Laura Blows speaks to Matthew Bullock, Investment Director - Multi-Asset, Wellington Management, about absolute return strategies
Looking at the bigger picture, we have trade wars occurring, uncertainty with the Chinese economy, central banks reducing stimulus and the shadow of Brexit looming in the horizon. How do you approach investing in these uncertain times?
It is such a fluid situation out there. There are a lot of political events and a lot of noise. It is important though, when looking at portfolio construction, to try and look through this noise and focus on the fundamentals. The fundamentals are strong. We are seeing global economic growth, including in the US and Europe – although the UK is a little more challenging because of Brexit. But overall, it is a positive picture.
The challenge is that there is a big difference between economic growth and market returns. From a client’s perspective, outcome is much more important than traditional asset allocation, so it’s important to focus on the outcome you want to achieve. A lot of the conversations we are having are about absolute return investing because people are concerned about what’s going to happen next. They are concerned that at some point we will see a correction, whether it’s because of a significant event or because valuations have got so stretched. In a situation where markets could fall, you need to think more about absolute return investing.
You mentioned the increased interest in absolute return strategies, but are you finding that investors are concerned? Absolute return sounds great in theory but in reality there has been quite disappointing performance in recent years?
It’s important to remember the purpose of absolute return. If you do a straight comparison with the returns of equities and bonds over recent years then yes, absolute return strategies have not kept up. But they are not supposed to. The whole purpose of absolute return is not to have market direction. We believe that to achieve similar types of return in the absolute return space you have to do one of three things:
1. Add significant risk to your portfolios, so a lot of leverage, which is not what a lot of these strategies should be doing;
2. Take a lot of risk off and wait for more favourable market conditions for absolute return;
3. Add more market exposures, although that’s not what absolute return is about.
The purpose of absolute return is to not have that direction in your returns. So, the re-emergence of volatility should create a better environment for absolute return strategies.
But at the moment is it a bit too tempting, with the equity and bond markets close to all-time highs? How can investors overcome that temptation?
That’s the hardest part. It is very hard to go into absolute return when you see great returns from other assets. One of the big things we talk about is that there is not one right outcome or solution. If you have absolute return, you run the risk of giving up some of the upside. So what we and a lot of investors do is keep some market exposures and blend them with absolute return. Let’s say markets continue to rally as they have done. Maybe absolute return doesn’t give you that same kick, but we know that markets move in cycles. By the time markets turn, it will be too late to start adding absolute return. That is why we are seeing more people adding absolute returns now, expecting something to happen, but not ditching markets altogether.
Within absolute return strategies, I have heard of something called alternative risk premia. Please could you explain this?
Alternative risk premia is a concept that has been around for a very long time, although the industry has done a very poor job of explaining what they are. When we take the concept of alternative risk premia, what actually sits under the name is something we are very familiar with. However, the industry has added so much jargon and made it appear so convoluted that people have got scared and maybe looked elsewhere for ways to generate absolute returns.
If we analyse alternative risk premia, we find there are four key components: momentum (or ‘trend’), carry, relative value (or ‘convergence’) and equity style premia.
Momentum is something we have in our day-to-day lives. Bitcoin, for example, rallied hugely in price and then declined sharply. As the market started to rally, the true value of Bitcoin became irrelevant. People got excited and were talking about it on the street. People actually started buying Bitcoin because it was up 1,000 per cent, which contributed to it continuing to go up in price. That is momentum. When it turned, we saw the complete reverse. Bitcoin’s value fell as people started to panic and sell, which generated an even greater fall. Investors who want to play this sort of behaviour can look at data systematically across all different markets.
Relative-value trades look at expensive assets versus cheap assets. You want to buy the cheaper asset and sell the expensive asset. Carry trades look to borrow at a lower cost to benefit from a higher rate somewhere else. The final piece is equity style premia. There has been a lot of talk about the factors that drive the equity market, for example, momentum, quality of companies, valuations and low beta. We want to buy the factors we believe are going to go up and sell the factors we expect to go down. The combination of those four blocks is what we call alternative risk premia.
Alternative risk premia is still considered a complex process. So is its use mainly for sophisticated investors with large pots of money to invest?
When we look at alternative risk premia (read our white paper to find out more*), it is fair to say it can be perceived as complex. However, when we go right back to the first principles, these are either principles we recognise in our day-to-day lives, or things we are already implementing ourselves in portfolios. We are just putting a name over the top of them.
So this is not for just the most sophisticated investors. There is a much broader base that should be looking at alternative risk premia strategies. The reason being is what we are trying to do with these approaches is generate absolute returns, with lower cost, with greater transparency, with greater liquidity, to get you a long way along the path of generating absolute return. We just have to remove some of the jargon.
For investors that would like to invest in this way, what advice would you give for them to select a manager to do this for them?
I think the biggest risk is that you see a lot of new strategies where the manager may not have the experience in running those solutions.
We believe running an alternative risk premia straegy properly, takes many years of building the models and infrastructure. That is not something you can do overnight. So the biggest thing is the experience of the manager. Have they done this before? How long have they been doing this?
The second things is whether they are willing to explain their portfolios. Sometimes when you move into this world of systematic, also know as ‘quant’, it can throw up the misconception of ‘black box investing’. There is no reason why a manager should not be willing or able to explain what they are doing in those portfolios. Absolute transparency is essential.
Third involves the build. There are two ways you can build a portfolio. You can go to investment banks and buy those strategies such as momumtum and value off the shelf and out them together. The benefit if doing that is it’s quick and efficient. The challenge is buying things from an investment bank is not cheap, and when you blend these together, you have no control over each of these building blocks; you can’t adjust them. So you get a very blunt exposure to the strategies you want to have.
The flipside is to build each of the exposures yourself. This is what we advocate. However, it takes a lot of time, a lot of infrastructure, a lot of cost, to build up the platform to do this. But the benefits are significant. You have full transparency You know its exact liquidity. You do not pay the costs of the investment bank. When you blend this together you can examine the result and make adjustments across the board. That’s imperative. You must be able to control your entire portfolio, so that the risk exposures you get are exactly as you want them to be.
To learn more about next generation multi-asset investing, visit www.wellingtonfunds.com/next-gen-investing/
* To view our alternative risk premia white paper, visit: www.wellington.com/understanding-alternative-risk-premia/