A return to absolute
Why might an investor look to absolute return now?
With mainstream equities and fixed income both transitioning away from their respective secular bull markets, a significant regime change may be upon us. This means investment strategies could deliver lower aggregate returns and it highlights the need to source alpha from other areas.
Certain investment strategies are now less able to rely on macro and monetary policy, which over the past decade or so have supported market-wide returns. Central banks have been raising interest rates from their all-time lows, and how economies and markets manage the additional transition to quantitative tightening and liquidity withdrawal creates additional uncertainty. Meanwhile, inflation is experiencing a generational shift to the upside after its extended secular decline from the 1980s.
This combination of policy shifts and geopolitical uncertainty, leads to a wide range of potential economic and portfolio outcomes. The resulting volatility could lead to wider dispersion in valuation measures or create attractive pricing anomalies that could be captured in portfolios.
Can an absolute return be successful in this environment?
We believe so, yes. Absolute return strategies aim to provide positive returns regardless of the underlying direction of markets because of the ability to hedge exposures and to take short positions. As a result, they aim to generate returns lowly correlated with those of other asset classes. Additionally, they seek to diversify positions across a range of underlying positions with the aim of broadening the opportunities for capturing alpha, while limiting the downside risk and volatility of returns.
How does a pair trading strategy work to generate absolute returns?
Using ‘pair’ trades helps a manager to hedge the stock market, country, industry or factor exposures within a share price, and to focus on the residual ‘bottom up’ factors that will drive ‘alpha’. In this way a portfolio of such trades attempts to generate positive returns irrespective of market direction or irrespective of other macro factors where the manager may feel they have no edge. This is particularly helpful in times of elevated macro uncertainty, in which share price direction can be volatile and unpredictable as markets attempt to price a range of potential outcomes.
For example, the manager may have a positive view on the performance drivers of a Spanish bank (the ‘lead idea’), which could be hedged with a short position in the Euro Stoxx 50 futures contract. This would help to hedge out the market direction from the position but would leave country (Spain) and industry (banks) sensitivity as share price performance drivers, as well as the stock specific factors identified. If the manager is concerned about the negative impact of these other macro influences on the share price, then the hedge could be ‘tightened’ by replacing the futures contract with a hedge in either the Spanish index (the Ibex 35), the broad European banking sector, or even a basket of specifically-chosen banking peers.
In this way the manager can focus the outcome of the position on their ‘alpha’, while hedging out many of the market, factor and policy risks that also contribute to share price movements.
What are the some of the potential opportunities in the current market environment?
Volatility has created a greater dispersion of equity returns – where the differential in share price performance between similar companies is greater – which we believe provides a ‘richer’ alpha environment. The rapidly evolving macroeconomic backdrop is affecting companies in different ways, creating winners and losers, which we think can generate investment opportunities for fundamental, bottom-up stock selection. Companies may be able to combat the economic cycle with their own self-help efficiencies (for example through supply chain initiatives); a new product or investment cycle (enhancing their pricing power) or may have valuation support from an underappreciated return profile and cash generation.
On the other side, some companies are very exposed to a cyclical downturn; may have little ability to pass on input price pressures and have high levels of leverage and hence refinancing risk.
It is highly likely that we are set to experience a more volatile economic and market regime than the last 10 years, and this we believe, is a more productive environment for bottom up, stock selection alpha and equity-based absolute return investing.
1044109 Exp: 10 October 2022