Market turmoil can benefit certain types of absolute return strategies, just when the other instruments are out of tune. High volatility, rising rates, and increasing correlation among asset classes demonstrate why an orchestra employs a full range of instruments.
Every instrument in the orchestra
By construction, long-short equity absolute return equity strategies use many instruments in their aim to perform. In dull markets, their returns can be dull, too, looking rather like a money market fund with extra bits and pieces. These approaches are also designed with the aim to actually benefit from rising volatility.
But like a money market fund, higher interest rates mean the bass note of expected return rises to a higher pitch. Also like a money market, when rates are rising, that bass note rises right alongside the other instruments, with little or no time lag.
Tuning up the instruments
Rising rates and the return of high market volatility were the themes of 2022. Both equity and bond markets have been ‘discordant’, to say the least. The MSCI World equity index has fallen nearly 15%, while the Barclays Global Aggregate bond index has lost more than 16% year to date through 23 November[1]. Nevertheless, absolute return equity strategies may be particularly well-positioned to benefit from the increased volatility and rising interest rates.
With positive correlation between equities and bonds for the first time since the 2008 financial crisis,[2] these strategies are playing their role as a diversifying asset class. If good news comes in threes, then three sour notes for the markets are in perfect tune with these types of investments.
Volatility favours absolute return equity strategies
Equity volatility has stepped up to a higher average. Looking at equity volatility, we can see an increase in the average level of the VIX in the most recent two years relative to 2012 – 2019 period.[3] Both these time frames exclude the Covid spike.
Rising volatility offers higher risk premiums. The ability to make rapid adjustments to changing markets means that when higher risk premiums appear, these approaches can capture new risk/return opportunities in real time. As most absolute return equity funds, they are providers of liquidity, and can potentially be more profitable in periods of high market volatility when that liquidity is well-compensated.
Rising rates mean better returns in the money market “bucket”
Contrary to traditional asset classes, absolute return equity strategies may benefit from an environment of rising interest rates. A special feature of certain alternative funds is that they may consist of the opportunistic investment strategies alongside an invested money market bucket.
Strategies are typically implemented using derivative instruments which only require a portion of the exposed amounts.
The remaining cash is invested in short term instruments such as repurchase agreements or money market instruments, whose rates have recently been rising.
Until a few months ago, absolute return products with conservative cash management policies have suffered from the negative return on their money market bucket, especially in the Eurozone. The successive increases in the key rates of the FED and the ECB have pushed short rates into positive territory. Thus, where a European money market investment was losing an annualized -59bps at the end of 2021, it should return around 1.4% at the end of 2022.
Past history does not guarantee future performance.
Dissonance -- risks
All our investment strategies involve risks.
Absolute return strategies are subject to risks of loss of capital. Main risks associated with investing in these strategies include derivative risk, currency risk, counterparty risk, and arbitrage risks. Other important risks include concentration risk, volatility risk, liquidity risk, and M&A risk.
All the instruments are warmed up
This new market regime combining high volatility, rising interest rates and increased correlation among most asset classes constitutes an alignment of the planets that may be more favourable to alternative management. Absolute return equity strategies may indeed benefit from these market conditions and provide more diversification to investors. For this reason, we remain optimistic that these strategies may be able to outperform in these new conditions.
Absolute Return equity strategies, by definition, seek to deliver alpha regardless of market conditions. Adding them to an asset allocation can reduce overall volatility and help the asset classes in your allocation play in harmony. Like an oboe tuning the orchestra, sometimes the unusual instrument is the right one for the task at hand.
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[1] Bloomberg, MSCI World Net return and Barclays Global Aggregate Net Return, 31 Dec 2021 through 23 November 2022.
[2] Bloomberg, Candriam. Based on correlation between the S&P 500 index and the Bloomberg US Aggregate Bonds Index between August 2007 and November 2022, there were only short periods of positive correlation until the second half of 2022.
[3] Volatility has risen from 15.2% (31 Dec 2011 through 31 Dec 2019) to 23.4% (1 July 2020 to 30 Dec 2022).