Not enough to just hold beta anymore
By Talib Sheikh, co-fund manager, JP Morgan Global Capital Appreciation fund
Balanced investing in traditional markets (ie being a buyer of long-only beta) has handsomely rewarded many investors in the years since the financial crisis.
The tide has lifted all boats as virtually every asset class has done relatively well. But relying on long-only beta to deliver returns through the lurches in today’s global markets is not be enough anymore, says fund manager Talib Sheikh.
As a macro-thematic, multi-asset investor who strives for a portfolio that can perform no matter the economic and market conditions, Sheikh has increasingly tapped into a mix of sophisticated strategies to diversify away from traditional asset classes.
Back in 2013 Sheikh had over 56% of his portfolio in traditional risk, investing in a more typical multi-asset split of equities and bonds. But as traditional asset classes have started to look less attractive, Sheikh shifted risk more towards less correlated sophisticated strategies, such as relative value, derivatives, and dynamic hedging strategies.
As a result, he now has 60% of the portfolio in sophisticated risk and just 40% of the portfolio in traditional risk. He’s taken down overall directional risk (meaning exposure to price changes in the broad markets) in the portfolio, focusing instead on pairwise and non-directional positions where he has high conviction.
Sheikh bases his fund on the belief that global macro-economic trends are the primary driver of all asset class returns and he takes a flexible approach to implementing strategies in the portfolio based off those trends. That means he can exploit a particular view through multiple different types of investments in order to generate returns, whether that means using traditional or sophisticated strategies, across any asset class globally.
This process allows him to seek to capture the upside potential in the markets whilst protecting against downside risk. For example, he has identified eight important macro-economic themes dominating the markets and is using as many as 30 different underlying strategies at any given time to play investment ideas based off these themes.
Included below is the macro-thematic framework on which Sheikh runs the fund and tactical examples of how he’s playing these ideas:
- Europe’s gradual growth recovery: With the ECB’s proactive response to low inflation, growth is returning in Europe and credit conditions are improving, despite the structure risks that remain. Once the situation in Greece stabilizes, the tailwinds of weaker EUR, improving Eurozone confidence, and an upswing in the credit cycle should combine to drive European risk assets higher
- How he’s playing it:A Greek deal looks likely, but many political hurdles remain he had has trimmed his tactical allocation to Europe as a partial result. He thinks any fallout from a Grexit would be contained and that price action has been sanguine because the backstops from the ECB are credible and contagion is not a major concern. Meanwhile, the portfolio has actually benefited from some of the near-term volatility in Europe through its long Europe versus short US variance swap, a trade which allows investors to bet on the volatility of one market relative to another market.
- Emerging market rebalancing: Unfavourable global conditions and fading credit booms are forcing slower emerging markets growth and external rebalancing, making this an area of concern overall. EM assets are under owned and relatively inexpensive, but until there is greater evidence of structural reform – or assets are and truly discounted levels – we would remain wary.
- How he’s playing it: A significant underweight to emerging markets is one of Sheikh’s highest conviction ideas and he is actively shorting emerging market equities. He’s also been meaningfully negative on the global commodities complex and second derivatives of that play. For example, he’s short emerging market commodity related currencies, such as the Aussie dollar, which is reliant on declining commodities demand from a slowing Chinese economy. He’s similarly done well from shorting emerging markets currencies in preference to the US dollar, including shorting the Korean won and the South African rand.
- US economic strength: US employment continues to recover, inflation is stable, the US consumer is set to benefit from lower oil prices and corporate balance sheets are strong. We are marginally of the view that a September rate hike from the US Federal Reserve is still on the cards. However this call is quickly becoming 50:50 – strong 2Q15 GDP and continued momentum in US jobs support a Sept move, but any spill over from recent market volatility into a stronger US dollar could stay the Fed’s hand. Nevertheless, we believe that the Fed will start hiking this year, and as such see the front end of US rates as overvalued. We would anticipate some volatility in equities over the hike itself, but history suggests this should be short-lived – particularly when, as will likely be the case, it is better growth prospects that are leading the Fed to tighten.
- How he’s playing it: Sheikh is sanguine on prospects for US equities to continue their six year bull market and has been holding onto exposure, in part through a long USD position. In contrast to many other fund managers, he doesn’t see the pending US Fed interest rate hike as a reason to take his chips off the table in the US. He particularly likes the tech and financial sectors, where valuations look attractive and has recently done well in the healthcare sector, where M&A activity has created opportunities.
- Low inflation: Significant output gaps and labour yet to regain its pricing power is keeping inflation very low around the world
- How he’s playing it: Some of Sheikh’s largest traditional positions in the portfolio, including healthcare equities and developed market fixed income exposure, are reflective of the low inflation theme. However, he has reduced risk in this theme, taking down equity and bond exposure to shelter the portfolio. He’s also reduced duration exposure in the fund, bringing it down to nearly zero across the portfolio, in order to keep interest rate sensitivity low.
- Supply side weakness: Low growth of labour forces and productivity globally will limit growth and may lead to earlier rate hikes from central banks
- How he’s playing it: Tighter supply side should put pressure on bond yields in the short term but lowers trend growth and hence terminal rates, which supports long-dated fixed income returns. As a result, Sheikh has positions in the fund set to benefit from a flattening of the US yield curve, in which short-term interest rates would rise in response to a Fed interest rate hike but longer dated rates would remain relatively static.
- Global policy divergence: Economic recoveries around the world have been on different trajectories since the financial crisis, which today is reflected in differing regional policy responses. The US Fed is on the cusp of beginning the path towards normalisation with the first interest rate increase in nine years, whereas the European Central Bank and the Bank of Japan remain committed to aggressive balance sheet expansion through asset purchases to reignite inflation to protect their economies.
- How he’s playing it: This theme is reflected in Sheikh’s long on European equities, which he thinks should benefit from ECB QE, although he has trimmed risk in that position recently. It is also reflected in his short on emerging market equities, which are likely to suffer from tightening US monetary policy, which may in effect pull capital out of EM. Finally he is long the USD as a reflection of this them, which he thinks is strengthened by improving internal and external balances.
- China in transition: China is slowing as it digests a rapid accumulation of credit. The extreme levels of recent volatility we’ve see in the Chinese markets suggest that policy tools may not be fully effective in addressing structural concerns.
- How he’s playing it: Recent volatility in China equities has caused Sheikh’s long China versus short US variance swap to perform well. He’s short various emerging market commodity related currencies that will suffer from China’s deterioration and short EM equities overall.
- Japanese economic recovery: The Japanese government and the Bank of Japan are aligned in their goals of reflating asset prices and reinvigorating the economy. Consumption is slowly recovering and the economy is showing signs of sustainable strength.
- How he’s playing it: Sheikh is investing in Japanese exporters, which are attractively valued and gain operational leverage due to the devaluing currency, so are poised to higher profitability. He is also long Japanese real estate stocks which should benefit from the domestic policy focused on reflation.
The ability to pick the investments that will benefit from the prevailing macro trends and hedge against those that won’t has helped Sheikh’s fund outperform across different market environments. For example, both stocks and bonds are down over the last 8 months (MSCI World has returned -1.5%, JPM Global Bond Index returned -.7%) whereas Global Capital Appreciation Fund was up by more than 1%. The fund also beat a balanced mix of 50/50 bonds and equities over the last 20 months and more recently has outperformed during the heightened volatility, significantly beating peers over 1 month, 3 months and year to date.
Commenting on how he seeks positive returns in different market environments, Sheikh says he takes global asset allocation to the next granular level, with the maximum flexibility to trade on convergences and divergences in global macro-economic trends, whether that is through dynamic hedging, shorting, currencies, derivatives or through traditional markets.
More on Comment
