FTAdviser.com

Advertising

The credit crisis did not descend into the systemic financial crisis predicted by some at the start of the year. While this appeared quite conceivable until Bear Stearns’ rescue in March, the collective loss of confidence it ushered has cast a dark shadow over markets in 2008. Perhaps more threatening to the future, however, has been the re-emergence of inflation after a 20-year intermission.

Cautious managed funds have not been immune to these threats, with the average manager down 6.5 per cent over one year to the end of June. It may well be time to embrace a new range of investment tools.

For cautious managed funds, traditional portfolio diversification approaches provided only limited capital protection given that, within mainstream asset classes, just cash and sovereign bonds have provided positive returns. Outside the mainstream, commodities, responding to higher materials and energy prices, have provided spectacular gains, although, for most in the regulated non-hedge fund world, they remain out of scope and accessible only partially through related equities and some exchange-traded vehicles.

It has not simply been credit-led financial market weakness or slowing economic activity weighing on confidence, but a seismic shift in investment fundamentals. Almost the full range of investment and risk measures - risk premia, cost of equity, capital, credit spreads and credit default insurance, interbank rates and volatility - has risen sharply in all regions over the last 12 months after an extraordinarily benign period in recent years.

They have closely tracked the rise in inflation and, more specifically, commodity prices. They reflect growing uncertainty about the future and imply a tougher and more variable climate for investment returns.

The response from portfolio managers so far has been to gravitate to the safest and most visible assets. Valuation has become a less influential driver, as the recent appetite for overvalued sovereign bonds - especially index linked - and cash would indicate. Indeed, US treasury bonds have outperformed Bric-based equities by 20 per cent year-to-date.

Changes to investment fundamentals affect the risk, performance and correlation behaviour of all asset types, influencing the critical dynamics in portfolio construction. Inflation has a corrosive effect on capital and company margins, which has led to the current difficulty being experienced by equities, which have historically outperformed other assets in mild inflationary conditions, as dividend growth usually outpaces prices.

Sovereign bonds are perceived as safe-haven assets and currently also benefit from the growing actuarial trend to match liabilities. They are, however, nominal assets, and if inflation persists, it will erode capital.

Higher corporate bond spreads impact companies’ profitability and have a bearing on company solvency, often negating the positive impact of lower interest rates. Unsurprisingly, corporate bonds perform similarly to equities in high-risk phases. Higher volatility affects option pricing and, in particular, the cost of protecting a portfolio using puts. When volatility spikes, it becomes less viable to use insurance than to sell positions outright.

The potential for inflation to deteriorate both in the developed and emerging world at a time when growth is slowing is the greatest source of market uncertainty. Central banks and bond market participants were remarkably effective in the 1980s and 1990s at expunging inflation, having seen the spectre of stagflation in the 1970s. However, after five years of above-trend global growth, thanks to ultra-low US real interest rates, surging liquidity and over abundant credit, the inflation genie has been let free again.

The position is exacerbated by the emerging world, which, until last year, was an exporter of deflation. With increased local imports, rising food and energy costs and speculative investment flows into real estate, these countries are now exporting inflation. Even though growth is now moderating, with inflation running at 8 per cent in China and 12 per cent in India, real interest rates are still negative.

Interest rate setters in the developed world, who are influential in governing rates for emerging countries linked to the dollar too, now walk a fine line between needing to snuff out inflation and preventing growth from stalling altogether. With core CPI in the eurozone now having risen above 4 per cent - a 16-year high - Europe has joined the fast growing club of nations, including the US, the UK and Japan, with negative or neutral real interest rates. The medicine could become the source of the ailment here.

Coping with these shifts in fundamentals and asset behaviour demands a thoughtful and pragmatic approach to asset valuation and allocation. Managers also have to consider equity and credit selection, together with the impact on non-directional strategies, instruments and techniques hitherto the preserve of hedge funds.

Traditional “cautious” approaches have been somewhat one dimensional, reliant upon a high, fairly static component of fixed interest assets to limit volatility - in conjunction with other less correlated assets - to provide periodic equity beta and income. Performance in relative terms in the post-millennium bear market was good but, more recently, higher inflation and widening credit spreads have served to increase overall volatility. And the recent bond bull phase has driven yields to excessively low levels, resulting in fairly pedestrian performance.

More progressive cautious strategies within regulated funds have emerged in recent years that have leveraged some of the “non-directional absolute return” of hedge funds and sought target-specific or inflation-adjusted returns, rather than relative returns. These exploit, to greater or lesser degrees, a more extensive array of assets, including commodities, third party and fund of hedge funds, as well as alpha-generating derivative and downside protection strategies permissible through Ucits III and Coll derivative changes. These have enabled them to side-step the worst excesses of recent market turmoil and provide a realistic hope of achieving positive returns in difficult market conditions in the medium term.

Even these more progressive funds, however, have found the most recent period difficult. The increase in inflation has made real-return hurdles harder to scale, and recent spikes in volatility have added to the cost of buying insurance through put protection. But looking forward, it will be very interesting to see over the next few years how many cautious managed funds can continue to ignore adopting similar derivative strategies if they want to continue to compete with those funds that do.