One key risk that's not been priced in

Patrick Poke

Livewire Markets

In an increasingly interconnected world, asset prices tend to move more in sync. Once, a simple asset allocation to traditional bonds and equities could provide acceptable diversification and returns across the cycle. But today, low rates and high prices make this less certain.

David Elms and his team take a different approach in managing the Janus Henderson Global Multi-Strategy Fund. They use a variety of uncorrelated strategies, along with buying explicit portfolio 'protection' to minimise losses in times of great stress.

In this Q&A, we learn about some of the strategies they utilise to minimise the downside while still producing solid returns. Elms tells us about the volatility opportunity he saw coming into 2020; how this looks now; and the biggest risks in markets today.

What is the biggest risk in the market right now that you don’t think is being accurately priced in?

It is apparent to us that there is a disconnect between financial market pricing and what is going on in the real world at present.

Governments and central banks have been complicit in creating this problem, with stimulus measures that have kept markets buoyant, while many industries continue to struggle with the ongoing fallout from COVID-19.

One risk that does not seem correctly priced into markets is the potential for stimulus measures to gain more traction than expected, feeding through to higher inflation, with a consequent impact on bond yields. Given that we have been in a secular bull market since the early 1980s, investors have virtually no experience of what a bear market for fixed income looks like and how to weather it. We recently took the decision to take a sizeable hedge against the risk of bond yields rising in the medium term, and we continue to keep a close eye on this particular issue.

With rates now so close to zero, what is the role of bonds in a portfolio? Are there any alternatives worth considering?

For the past two decades, the negative correlation between equities and bonds has been a gift for investors looking to build diversification into their portfolios. Bonds have acted as a hedge during periods of stock market uncertainty; weakening sentiment usually coinciding with falling expectations for interest rates and a consequent flight to quality. This mechanism hinges on the ability of yields to move so that bonds can achieve capital gains.

With yields at such low levels, and little room for further interest rate cuts, the room for further compression is limited.

Persistently low levels of inflation have also contributed to the negative correlation between bonds and equities. Should current stimulus measures feed through into higher inflation, without an equivalent level of growth, this could indicate that something is fundamentally changing. The behaviour of markets is not fixed, although it can take a while for investors to change their habits.

We believe that alternatives are well placed to perform a similar role for investors, in terms of delivering uncorrelated performance throughout the market cycle. There are many potential options within the ‘alternatives’ arena, but an allocation to a ‘multi-strategy’ platform of market neutral strategies combined with a protection strategy may provide an attractive alternative to a traditional bond/equity allocation, diversifying a portfolio with a greater range of potential sources of alpha.

The Bank Bill Index +7% is a very high benchmark. Do you need to take a lot of risk to achieve these returns?

Risk management is a very important component in the structure and deployment of our strategies. Rather than aiming to take a lot of risk to generate performance, it is more a question of efficient risk-taking.

The structure of our overall strategy naturally leads to a truly diversified exposure to risk. The low correlation between sub-strategies is designed to not only enhance the risk-adjusted return, but also maintain low correlation to the performance of major asset classes and other alternative investment strategies.

A separate top-down explicit ‘protection’ strategy aims to mitigate risk from any unexpected market events, while enabling the other sub-strategies to weather short-term market stresses, in order to capture long-term return opportunities.

In your 2020 outlook you stated that you thought volatility was underpriced and could rise. How did volatility perform in February and March?

Volatility is never a one-way bet, but it was our view at the end of 2019 that it had been significantly underpriced for some time, due to the prevalence of systematic volatility selling programs. The speed and breadth of the spread of COVID-19 in February and March saw a significant and sharp repricing of volatility, with markets understandably stressed and illiquid as economies around the world ground to a halt. Companies were laying off workers at an unprecedented rate, with business survey indicators for economic activity breaching new lows.

Systematic Long Volatility, which is a core component of our protection strategy, invests in equity index put options, with the aim to produce gains when either realised or implied volatility rises. In normal circumstances, such trades can be expensive to run, but underpriced volatility enabled us to build a position that we believed would deliver ‘crisis alpha’ at low carry cost (the total costs incurred to take an investment position). Option strategies of this sort performed exceptionally well in past risk events (for example, Black Monday in October 1987 and the 2008 global financial crisis) and the scale of the move in volatility – as volatility sellers short-covered – ensured the COVID-19 crisis was no different.

Where are you seeing opportunities to buy or sell volatility today?

While we still see some opportunities to buy volatility, the trade is no longer the ‘slam dunk’ it was at the start of the year. Markets are always evolving, and the cost of carry on a long volatility position strategy has risen commensurately with the level of current uncertainty. This raises an interesting question about what other strategies can systematically provide uncorrelated returns during periods of high cost of carry for long volatility.

Our response has been to develop a flexible 'Tail strategy' that can be tactically deployed to maintain required protection levels during periods of high cost of carry, when holding a long volatility position is expensive. The strategy is designed to capture as wide a series of shock events as possible, rather than just equity market risk, and can be switched off during periods of low volatility. The Tail strategy provides a highly complementary addition to what we see as an already robust suite of protection strategies.

See alternatives in a different light

To perform differently from the market, you have to invest differently. You can find further information on David and his Global Multi-Strategy Fund here. 

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Patrick Poke
Managing Editor
Livewire Markets

Patrick was one of Livewire’s first employees, joining in 2015 after nearly a decade working in insurance, superannuation, and retail banking. He is passionate about investing, with a particular interest in Australian small-caps.

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