s a consequence of the historically low yields offered by developed market government bonds, the traditional role of duration as a natural counterbalance to equity beta is not efficiently working for multi-asset managers today. The low yields in renowned 'safe haven' government bond markets – as evidenced by a 10yr German bund yield of just above zero – additionally bring sizeable drawdown risks.
Many DGF funds struggled during the volatility this year because managers failed to address this new fixed income paradigm and cannot identify truly defensive (anti-beta) assets. Many managers look to de-risk and limit drawdowns either by buying expensive protection, or try to time the market. This approach leads to inconsistency and proved to be insufficient for most funds during the drawdown and subsequent rebound in Q1. Instead of the notoriously difficult task of repeatedly making accurate macro calls, multi-asset managers need to find alternative solutions to fill the role traditional duration can no longer fully serve.
One substitute to government bonds in protecting downside is quality low-risk equities. Stocks with robust fundamentals and more resilient earnings tend to behave better than overall global equities during negative periods – as witnessed at the beginning of this year. For example, stocks such as Verizon Comm. and Infosys rose by 7% in January, a month where global equity markets plunged more than 10%.
In addition, a currency overlay based on Purchasing Power Parity principles also displays anti-beta behaviour. We select highly-liquid G10 pair trades on two main criteria. Firstly, trades are analysed for correlations with S&P and HY indices, to ensure the positions can offer protection during stressed periods. Each pair trade also has to be undervalued on PPP principles, to ensure the diversification benefits will persist. For example, a long JPY/ short GBP pair trade was able to return more than 10% during the volatile Q1 this year.
Despite the alternatives, duration can still play a role, but investors must find premiums offering attractive risk/reward characteristics, as well as decent protection. Which high-quality Alternatives to broken duration government bonds offer the best protection and the most attractive expected return?
Considering where yields are, we believe the answer is the UK and US. Both gilts and treasuries offer a higher buffer, as well as a higher coupon to compensate mild increases in yields. Another overlooked area is covered bonds, which offer similar safety as sovereigns, but with an attractive yield pick-up. Finally, with traditional assets displaying volatility this year, many investors may be tempted to seek alternative assets. However, real assets – areas such as infrastructure, private equity and real estate – often suffer from illiquidity and are artificially lowly-correlated to traditional betas. Efficient diversification is not about the number of assets, but rather a select number of truly uncorrelated positions.