Always essential but rarely the portfolio star, Absolute Return strategies are outperforming right now (and with much less volatility)
By Ted Katramados, Director & Associate Portfolio Manager, TAG Relative Value Fund
Sometimes, the real star of a hit movie or TV show is a supporting actor. They were only supposed to be there to help the main roles shine, but they perform so well that they can’t help but move into the limelight for a while.
That’s the role Absolute Return strategies are in right now. Investors who cannot turn to stocks or bonds for a safe investment harbor are finding that Absolute Return is significantly outperforming both.
The hallmark of Absolute Return investing is its focus on maintaining a strategy uncorrelated to the rest of the markets. It is designed to return a positive result regardless of the market direction.
A nondirectional investment component as part of an overall portfolio construction is always a critically important allocation in any market. But these strategies often come to the forefront in uniquely challenging markets.
The reality of inflation, rising interest rates, and the strong possibility of a recession looming over everything has sent markets into tenuous territory. This is where Absolute Return can stabilize investment portfolios.
Absolute Return Strategies
An Absolute Return strategy, like the one we employ at TAG Associates, targets 4-7% annual returns, with low volatility and low correlation to stocks and bonds[i]. The idea is to focus on highly differentiated, all-weather managers that can earn positive returns regardless of environment. That includes arbitrage and relative value strategies, which bet on the relationship between two securities rather than directional market movements.
Some Absolute Return tactical approaches include:
- Global Macro: A strategy where managers invest across asset classes including equities, bonds, foreign currency, commodities and credit. Some macro funds tend to trade around top-down macroeconomic themes based on research, market trends, or other factors. Other macro funds are systematic, looking to capture inefficiencies and/or market trends through sophisticated computer models.
- Merger Arbitrage: Investing in the difference between where a merger was announced and where it is trading currently. Merger arb has been in and out of favor over the years, but the right manager approach can be effective.
- Convertible Arbitrage: An old strategy where investors try to trade between convertible securities (those that convert from bonds to stocks) and the same company’s underlying stock. A lot of hedge funds moved away from it, and it has now become somewhat attractive again as a place to unlock relative value.
- Volatility Arbitrage: Using listed option markets to identify deviations between predicted and market implied volatility. These funds attempt to generate consistent returns with minimal exposure to macroeconomic shocks and zero correlation with equity markets.
- Fixed Income Arbitrage: Looks to exploit aberrations in historical relationships. For example, the yield curve has historically foreshadowed future rate moves and can provide trading opportunities for managers. It also seeks mispricings or anomalies between different types of fixed income securities such as cash, bonds, swaps and futures.
Good managers, using these strategies, will benefit from higher volatility and high interest rates, and in particular, when stocks and bonds are down. A lot of long-only stock and bond managers don’t have a strategy to thrive in those markets.
A Fixed Income Alternative
Normally, when equity markets are going through periods of severe volatility, investors turn to fixed income strategies to endure the rough waters. In some markets, such as the one we’re in now, fixed income is no safe haven.
Right now, bonds and stocks are moving in the same direction (down!) due to higher than normal volatility in stocks and rising interest rates affecting bond prices. Stocks and bonds haven’t been this persistently correlated since the early 1980s, and Absolute Return strategies can thrive in noncorrelated markets.
The above chart shows the performance from April 2020 through June 2022 of the Bloomberg Aggregate Bond Index (white line) along with 10-year US Treasury Yields. Yields (light blue line) have risen sharply, resulting in an 8% loss for bonds over this period. On the other hand, the HFRI Conservative Fund of Funds Index (yellow line), a proxy for Absolute Return investing, has been positive throughout this period, rising over 19% in that time frame.
Diversification From Equities
Since the Global Financial Crisis of 2008, central banks have been buying securities and increasing their balance sheets to unprecedented levels. This has provided a substantial lift to risk assets, but to stocks in particular, which have defied historical return patterns since 2008.
As the Federal Reserve in the United States has purchased fixed income securities, correlations among asset classes have risen. Many investors have overallocated their portfolios to equities due to the continued upward movement of stocks and a heavy fear of missing out on a continuing rally. There’s a belief that central banks will always have the back of equity markets, but that isn’t necessarily true and something that investors should be increasingly mindful of.
Over the past 20 years there have been two 50% equity drawdowns that have jarred investors. It’s not out of the question that this could happen again. Absolute Return investing has a history of providing stability. It doesn’t have the upside potential that heavy equity exposure has, but it should limit downside.
Absolute Return Hedge Fund Index (HFRXAR) vs. S&P 500 YTD
The above chart shows the YTD return of the HFRX Absolute Return Index (HFRXAR), a proxy for Absolute Return hedge fund investing, vs. the S&P 500 (yellow line). The S&P was down 17% through Aug. 31st while the HFRXAR was down 1.3%. As the chart shows, not only was the performance of the HFRXAR far superior, but much less volatile, as well. Further, an experienced Absolute Return allocator can and should outperform the HFRXAR.
Absolute Return investing is an effective alternative and/or complement to traditional “60/40” investing. It has proven itself, especially during 2022, to be a strong fixed income substitute and a hedge against equity market volatility. Ongoing high volatility, which has continued and even increased lately, would be favorable for most Absolute Return managers.
Having Absolute Return exposure will reduce portfolio volatility and should provide positive returns most years, especially in down market years when investors need it most. It will play a key supporting role in most markets, but right now, it’s the star of the show.
[i] This article is intended for discussion purposes only. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by TAG Associates LLC), will be successful.