Investing strategies in a post-QE world

It is widely anticipated QE will be completely wound-up in September or October; whether interest rate rises will follow soon after is an important question for fixed income investors.

Consensus forecasts are for US rates to rise in the second half of next year but, just as the Bank of England governor Mark Carney has implied in the UK, it is possible a rise could come sooner, as the economy improves and a desire to return to more normal monetary conditions strengthens.

Such uncertainties are prompting investors to consider new approaches to complement traditional long-only fixed income strategies, as indicated by the high levels of retail inflows into the IMA’s Strategic Bond sector, while flows into other fixed income sectors have been slowing to almost nothing.

So what are investors looking for? They want solutions that are designed to be flexible and perform during different market conditions. Most pertinently, these strategies should have the ability to deliver meaningful returns over and above risk-free levels, as we go through a period of rising interest rates.

The hedge fund world has long been home to flexible, absolute return approaches to credit investing – free from benchmark constraints and able to invest across global corporate bond markets. Such strategies are becoming more common outside of hedge funds, although there are some notable differences in these newer breed strategies – the absence of performance fees and leverage are important ones, as well as the likelihood of tighter risk controls and more robust regulatory frameworks.

Multi-asset approach

A good multi-asset credit portfolio should be able to generate returns from a wider number of sources than a traditional portfolio. Its manager will be able to use a range of techniques to capture highly attractive risk-adjusted returns, avoid out-of-favour sectors and – importantly – dampen volatility and hedge risk.

One of the distinctive features of multi-asset credit strategies that may help do this is the absence of standard benchmarks. Benchmarks are an integral part of fixed income investing, particularly when it comes to single sector/asset class portfolios. But traditional benchmarks carry interest-rate sensitivity by being tied to duration parameters. By removing the benchmark and link to duration, managers have far greater flexibility to control interest-rate risk and potentially enhance returns by allocating to assets with less sensitivity to duration as market conditions dictate.

The absence of a benchmark also means an investment manager can freely allocate between credit sectors. The dispersion of returns from major fixed income indices globally tells you that being tied to one or two markets may hamper return potential. For example, in 2013 and 2012 European high yield was the best performing fixed income asset class, but in 2011 it was the worst – while lower risk fixed income assets outperformed that year.

The preceding years tell a similar story, with different fixed income indices rising and falling, outperforming and underperforming. By being able to navigate between sectors, a wide array of opportunities to deliver alpha and reduce risk opens up.

Hedging is likely to be an important feature of global multi-asset credit strategies. Some managers may seek to generate significant additional returns from shorting markets or individual credits. Others use hedging to dampen volatility and neutralise market beta in order to allow long-only asset allocation – and underlying credit selection – to generate the bulk of returns.

The growth in demand for multi-asset fixed income strategies does pose some problems for investors. Having no benchmark can raise questions about how to evaluate an investment. The simplest way to do this is to assess whether the strategy delivers on its investment goals, typically ‘x’ percentage points above the risk-free rate.

The big question as we enter what appears to be a new phase of the post-financial crisis economic environment is, will these strategies deliver? With the right investment manager and strategy, the answer to this question will be ‘yes’, with multi-asset credit solutions playing an increasingly integral part in fixed income portfolios.

Mike McEachern is CFA at Muzinich & Co