TOL - 22nd Mar, 2024
The definitive guide to finding "relative value" in a noisy market
There's duration, there's credit, and then there's the third and lesser-known lever of fixed income investing.
In a previous episode of The Pitch with Gopi Karunakaran of Ardea Investment Management, we discussed the two regular levers of fixed-income investing - duration and credit. And as Gopi revealed during that interview, they like to do things differently compared to the consensus.
In this episode, you're going to find out what makes them different. In short, it's the pulling of a third lever in fixed-income investing called "relative value". Without stealing all of Gopi's thunder, the difference with this style of investing is that the Ardea team need not have a view of the macroeconomic backdrop at all. This makes the Ardea team a rarity in a market that is famous for its widely espoused views on the global economy.
In this video, you'll also find out how increased volatility in the last few years has made the search for alpha in fixed income more challenging - and how Ardea takes advantage of it.
Edited Transcript
Hans Lee: Hi, and welcome to The Pitch brought to you by Livewire Markets. I'm Hans Lee, and joining me today is Gopi Karunakaran of Ardea Investment Management.
Ardea are specialists in a specific kind of fixed income investing called relative value.
So, to start with, what in as simple terms as possible, is the concept of relative value investing?
What is "relative value" investing?
Gopi Karunakaran: The universe that we operate in is global interest rate markets, so that's government bonds and some derivatives related to those government bonds. Now, what's interesting to us as relative value investors is in this market you have a unique feature that you don't see in other markets, which is that you have lots of securities that are ultimately all related to each other by some kind of well-defined pricing relationship.
What pure relative value investing is all about is recognising that there are these relationships are well-defined. If markets were perfectly efficient, then all these securities should always be priced consistently with those relationships. In the real world, of course, markets are not efficient all the time. And in rate markets, what you have is this phenomenon where you've got lots of buyers and sellers who are there for other reasons other than profit.
They're doing things for hedging purposes or matching liabilities, central banks for policy purposes. As they come into the market and they buy and sell, they create temporary demand-supply imbalances. That is what creates a situation where two securities that are very closely related and have very similar underlying risk characteristics become priced inconsistently with each other.
What we do is we take advantage of that - buy the cheap one, sell the more expensive one, and wait for those prices to align to a more consistent type of framework and do that in a way that's market neutral. We're not trying to take a view on what's going to happen to the bond market or the economy or anything like that. We want to very precisely isolate just these relative price differentials.
Lee: And the profits you make are your spreads, right? Just to clarify between the two.
Karunakaran: That's exactly right. And the key is repetition. So, each time you do this, you're not going to make very much, these are small mispricings. But the key is to do it over and over again. So, it's turnover, it's velocity, and doing it repeatedly through time.
How relative value differs
Lee: That leads nicely to the next question that I have. How is relative value, as a concept, different from the more conventional methods we're used to when we talk about fixed income investing like duration and credit?
Karunakaran: So good question. We think of this in the context of levers, so the different levers you can use as a fixed income investor or an allocator to fixed income. And when you look at conventional fixed income, there are two levers.
You've got lots of different funds that have all kinds of different names. But when you decompose to the risk-return profile, it comes down to some combination of two levers. Lever one is what is called duration. And so, that's sensitivity to interest rate changes. So, government bonds would have a lot of duration in them. Lever two is credit, sensitivity to credit spreads or default risk. Corporate bonds would have a lot of credit.
Most fixed income portfolios are a combination of those two levers, and most of your return is coming from holding the bonds, earning the income, and having exposure to either interest rate duration, risk or credit risk.
We think of relative value or pure relative value as being a third lever in fixed income, not as well known, but crucially different. So, it's not dependent on the level of rates, it's not sensitive to duration, it's not involving credit. So, it's something different, not better or worse, different. And why the difference matters is the difference is what unlocks diversification.
Hans Lee: Why is relative value investing a more effective lever for generating returns?
Karunakaran: The message that we give to clients and certainly a lot of the conversations we talk to clients is around complementary fit. So, traditional fixed income investments are very sensitive to the level of rates, the level of yields, and what's happening in the macro universe, whereas this third lever relative value is not sensitive.
It's completely independent or uncorrelated, to use the technical term, to all of those things. Putting those three things together can be very powerful because in an environment where levers one and two may not be doing so well.
Think about an inflationary environment like 2022 when government bonds got hit badly. Think about a recession like the GFC where credit gets hit very badly. RV or relative value is not affected by those things in the same way. So, it helps diversify portfolio risk.
How do you deal with volatility?
Lee: When you think about conventional fixed income, I just think during the last two years we've seen such a massive surge in volatility, I think of how bond markets can now move on one word from a central bank speaker or I think of the SVB and Credit Suisse crisis and the massive fiscal deficits being run after COVID.
How have you dealt with this volatility as an investment house, and does it make it more challenging for you to generate that alpha?
Karunakaran: It does make it more challenging at times. Dealing with the volatility is the key to doing relative value. Ultimately, what we're trying to provide is a defensive type of investment. So, it's no good to have an investment profile or offer an investment profile. In the good times, we're generating alpha, and then you get a crisis and we're down a lot. That's not fit for purpose.
So, volatility control is crucial and there are two ways that we control volatility in those more challenging markets. What we don't do is try to take a view. We don't try to say, "Oh, well things are looking bad. Let's do X or Y," because we just have no competitive advantage doing that.
We use portfolio construction and what we do specifically is first we diversify risk in our portfolio.
So, just size your bets small is the basic idea. Lots of small independent bets and use the power of diversification. The second thing that is a bit more nuanced is this concept called risk balance. And this involves, without getting too technical, buying interest rate options and other things like that, that will do well in that stressed environment.
What we try to do with our portfolios is always have that bit of a balance there, where in a stressed environment, some of the things are going to not go well, but you've got these other things that are biased to go well.
If you get that balance right, then your portfolios should be able to sail through those. And that's the experience we've had. If you look at 2020 during COVID and 2022 during inflation, the portfolios held up pretty well.
ETF
ActiveX Ardea Real Outcome Bond Fund (Managed Fund) (XARO)
Global Fixed Income
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Managed Fund
Ardea Real Outcome Fund
Australian Fixed Income
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Hans leads the team's coverage of the global economy and fixed income. He is the creator and moderator of Signal or Noise, Livewire's multimedia series dedicated to top-down investing.
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Hans leads the team's coverage of the global economy and fixed income. He is the creator and moderator of Signal or Noise, Livewire's multimedia series dedicated to top-down investing.
Expertise
Hans leads the team's coverage of the global economy and fixed income. He is the creator and moderator of Signal or Noise, Livewire's multimedia series dedicated to top-down investing.
Expertise
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