In the award-winning German strategy board game The Settlers of Catan, players compete to generate resources that can be used to buy or build settlements and cities.
However, players’ resources can be stolen by robbers, which can only be defended against using soldier cards. Because soldier cards cost valuable resources, they are often dismissed as unnecessary purchases. But when the robber is in action, the soldier becomes the most important card to possess.
Just like the robber in The Settlers of Catan, global market volatility in the first few weeks of 2016 has forced investors to lose resources. Now would therefore be a good time to consider using a soldier card to hedge against losses. For investors concerned that equity markets have rallied a long way, and that government bond yields are too low for any substantive income, hedge fund strategies are the soldier card that we have looking for. They offer the potential for better returns than cash or government bonds, while providing added diversification, reduced volatility and more downside protection.
The bull market in stocks is nearly seven years old, and government bond yields remain close to record lows after a near 35-year bond rally. While it does not look like a global recession that could end the equity bull market is imminent, it does seem likely that returns over the next few years for both stocks and government bonds will be lower than they have been since the end of the financial crisis.
Equity valuations are nowhere near as expensive as in previous bubble periods, such as 2000. In fact, valuations are only at around their 1996 level. But valuations are now higher than they were at the start of this bull market, and growth forecasts are below their long-run averages, which is why we expect equity returns to be lower in the near future. Government bond markets, on the other hand, look more extended relative to their past history. Returns in this sector are likely to be lower or even negative in 2016, depending on the region and the pace of US interest rate increases.
Equity markets tend to rise and fall together. Traditionally, investors have relied on government bonds to provide some protection when equity markets fall. However, government bonds currently provide a less reliable source of portfolio diversification and downside protection, as the correlation between bonds and equities has become less stable and yields remain near all-time lows, providing little cushion if rates rise. The relationship between stocks and bonds in the past 24 months has been more correlated than in the past several years, meaning stocks and bonds are not necessarily perfect complements in a multi-asset portfolio.
In this environment it could make sense to focus on risk-adjusted returns and downside protection. High returns are good, but they are even better when they are stable. Investment principles teach us that slightly lower but less volatile returns are preferred to high but unpredictable gains. As the likely returns available from traditional assets diminish, investors should focus even more on achieving returns without volatile swings.
Hedge fund strategies have the capacity to make money in different market environments by taking advantage of return opportunities that have low or negative correlations with each other. They use derivatives, such as options, to protect returns when there is a downturn. They can also short sell a market and its sectors when they believe those securities will lose. With the ability to profit from expectations that assets will fall, as well as rise, hedge fund strategies have a much broader set of investment opportunities than traditional funds.
Multi-asset hedge fund strategies with a ‘go-anywhere’ approach benefit from this wider toolkit and also from the opportunity to invest in more asset classes than traditional funds. These real-life soldier cards can express their positive, negative or relative market and macro-economic views across equity, bond, currency and commodity markets. Perhaps it is time investors added soldier cards to their hands.
Nandini Ramakrishnan is global market strategist of JP Morgan Asset Management
