Capital preservation, the part of investing that actively aims to minimise drawdowns, has always been seen as the boring counterpart to investing for growth via equities, not least because of the difference in expected returns. Numerous studies1 conclude that the long - run return from equities lies somewhere between 6.5% and 7.2% p.a. after adjusting for inflation. This is testament to the ability of the listed corporate entity – one of the world’s greatest inventions – to capture economic progress, population growth, immigration, innovation and productivity over time.
For many investors, some kind of allocation to equities is therefore likely appropriate and the investment industry correctly relies on their intrinsic characteristic to build portfolios for its clients depending on their risk profile and investment objectives. But for many investors, a 100% equity allocation simply may not be appropriate given the asset class’s vulnerability to near-term sentiment. An investor with a two-year time horizon for example would not have been served well by holding only equities in 2001 as the technology boom unwound.
In addition to growth potential, many investors require some kind of portfolio brake or dampener to smooth out the return profile, much as a ship or airline captain will reduce power to aid passenger comfort when the journey gets choppy. For this reason, the 60:40 portfolio was traditionally the asset allocation of choice, with 60% allocated to equities to deliver growth, and 40% allocated to capital preservation assets (notably fixed income) to dampen the volatility arising from the equity exposure. While few would doubt that, over the long term, equities should continue to deliver strong returns, market conditions have evolved and the increasing correlation between equities and bonds, together with a collapse in bond yields, casts doubt over the reliability of the assets traditionally used for capital preservation to deliver on such a mandate. These developments demand no less than a profound re-appraisal of this less glamorous, but vital, part of portfolio construction.
Developed market government bonds have traditionally fulfilled the ‘40’ role in the 60:40 portfolio with aplomb for over a generation. Not only did they provide diversification from equities and generate a reasonable income but they also enjoyed multi-decade capital appreciation during the ‘Great Moderation’ begun by former Federal Reserve (Fed) chair Paul Volcker in his successful quest to kill off inflation. Government bonds could therefore do little wrong from the early 1980s to today, with yields falling from a massive 15.8% (as at the end of September 1981) to just 2.7% (as at the end of December 2018). This clearly helped deliver capital preservation during that period as bonds were on a quasi-permanent, multi-decade rally which lasted through the recessions of the 1980s, the bursting of the internet bubble and more recently the global financial crisis.
Government bonds were therefore, in our view, rightly institutionalised as the capital preservation asset of choice, but may make less sense today. Given that their yields should reflect nominal GDP growth, we believe the 10-year US treasury yield is completely ‘wrong’ at 2.7% (as at the end of 2018) since US GDP and inflation combined are running well north of 4% for example. Such mis-pricing can also be illustrated by the application of a traditional equity valuation measure to the same 10-year US treasury bond; on this basis its valuation is clearly exorbitant compared with the S&P 500 equity index. Treasuries were trading at a ‘price / earnings ratio’ (P/E) of 37x at the end of 2018 (assuming ‘P’ to be 100, and ‘E’ to be 2.7% yield), compared with just 17x for the S&P 500. The equivalent for the German 10-year bund would be 413x, compared with the MSCI Europe ex UK at 15x. While investment managers’ reputations have been damaged by premature calls for the end of the developed government bond rally, we believe it seems unwise, at current levels, to deploy the asset class in a structural role as crucial as dampening wider portfolio volatility.
Exorbitant cost of safety: government bonds trading at much higher ‘p/e multiples’ than equities:
Past performance is not an indicator of future performance and current or future trends. For illustrative purposes only.
For larger and more sophisticated investors, hedge funds have historically offered a potential capital preservation alternative. Skilled traders could, and did, produce strong returns independent of equity markets and, for a golden period in the 1990s and some of the 2000s, the consistency of returns among hedge funds and alternative investments was something to behold. But average returns as measured by the HFR hedge fund peer group indices have since fallen away, with their once-coveted diversification properties becoming increasingly elusive for the average investor. The reasons for this are not strikingly obvious, but we believe they are likely related to the rally in government bonds described above.
Many macro hedge funds historically leveraged the yields available from these bonds in order to generate a healthy ‘starting return’ from which to build on selected high-conviction trades. As government bond yields bottomed out, or at least their rate of descent slowed, so too did the natural returns available to many hedge funds. This had the effect of exposing many hedge funds, since the average return deteriorated. As Howard Marks, co-founder of Oaktree Capital Management said recently, “In 2004, I said there are 5,000 hedge funds and I don’t think they’re run by 5,000 geniuses. Today we’re probably up to 10,000.”
In 2018, the negative performance of major hedge fund indices bore this assessment out, reflecting the continuation of a low interest rate environment (described above) and a rockier climate for stocks. At the same time, the hedge fund sector’s Darwinian ability to replace dead wood has been compromised by higher barriers to entry arising from new regulations.
Average hedge fund returns a function of bond yields:
Past performance is not an indicator of future performance and current or future trends. The performance is net of fees, commissions and other charges. For illustrative purposes only.
The New Capital Preservation
The developments described in the preceding section present a profound challenge to investors, since today’s low bond yields suggest a tough outlook not just for bonds but also for many alternative investments. Where then are investors to turn to for reliable, low-correlation returns that can complement their equity allocations? We believe the answer could lie in a rigorous, professional screening of the investment universe, coupled with a cool-headed assessment of market conditions and the resultant prospects for different styles of capital preservation.
To this end, ‘alternative fixed income’ is an emerging category that has, in some cases, delivered encouraging results that are independent of equities or government bond indices in recent years. Examples include insurance-linked bonds whose return stream is tied more to weather events and particularly Florida’s well documented hurricane season. Attractive yields are potentially available, and skilled managers aim to pick up bonds cheaply after declared events in the market. Similarly, mortgage-backed securities (MBS) complement insurance-linked bonds well in our view, with the potential to deliver a sound yield from both private and agency-backed pools, as US consumers maintain debt discipline amid rising wages and low unemployment.
As for traditional corporate credit, we believe this can still play a role if handled with care. For example, US high- yield corporate bonds have the potential to offer attractive yields but prices in the short term tend to move with equities and the asset class was hit hard at the end of 2018 as equities sold off. To minimise this undesirable characteristic, we believe high-yield bonds with a shorter maturity and duration (sensitivity to interest rates) can be selected in order to produce less volatility and more independence of return than their longer-dated cousins.
With respect to alternative investments, excessive nihilism can almost be forgiven by dint of the asset class’s recent track record and over-reliance on the twin bond and equity rallies. Nevertheless, we believe some attractive sources of return still exist. For example, merger arbitrage funds which focus on ‘Tier 2’ corporate deals have demonstrated an ability to generate steady returns over time, while select market neutral equity long / short managers have demonstrated an ability to dampen portfolio volatility effectively, given that ‘alpha’ is the sole source of investment performance. Meanwhile, we believe target return approaches with a strict focus on low correlation and risk-weighted, thematic positioning can further enhance risk-adjusted returns.
Over the course of 2019, we believe we are likely to witness greater volatility and dispersion, both across and within markets. In theory, this might improve the overall opportunity set for flexible, alternative investment funds, including the styles described above, as well as macro trading and alternative risk premia approaches. However, it should be noted that increased dispersion has the potential to excessively reward and punish in equal measure. We believe managers who make the right calls could really, really get it right in 2019, while those who don’t, could see greater losses as a function of larger market moves. The key will be to identify skill in advance, which demands a combination of scepticism and hard research. So, while the alternative investment universe is unlikely to make a 1990s-style comeback in the coming year, in our view, carefully studied opportunities do exist and could play a meaningful role.
Finally, cash could also serve a valuable function and deserves to be recognised as no less than a fully active portfolio allocation decision. With the yield on the US 3-month government t-bill now over 2.2%, here is an asset class that gives a near-guaranteed rate of return with very low correlation to equities and longer-dated bonds. In 2018, US near-dated cash comfortably outperformed both the S&P 500 and the 10-year US government bond. In Europe, negative interest rates make this point less relevant but UK investors can certainly join their US counterparts in taking advantage of cash rates as part of a well-constructed capital preservation book.
‘The New Capital Preservation’ is not a single fund or asset class which investors can simply slot in place of their traditional diversifiers. Instead, it is a nuanced and carefully constructed strategy comprising alternative fixed income, hyper-selective alternatives and near-dated liquidity instruments. In this evolution, we believe the reliability of return and low correlation to equities and bonds take precedence over high return expectations and a misplaced reach for yield. In our view, this is anything but an unambitious aspiration - in a world where government bonds start to sell off, such characteristics will be at a sizeable premium.