Moving from relative to absolute
Balance skill with market risk It is crucial in sub-advisory investment management to pick managers that can offer clients the highest likelihood of strong consistent returns. While great care is always taken over assessing managers’ philosophy and process (in order to build up an idea of potential future performance), less time is typically spent on ensuring that the manager has the opportunity to apply that skill in as many areas as possible. Last month, we addressed how relaxing the long-only constraint on equity portfolios can enable managers to fully express their negative, as well as positive, views on a stock. This may enable skilful managers to increase the target returns per unit of risk (indicated by a higher information ratio). This month we examine new approaches which can be taken in the global fixed income and currency market that provide investors with access to manager skill while seeking to mitigate market risks.
Is relative the right approach? The aim of selecting fixed income as part of a portfolio is typically to provide investors with less volatile returns than equities. However, while investing in this asset class can offer some comfort, fixed income investments can still produce uncertain returns. A manager can deliver outperformance but, if the overall market is trending lower, this ultimately can still lead to losses. How should investors address this dilemma? The starting point is to consider whether it is always appropriate to measure portfolio returns relative to a market index. It may be more beneficial to bring an absolute return approach to your investment portfolio. This will provide access to the skill of the manager without tying the manager to market returns. By thus removing the constraints and allowing the manager to express their best ideas, you are maximising the portfolio’s alpha potential and simultaneously minimising exposure to market beta. Life beyond market cycles Absolute return approaches aim to beat Libor and thus deliver returns independent of market cycles. This means that picking an effective manager becomes more important than picking a particular market. Your chosen manager can then use all the tools available to them to invest in any area of the fixed income and currency market where they see value, seeking to extract the maximum gain from every opportunity and drawing on ideas from the world’s different regions, sectors, economies and individual securities. It’s all about the blend But isn’t this very risky – allowing a manager complete discretion to invest where they choose, with no reference point? The answer is that the skill lies in the blending – exposing the portfolio to the broadest possible array of different investment decisions actually provides diversification, which moderates the overall risk. How? Each fixed income strategy has different risk characteristics as it is affected by different factors. For example, central bank interest rate decisions may have one effect but isolated business decisions may have another effect on corporate bond yields. This means that correlation between different fixed income strategies can often be very low. A broad palette is a key to opportunity By allowing your selected manager to choose from the broadest palette of strategies, you are allowing both thorough diversification of risk and multiple alpha opportunities. With absolute return strategies, the manager has the versatility to pursue profit in all environments. This means that performance no longer has to be simply relative and investors can fully seek value by unleashing their active manager’s potential.
