Key takeaways

• Perhaps the most concerning issue for multi-asset investors as we turn to 2023 is diversification.

• The correlation of bonds and stocks is not constant, can be positive, and is environment dependent. It is likely that the market environment for the next decade looks very different than the one we have seen over the past 10 years.

• With this type of market environment in mind, we see merits in offering a strategy that has the potential to deliver outcomes when other assets can't.

• We have run a strategy called “Absolute Return” since 2005 that aims to mitigate the sensitivities to both broad equity markets and broad fixed income markets.

Perhaps the most concerning issue for multi-asset investors as we turn to 2023 is diversification—or the lack thereof in recent times. This is especially true for those holding Treasuries, which many have grown accustomed to relying on when stock markets fall.

And while this is not the first time that the “traditional” correlation between U.S. Treasuries and equity markets has broken down—people tend to pay less attention when both are producing positive returns—it has been one of the worst years on record for the total return of a 60/40 portfolio in 2022.

Some have therefore suggested this is the “death” of the balanced portfolio, but we'd argue this is significantly overblown. That said, it has awoken investors to the risks that may be inherent in counting on the risk-mitigation efficacy of a 60/40 strategy across all environments—particularly if a client has short-term financial goals. Herein lies the merits of discussing an absolute return approach with clients.

A Tailwind for Absolute Return?

For many investors, both their equities and their bonds lost double-digit percentage points in 2022.While we would not claim to have “called” the type of market environment experienced, we have been cognizant of the potential risks that could impact a traditional stock and bond portfolio. An absolute return approach seeks to hold the right levers to handle such a scenario.

The correlation of bonds and stocks is not constant, can be positive, and is environment dependent. It is likely that the market environment for the next decade looks very different than the one we have seen over the past 10 years. Or said another way, “beta investing" will likely be different, given the shift in central bank asset purchasing, market exuberance, and economic prosperity. It may be harder to count on those drivers of financial markets moving forward. We believe that the Absolute Return strategy can help clients diversify away from these broad market risks.

Behind the Scenes of an Absolute Return Approach

We have run a strategy called “Absolute Return” since 2005 that aims to mitigate the sensitivities to both broad equity markets and broad fixed income markets.

The Absolute Return mandate was designed with specific client objectives in mind. That is, we seek to offer a strategy that can deliver outcomes in line with the goals of a client, but in a manner which is relatively agnostic to market moves. It therefore carries unique attributes which can be helpful delivering over a shorter time horizon, especially when compared to most traditional portfolios.

Not Just for Clients with Short Time Horizons

Often times, when investors have shorter-term financial goals, they dial down their exposure to equities and ramp up their exposure to cash or fixed income. For decades, this appeared a reasonable strategy as yields on higher-quality¹ fixed income seemed to only come down and interest-rate risk became something that people became more and more comfortable with. But as 2022 showed, higher-quality bonds can lose meaningful value when interest rates rise rapidly.

With this type of market environment in mind, we see merits in offering a strategy that has the potential to deliver outcomes when other assets can't. However, the case for the Absolute Return strategy is broader than that, and is potentially suitable for any time horizon, focusing on minimizing the sensitivities to broad traditional asset classes—namely U.S. stocks and bonds. So, by virtue of its name, this strategy seeks to generate absolute level of returns, not to beat a market-based benchmark.

Different is Different

Reducing the sensitivity to swings in broad equity and bond markets is easier said than done. Interest-rate movements and swings in equity markets impact nearly every financial asset, especially those that are publicly listed and have sufficient liquidity.

The reality is that even within the “alternatives” space, many strategies carry indirect sensitivities to broad asset prices. When there is market exuberance, many alternative strategies with sensitivities to equity markets tend to outperform their peers and when the market falls they move to the bottom of their category. These types of strategies are not suitable for the objectives of Absolute Return. Moreover, we would be concerned if the alternative strategies used in an absolute return strategy exhibit abnormally strong or weak performance. We are striving for singles and doubles, not home runs.

This idea of market beta (tracking the ups and downs of broad markets) is problematic. But in addition to market beta, there are other troubling characteristics that can often come along with alternatives.These include high costs, a lack of transparency, and illiquidity. We strive to avoid those pitfalls, too, by seeking liquid alternative strategies that we truly understand and that can be achieved at reasonable costs.

Finally, in designing the mandate of the Absolute Return strategy, we need to have a focus on vulnerabilities. This is paramount if it is to be considered for clients that seek a strategy with financial goals in mind. We seek to minimize any such vulnerabilities that could have a meaningful impact on their financial health.

What Does an Absolute Return Invest In?

Much effort goes into selecting alternative strategies that capture non-systematic risk without exposing to outsized drawdowns. Since 2005, our team’s understanding of different managers has evolved by going through different market environments and investigating different strategies. A good example was coming out of the Great Financial Crisis in 2008/09.

The emphasis on the ability to mitigate losses within the alternatives space heightened and the team spent several years slimming down the list of options that we felt were truly capable of helping us achieve our dual mandate of limited beta and limited drawdown.

Two of the managers that were found in those years remain core holdings in the Absolute Return strategy today—Water Island Merger Arbitrage and SSI Convertible Arbitrage. The only addition to the alternatives line-up in the past decade is the BlackRock Systematic Multi-Strategy portfolio.

We believe each of these unique strategies are capable of delivering outcomes at reasonable costs and without overexposing to market risk.

Added Investments That Can Work

The above said, we believe there can be opportunities within bond and equity markets that carry less sensitivity to broad-market movements. Often, this may be because they offer unique characteristics or unusually cheap valuations. As such, we seek to couple our large stake in very-intentionally selected alternative strategies with niche opportunities within short term bonds (therefore limiting our interest-rate risk) and the global equity opportunity set.This provides not only diversification, but the potential to capture some upside.

A Critical Eye on Absolute Return

While this may be a good narrative, there is no question that alternative strategies have disappointed through the years. In a world of steadily declining interest rates and strong equity market returns, many investors wrote these types of mandates off. Conservative investors were able to achieve reasonable outcomes in fixed income and equity markets, or if they didn’t, they recovered quickly.

That changed in 2022 and makes an Absolute Return mandate worthy of consideration. Bonds and stocks have both fallen in an environment of high inflation, an aggressive federal reserve, and concerns about the economy. So, this has become a good test for the efficacy of an Absolute Return strategy, including our one that we have run for nearly two decades.

The Merits of an Absolute Return Approach Today

Some clients have asked if they have missed the boat. Given where fixed income yields are now, it is a reasonable question. But client robustness is more than timing. For example, the potential for a long tail to inflation remains and the Federal Reserve may stay focused on fighting it. Taking on a lot of interest-rate risk may not be prudent for every client.

_{1 In the broadest sense, we mean fixed-income assets with low credit risk and/or a high likelihood of delivering on their coupons over the term of the bond.}