By Oksana Aronov, chief client portfolio manager, Opportunistic and Absolute Return Investing at JP Morgan Asset Management
Absolute return investing – which seeks to generate returns regardless of underlying market conditions – has grown tremendously. Inflows in the UK and across Europe are on the rise as investors seek diversified sources of return, lower volatility and less reliance on market beta. When most investors think of absolute return, hedge fund like strategies such as equity long/short come to mind. Or they think absolute return strategies focus on areas such as commodities or FX.
But what does absolute return mean in the context of fixed income investing? And how does it hold advantages over traditional fixed income investing, especially in the context of today’s rocky bond markets?
In some respects, investors have always thought of fixed income as an “absolute return” asset class. For decades they have relied on it to deliver capital preservation, income, and diversification from risk assets. A 30+ year bond bull market fostered an environment where investors were lulled into complacency, used to outsized returns and low volatility.
However, a major source of those stable returns have been duration or interest rate risk, which has been a powerful stabilizing force in fixed income and the only real source of diversification versus riskier assets. Now with global yields at all-time lows, duration turns from a stabilizing force for portfolios, into a potential source of losses should rates normalize.
With rising awareness of the risks inherent in fixed income, as investors see the writing on the wall, has come an explosion of non-traditional styles of investing. Unconstrained fixed income strategies have become popular for example, but investors would be mistaken to confuse them with absolute return. In fact, being called an “unconstrained fixed income strategy” merely describes the opportunity set, but tells nothing about the manager’s goals, risk tolerance or willingness to use leverage.
Absolute return fixed income strategies are actually a subset of unconstrained and have three purposes:
- Generate positive returns regardless of market environment
- To diversify the fixed income allocation, and/or
- To add a different investment style into their alternatives allocation, without significantly amplifying correlation to risky assets.
In other words—investors who buy absolute return funds seek traditional fixed income benefits such as capital preservation and consistent returns but achieved through alternative instruments and techniques with low correlation to traditional market betas.
It’s worth looking under the bonnet at some of the ways that absolute return funds manage to achieve steady return streams with low volatility and low correlation to understand how they work. There are five main characteristics to look for:
- These funds are tactical in their exposure to interest rate and credit risk
- They access sources of returns that aren’t correlated with the markets. An absolute return strategy should be a true diversifier in an asset mix and is only relevant if improving the overall risk-adjusted return across an investor’s broad portfolio. To achieve this, managers can employ relative value techniques to generate alpha such as trading credit long/short or yield curves. Strategies can also access less correlated sources of income from niche areas such as structured products, insurance linked securities, and non-traditional instruments in the private markets.
- These funds manage risk to focus on capital preservation first and limiting drawdown, which is fundamentally every investors’ concern
- They construct portfolios that can produce returns in a variety of scenarios, with the goal of delivering positive returns no matter the underlying market environment. In order to achieve that, they need to have multiple sources of return and understand the impact from extreme market stress
- They take a systematic approach to hedging, in order to mitigate drawdowns and be prepared for any tail risks. The level of the hedge ratio may vary, depending on market opportunity, but the process for identifying the right level and actual hedging instruments must be consistently present in an absolute return strategy.
- Managed by an experienced team. Absolute return investing is a different ballgame from long-only, benchmark oriented investing. The toolkit needed to identify and manage both risks and opportunities across multiple sectors, geographies, instrument types and long/ short exposures is quite distinct from that of a traditional manager.
The fixed income landscape is changing and presenting investors with new risks and opportunities. Historically low income is forcing investors to reconsider their objectives, while high correlations across asset classes are creating obstacles around diversification. Coupled with the prospect of higher rates, the need for diversification and steady returns has never been more important. Absolute return fixed income can deliver on this proposition, in today’s market and all markets.