Investment strategies to deliver diversified returns

Recent press attention within the European fund industry has focused on the shift in investors’ product requirements, with the rise in alternative investments such as hedge funds and guaranteed products a recurring theme. While there is no doubt these vehicles can play an important role in an investor’s portfolio, it is likely that long-only products will continue to comprise the biggest proportion of any balanced, diversified portfolio.

With these developments driven by an ever-changing economic and social landscape, a continuous, evolving product line with new and innovative investment strategies is needed to deliver the solutions sought by investors. Today’s investors therefore require an asset manager who fully understands their needs and can develop new investment ideas that meet their requirements and expectations.

Changing needs

The launch of less conventional long-only investments, such as absolute return products and investment strategies offering diversified forms of alpha demonstrates how the asset management industry has sought to meet changing investor needs. In addition, it confirms that there remains an active market place for long-only investing, despite the recent clamour for alternative investments. The following article will discuss some of the more innovative long-only investment strategies now available to investors, and highlight a few key features that are central to each strategy and which investors should take into account prior to investing.

The rising prominence of absolute return products over the past few years has come against a backdrop of negative returns generated from standard benchmark tracking funds between 2000 and 2002, and the regulatory changes of UCITS III. Such products have been launched to provide investors with a more flexible alternative, typically permitting strategic allocation to multiple asset classes and potentially generating attractive positive returns over a market cycle.

The rapid growth of this particular fund group raises the question of what key features investors should take into account when considering an investment into absolute return products. With the desire for positive returns balanced against the need for a degree of limited downside risk, there are two key features that come to the fore. These are risk control measures in order to minimise any downside potential, and the capability and structure of investment management teams so as to deliver the returns.

The introduction of an expanding range of more complex fixed income instruments, each with its own individual risk characteristics, is challenging the traditional asset allocation and risk management strategies employed by asset managers. Developing successful absolute return strategies to invest in ‘enhanced’ asset classes such as emerging markets, convertibles and high yield, as well as more traditional fixed income securities, requires both an in-depth knowledge of these new instruments and, crucially, the expertise to understand and control the risks therein.

Risk control

One such strategy is a Target Return product. Based on a process that takes a blended approach to investing in fixed income instruments, convertibles and currency, investors are provided with a positive investment objective that remains within strict risk parameters.

The approach to managing risk within the Target Return concept is both innovative and transparent. Risk analysts within the portfolio management team identify the fundamental and structural differences between the various asset classes.

As one would expect, capturing all the risk embodied in a complex portfolio is impossible using only one volatility parameter, such as Gaussian VaR. For an optimal risk/return profile the downside risks of non-government asset classes need to be captured accurately and the Cornish Fisher VaR model addresses this issue by including other risk metrics such as skewness and kurtosis, as well as volatility, in its methodology. This allows asset allocation strategies to select asset classes not only for their risk premium, but also their ability to offset downside risk in the portfolio as a whole, thereby maximising potential positive alpha generation.

This encompassing risk management tool also uses sensitive triggers to ensure both upside and downside events are constantly measured. Termed an asset class ‘envelope’, both upside and downside scenarios are measured against the actual performance of the relevant asset class on a daily basis. Triggers are set should the upside envelope limit be breached where profit taking may occur. Similarly, if the downside envelope limit is broken, the position is re-evaluated and re-allocation may occur. (See Chart 1.)

When considering which absolute return product to invest in, investors need to ensure the product selected has robust risk management systems capable of capturing the risk profile of both traditional and enhanced securities contained within the portfolio. In so doing, investors can benefit from a strategic and optimal allocation to a wider range of asset classes, for a relatively modest risk budget. Additionally, full product transparency also offers investors the advantage of clear communication of risk processes and a greater understanding of what level of downside risk protection is being offered.

With a good understanding of risk management now in place, investors can turn to the issue of manager capability. This feature is particularly important given that absolute return strategies commonly seek to exploit thematic or regional opportunities, as well as invest in a diverse range of asset classes. Furthermore, timing is a key issue in running multi-asset class strategies and, as such, local knowledge of the markets where the product invests can be decisive.

Capability

Another often overlooked feature that investors should consider is the way that information is leveraged within the investment management team. Credit Suisse Asset Management’s Total Return Asia Pacific fund provides a useful example of how team structure can provide an information advantage.

The growing awareness of the Asia Pacific region’s remarkable growth potential has seen investor interest increasing rapidly in recent years. The combination of these factors made a compelling investment argument for the development of an absolute return fund focused on this region. Investing across equity, fixed income and cash markets within Asia Pacific, this absolute return strategy provides an opportunity for tactical allocations within the region’s markets. Divided into three core regions (Asia ex-Japan, Japan, and Australia), their unique characteristics offer the scope for continued attractive investment returns in future years, as well as providing additional diversification benefits.

Central to the success of such a product is the innovative structural approach used within the asset allocation process. The key component of this structure is an advisory board composed of investment professionals with long-standing experience of advising and investing in Asia-Pacific markets.

Its role is to monitor the various markets so as to develop macroeconomic views and provide the core thematic investment ideas that will then be translated into optimal asset allocation decisions. The key portfolio manager acts upon the decisions made at advisory board level by allocating the appropriate assets to the local product portfolio managers, who are ultimately charged with stock and security selection. Leveraging the proprietary research teams at the local level should also enhance the identification and selection of valued enhancing stocks.

Top-down strategic information flow, coupled with bottom-up analysis from investment specialists, provides the opportunity for the product portfolio managers to leverage wide-ranging skills and expertise. This structure also ensures a consistent information flow down to the product areas and enhances the investment management teams’ capability to identify value added investment opportunities. Irrespective of how financial markets behave in the coming years, growing numbers of investors are likely to add absolute return products to their portfolio to generate more consistent positive returns and further improve diversification. Asset manager capability to deliver the products and returns, together with the necessary risk management systems to ensure risk is controlled, are the two key criteria by which investors are likely to evaluate these products. Of course, an understanding of these criteria are just as important for other investment strategies, particularly given industry focus is on ensuring investors’ portfolios make the most efficient use of their available risk budget.

One method that can contribute to achieving this aim is to ensure portfolios include a broad range of alpha generating products that enhance diversification and make efficient use of available risk. As part of the selection process, correlation will play a central role, with the optimal combination of asset classes within a portfolio key to delivering consistent positive returns. The following three innovative relative return investment strategies deliver such diversification benefits, as well as provide investors with alternative forms of alpha generation.

Real estate investments offer investors a diversified source of alpha returns given their lack of correlation to traditional financial assets. The low correlation of these returns is demonstrated by data from the Investment Property Forum. This data points to correlations over the last 30 years of around 0.19 between property and equities. On the commercial side, in particular, real estate can generate predictable cash flows and has a low volatility of returns, both of which have a positive impact on the risk/return profile of a conventional portfolio. Market inefficiencies can also be a potential source of added value, particularly in a cross-border context. The unique features of this asset class have contributed to its strong outperformance of European equities since the beginning of 2004. (See Chart 2.)

With the expected passing of Real Estate Investment Trusts (REITs) legislation in the UK and Germany by 2006, and many other countries initiating similar legislation, efficient access to the global real estate market will markedly increase for European investors in the near future.

The key feature of REITs is their requirement to return the bulk of income received to investors. Given that this could lead to higher valuations of real estate stocks, this makes them a particularly attractive form of investment. New markets are also providing investment opportunities, as rising world cities such as Sydney and Toronto, together with transition cities in Eastern Europe, continue to mature.

Real estate

Over the past year, commodities have received increasing attention from investors as demand from both emerging and developed economies has outstripped supply. In turn, this has encouraged more investors to consider including commodities within their portfolio. While this movement appears sensible from a purely supply/demand perspective, there are a number of other important features of this asset class that merit its inclusion within a balanced portfolio.

As with real estate, commodities can provide investors with a diversified source of alpha given their low correlation to equities and bonds. Commodities are real assets, with prices moving up and down in relation to real-time supply and demand dynamics, contrasting sharply with equities, for example, whose prices are determined from a calculation of expected future returns. In particular, exposure to commodities can help reduce the impact of equity market falls at the end of a business cycle and complement a portfolio of conventional assets.

Investing through vehicles that invest in commodity indices provides the additional benefit of further diversification, with overall volatility of a diversified index lower than the individual components. The extent to which commodities move against the grain of most financial assets can be seen directly by examining the relative correlations of the various asset classes.

Financial assets have historically exhibited relatively high correlation with one another. Over the period 1979-2004, for example, large cap stocks had a strong positive correlation with small caps (0.80) and foreign equities (0.54). But the risk and return characteristics of commodities display little or no connection with those of financial assets. Commodities as represented by the Goldman Sachs Commodity Index exhibit lower correlations with large-cap stocks (0.03), foreign stocks (0.10), small caps (0.08), and bonds (-0.03), than many other asset classes. It is this contrary behaviour of commodities relative to the standard asset classes that produce their unusually strong “diversification effect” on almost any traditional portfolio¹.

Commodities

Therein lies the long-term strategic value of commodity indices for most investors. Given the degree to which they move against the grain of the broader market, the addition of a basket of commodities to any traditional portfolio will expand the bounds of its efficient frontier, potentially enabling the same or better return while helping to reduce its exposure to the volatility of the financial markets. (See Chart 3.)

Whilst recent enthusiasm has cast an overdue spotlight on commodities, it has also obscured for many, the true value of this unique real asset.

Diversification is what commodities primarily bring to a portfolio, helping to hedge away overall exposure to market movements. Understood from this larger, strategic point of view, commodities appear to be the real asset alternative that many investors seek in their pursuit of positive, uncorrelated returns. Furthermore, commodity investing provides a significant reduction in risk via diversification when complementing a portfolio of stocks and bonds. An investor seeking diversified sources of returns would be well served to consider the potential of generating additional return from an active currency management strategy. Global currency markets are not homogeneous, and therefore they provide varied sources of return: country allocation, duration, relative value and volatility. Consequently, this specialist asset class is increasingly appearing on investors’ radar screens.

Active currency

The question is: what role can currency management play in an overall investment strategy? There are two choices available to investors. The first is by overlaying currency positions across underlying portfolios, a process that can easily be applied to diverse asset classes, which range from conservative money market accounts to more aggressive equity and total return products. (See Chart 4.) The end result is an optimised asset allocation that benefits from the additional returns generated by the currency overlay.

Alternatively, total return currency portfolios provide a distinct asset class option, which can be packaged as a product with a specific risk/return target. The benefit of a segregated currency vehicle is that it has very low correlation with other traditional assets and thus adds diversification to an overall portfolio.

Many investors have historically tended to view currencies as a residual from their overall asset allocation decisions. Just a few years ago currencies were of little concern, as double-digit equity returns meant that a few basis points made or lost on the currency deviation from the benchmark was unlikely to register on investors’ radar screens. But with a future of more modest returns from both equities and fixed income, the search for new sources of alpha has spread to areas such as currency management.

The asset classes discussed above highlight the expanding range of products now available to investors and provide positive indicators as to the health and direction of the investment management industry. The launch of innovative long-only products such as absolute return funds offer investors a new investment approach and source of positive return.

Furthermore, despite recent comments that benchmarked products have possibly had their day, the launch of funds focusing on asset classes such as property and commodities provide ample evidence that there is much life left in these type of investment vehicles.

¹ Source: Ibbotson. Correlation data refers to indices GSCI, S&P500, MSCI EAFE, LB Aggregate and Russell 2000 from period 01/01/76 to 01/07/04.