Sometimes the real star of a hit movie or TV show turns out to be a supporting actor — the one who was there to help the leads shine, but who performed so well they couldn't help but move into the limelight, at least for a while. That's the role absolute return strategies are playing in today's market as they significantly outperform the stocks or bonds to which high net worth investors can no longer turn for safe investment harbor.
The idea is to focus on highly differentiated, all-weather managers that can earn positive returns regardless of environment. (The strategy we employ at our firm targets 4% to 7% annual returns, with low volatility and low correlation to stocks and bonds.) That includes arbitrage and relative value strategies, which bet on the relationship between two securities rather than on 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. Others look to capture inefficiencies and/or market trends through sophisticated computer models. In 2022, these strategies have capitalized on rising interest rates, the strength of the U.S. dollar, and the decline in global equities.
Merger arbitrage: Investing in the difference between when a merger was announced and where it is trading currently. Merger arb is an opportunistic strategy that has been in and out of favor over the years. The best way to capitalize is to quickly allocate capital once spreads on between deal prices and actual trading levels have pushed out, and then monetize as they revert. Buying and holding spreads can lead to losses when spreads widen or during long periods of sluggishness when deal volume, market volatility or interest rates are low. But with the right manager it can be effective.
Convertible arbitrage: A venerable strategy where investors try to trade between convertible securities (those that convert from bonds to stocks) and the same company's underlying stock. Too many hedge funds crowded into convertible arbitrage in the post-2000 period, making it difficult to find value. Periodic crises hurt returns, as did lower interest rates and the lower volatility of the quantitative easing era. Although touted as long volatility, many funds suffered large losses when volatility spiked. That led absolute return managers to other areas. But it has become more attractive 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. Since volatility arb managers both buy and sell volatility, they are agnostic to market direction and often exhibit low correlation to it. But higher volatility environments, like those we've experienced this year2, are better because they offer more bites at the apple, so to speak.
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.
Managers who effectively use these strategies will benefit from higher volatility and high interest rates, particularly 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.
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. However in some markets, such as the one we're in now, fixed income is no safe haven: 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, making absolute return strategies' ability to thrive in non-correlated markets a valuable asset.
From the start of the pandemic through the third quarter of 2022, the HFRI Conservative Fund of Funds Index, a proxy for absolute return investing, rose almost 20%. Over the same period, the Bloomberg Aggregate Bond Index and U.S. Treasury yields fell more than 12%, showing the significant strength of absolute return strategies versus bond investing.
Diversification from equities
Since the 2008-2009 financial crisis, 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 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 big 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 doesn't always hold true — 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 of heavy equity exposure but it should limit downside.
Similar to bonds, absolute return strongly outperformed stocks through the third quarter of this year. Amid high volatility, the S&P 500 dropped almost 25%, while the HFRX Absolute Return Index was up over 1%. Additionally, the HFRXAR was much less volatile.
In summary, absolute return investing has proved itself, especially during 2022, to be an effective alternative or complement to 60/40 investing as well as a strong fixed income substitute and a hedge against equity market volatility. The strategy reduces portfolio volatility and provides positive returns most years, and especially in down markets when investors need it most. A key supporting role in most markets, right now, it's the star of the show.
