Known knowns, known unknowns, and unknown unknowns… Donald Rumsfeld was widely credited in 2002 for bringing this concept to the public eye through his response to the US Department of Defense on the topic of weapons of mass destruction.
He said: “There are known knowns: these are things we know we know. We also know there are known unknowns: that is to say we know there are some things we do not know. But there are also unknown unknowns: the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tends to be the difficult ones.”
It could be said that our world today – and financial markets as a subset – has faced and is facing an unprecedented number of unknown unknowns. Cast your minds back to the surprise election victory of Donald Trump to find a fitting example to a popular ‘unknown unknown’ definition – “situations so out of this world that they never occur to you”.
It therefore becomes vital in investing to be very clear about what we know, what we don’t know and most importantly what we are likely to miss.
As we don’t know what president Trump’s economic policies will be, we find it difficult to forecast interest rate movements in the US but expect volatility to remain elevated for the foreseeable future. However, there are things we know which ultimately help shape portfolio construction.
For instance, the 30-plus-year cycle of falling bond prices has ended, and with the US Federal Reserve looking to continue on the path of tightening policy and remove accommodation, the status quo of typical bond management must be revised.
Absolute return bond strategies attempt to manage against the resulting change to the risk and reward asymmetry, while simultaneously targeting an expected return that exceeds the current yield on traditional bond indices.
Investors that use duration-laden, benchmark-relative strategies can no longer count on realised gains from the secular decline in interest rates.
The global financial crisis ushered in the swelling of global government balance sheets, worldwide quantitative easing, and zero or near-zero policy rates that effectively lowered the carry in most fixed income portfolios.
Therefore, investors face a lower total return potential from anticipated price depreciation, lower carry and asymmetry of duration risk in traditional fixed income portfolios.
Put differently, investors are not being properly compensated for bearing duration risk. Absolute return bond strategies serve as a substitute because they seek to address these issues by focusing on capital protection, maximising the carry component of total return, and addressing the asymmetry of duration risk in standard fixed income benchmarks.
In the current environment, investors who maintain the status quo of conventional fixed income approaches are likely to be forced to take on greater volatility coupled with lower returns.