Real Return adds defensive strategy

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The Real Return team at Newtoni has expanded the tools it uses to hedge any market downturns, adding risk premia to its arsenal for combatting volatility[1]. Here’s what’s happening.

Why are you changing the defensive elements of the strategy?

At different times in the business cycle you want to use different instruments. Right now, we have raised cash but that can drag on performance if held for any length of time. Bonds and gold are also less appealing in a rising yield and strengthening dollar environment as central banks embark on tightening monetary policy, although we are invested in these at this time given the heightened volatility in the market due to Russia/Ukraine.

What is risk premia?

It is the amount by which the return of a risky asset is expected to outperform the known return on a risk-free asset. It may sound esoteric and complex when in fact it is simply a ‘premium’ for risk compared to something that has no risk, cash being the closest concept.

In the context of a risk premia strategy within the fund, it is about getting exposure to the risks you want and getting rid of those you don’t.

For example, imagine you want to buy XYZ oil company. There are different risks involved here. 1) Stock specific risk – what if it is involved in an oil spill? 2) Market risk – how will it perform in a recessionary environment? 3) Price of oil risk – just look at what happened to such companies when the oil price turned negative a few years ago. And 4) Currency risk – we may buy the stock in sterling but the company’s earnings are in US dollars.

With risk premia techniques, you can hedge out things like the currency or market risk and just be left with the company risk. It then becomes a return stream on a single factor.

What risks will you hedge out using risk premia?

We are aiming to hedge out some of our market risk but in a cheaper, more efficient way than just using “insurance” such as puts. Since the Covid 19 pandemic there has been a structural increase in the cost of index protection, which has led to put options being very expensive.

How does it work?

Such strategies are implemented through either a structured note or swap, which offer daily liquidity and are fully collateralised with high-quality government bonds.

They are designed to have a negative correlation to equities. This means, we’d expect that in a falling market they would have a positive contribution. In a rising one, they would have a small negative impact, although again they would have much less drag than puts.

How is this different to the derivatives exposure you have used in the past?

This will behave similarly to the long puts we had back in 2020. The problem with those, however, is the timing element and the cost of maintaining those puts proved costly. Risk premia offers a comparable level of protection but as it is more cost effective, we can use such protection for longer.

For example, one available defensive risk premia strategy would be expected to lose around 3 to 5% in normal market environments and yet in March 2020 it rose over 60%. And the cost of holding 2% in such a strategy would have been around 10bps per year – far cheaper than buying put options.

Why not use more conventional hedges, like government bonds or gold?

At different points in the market, government bonds or gold might be both cheaper and more effective in offering downside protection but that isn’t always the case. We can also de-risk into cash when needed, although it can be a drag on performance. This is about choosing the best tool for the prevailing market conditions.

In the past, Real Return was more of a conventional absolute return fund but over time more derivatives have been used. Is it becoming too complex?

We don’t think so, no. Over the lifetime of the strategy, we have used other instruments to help with diversification, such as infrastructure or windfarms.

Our use of derivatives and other such tools are no more a permanent fixture than any of the other strategies we use to make returns while protecting capital and importantly risk premia strategies offer daily trading and daily liquidity.

We believe great multi-asset design needs to be robust enough to accommodate as many possible futures as practicable. To do otherwise would be to assume that what worked in the past will continue to work in the future. Volatility and shifting correlations of asset classes, proves this wrong.

In the past hasn’t some of the protection dragged on performance?2

Yes. The longer we run a position, hedging a market fall, the more expensive it can become. Risk premia is like buying insurance without paying the ridiculous costs associated with such protection. Given the lower cost of employing a risk premia strategy, we could maintain protection for a long time while not incurring the same drag on positive performance.

For example, in 2021 – a “normal” up market – we spent some 2.5% on traditional protection tools and hedges, including positions in gold as well as options. Had we used risk premia to provide the same level of downside protection it would have cost us about a quarter of that.

How much of the portfolio will be in risk premia strategies?

This depends on the prevailing market conditions. In early February, we had zero in government bonds and gold but two small positions using risk premia, less than 5% of the strategy. However, we will never have more than 10% exposure to this type of defensive instrument.

Are you managing this exposure within the team or are you using Newton’s quant team to make these calls?

We are managing this within the team. We have used derivatives for years and are very familiar with these techniques. Andy [Warwick] also successfully employed risk premia strategies during his 12 years managing multi asset portfolios at BlackRock.

Choosing when to implement such tools and in what quantity is part of the overall management of the strategy, although we will always avail ourselves of input from other teams when needed. Risk modelling and oversight is provided by the Newton Investment Risk team, with a full look-through to underlying positions.

[1] The value of investments can fall. Investors may not get back the amount invested.

[2] Past performance is not a guide to future performance.

[3] Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA), BNY Mellon Fund Managers Limited (BNYMFM), BNY Mellon Fund Management (Luxembourg) S.A. (BNY MFML) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA, BNY MFML or the BNY Mellon funds.

909459 Exp: 31 August 2022

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