design; they tend to do that with long/short strategies.
Volatility: If executed successfully, over the medium term, such strategies tend to exhibit a lower risk profile than a long-only or short-only strategy. While that may be true for long/short strategies in general, any specific investment allocation may prove to be riskier than a long-only investment, as it is possible to lose money on both the long and the short positions.
Positive or Negative Carry? That depends. As long/short strategies, they tend to borrow (go short) in something to buy (go long) something else. Depending on the strategy, they might have a positive or negative carry; that means the carrying cost of an absolute return strategy might be low (although this is not necessarily the case).
Track records? One reason many investors have moved on from absolute return strategies is because they had a lackluster track record during the roaring bull market. In the context of this discussion, this should neither come as a terrible surprise, nor be a reason not to consider them going forward. During the bull market, higher risk assets tended to outperform, whereas anything that was lower volatility by design quite possibly under-performed. Further, when equities go up, up and up, the risk/return tradeoff for alternative investments appears less appealing to some. To us, we see what we believe are compressed risk premia in equities as a reason to favor alternatives.
A challenging sandbox. A common criticism of absolute return strategies is that they play in a difficult sandbox. There is no ‘beta’, i.e. there often is no benchmark. So comparisons are difficult. An equity investor leans back and feels smart when the markets go up. An absolute return investor has to ‘generate alpha’, i.e. have an ability to make money independent of market direction..
Nobody said it’s easy. The criticism is fair, but the reason why some – including yours truly – pursue absolute return strategies is because we see a world where asset prices are expensive and where traditional ‘carry’ strategies might go into reverse. An absolute return strategy might offer investors the opportunity to diversify and help navigate challenging markets. Notably, it may be worthwhile to consider an alternative strategy that deals in markets that are liquid, such as the currency space. In the UK, some real estate funds have suspended redemptions – that’s not the type of alternative we are thinking of. Investors that believe stocks always go up, should not bother. However, others might want to have a look.
It’s about investment process and risk management. So how does one choose an absolute return strategy if the track record has been lackluster? In our opinion, it’s about investment process and risk management. With regard to investment process, it’s about understanding how the portfolio manager seeks to generate absolute return. With regard to risk management, the proof may be in the pudding when it comes to rough patches in the market.
Case study: Merk Absolute Return Currency Fund. Blatantly self-serving, let me discuss this in the context of our own absolute return strategy. I’ll conveniently skip over any rough patches the Fund has had in the past (feel free to contact us to discuss these in more detail), but would like to explain why we have dedicated large resources to make this product into the one it is today. The motivation is obvious: we are negative on both stocks and bonds, but want to do something about it rather than merely complain. While we may not have the solution to all the ills in the world, we believe absolute return strategies may have the potential to help investors navigate what’s ahead.
When it comes to investment process, the Fund may utilize statistical currency analysis to manage overall portfolio risk. We have turned risk analysis into what may be considered its own volatility strategy. That is, the Fund may take different risk environments and risk dispersion amongst currencies into account. When markets show signs of stress, we have the ability to emphasize risk sentiment analysis; in contrast, when markets are quiet, we have the ability to emphasize other strategies that may be more suited for calmer environments. We call this regime management. In the context of our discussion that we may be in an environment where negative carry wins the day, it may be noteworthy that this Fund might benefit from a focus on risk as a strategy.
That’s not the same as risk management, which is a separate layer. While the vote for the UK to leave the European Union (“Brexit”) may be just a brief data point, let me just state from the Fund’s attribution analysis: “The period around the U.K. referendum generated another spike in volatility in global markets, which MABFX managed to profit from due to its regime framework analysis and focused risk management.” In our outlook, we write:
We continue to see more evidence that global markets have entered a new risk regime of increased asset volatility and financial instability. In past outlooks, we have warned that investors are vulnerable to these trends, and continue to believe that our blend of fundamental and quantitative systematic investing, using a non-directional approach, is the appropriate strategy to extract uncorrelated alpha in this environment.
The excessive surge in implied volatilities in currency markets ahead of the U.K. referendum is in our opinion not only an indication of increased systemic risk, but also symptomatic for structural changes among liquidity providers. Banks as primary market makers have been constrained by regulation in their ability to warehouse risk, and are therefore less capable of absorbing market turbulence during events like the U.K. referendum. In the coming months and even years, investors might see increased pressure to deleverage and hedge, while experiencing higher cost of doing so through increased risk premia and slippage.
As a result, aside from overall heightened volatility, we believe there is increased chance of market turbulence that can be triggered by a number of global catalysts, including central bank intervention, economic fears in China, slowing earnings momentum and uncertainty about the Fed rate path. Our risk management and portfolio management approach has proven itself to be prepared for this market environment, and we have positioned ourselves to potentially profit from the outlined market risks and provide investors with diversification to their other investments.
A pitch for our absolute return currency fund wouldn’t be complete without a link to the fact sheet, prospectusand full attribution analysis. Please also register for our July 21 webinar with our quarterly update on our Funds and investment outlook. Also make sure you subscribe to our free Merk Insights, if you haven’t already done so, and follow me at twitter.com/AxelMerk. If you believe this analysis might be of value to your friends, please share it with them.
Merk Investments, Manager of the Merk Funds