Carry strategies, where investors borrow currencies in low-rate jurisdictions to invest in currencies with a higher rate, tend to be unwound during risk-off episodes.
While the pandemic has had the effect of normalising interest rates around the globe, the current rate repricing is creating interest-rate divergences, bringing to the fore once again traditional defensive currencies.
The US dollar has also acted as a defensive currency in past risk-off episodes, with the March 2020 liquidity event being the starkest example.
Diversified tail-risk hedging
Tail-risk strategies, where investors seek to protect portfolios against extreme market moves by purchasing protection at the expense of some returns, can be designed to offer modestly positive excess returns over the very long term, with a negative correlation to equity markets.
A winning tail-risk strategy might use a variety of instruments, including futures, swaps, 'vanilla' options and more exotic options such as digitals and contingents, as well as variance swaps, equities, fixed income and credit.
Generating convexity, whereby hedges become increasingly effective as their value increases, is necessary, but successful tail hedging depends on a real-time assessment of market positioning and detailed evaluation of market complacency or readiness for tail events.
Target return strategies
Liquid, macro-oriented, diversified absolute return strategies, somewhat more simply referred to as target return strategies, are capable of employing most of the above approaches – which can be complex for some investors to deploy – to provide a target return with a stable risk profile.
Historically, their unconstrained approach has enabled them to not only enhance the low expected returns from bonds, but also to protect portfolios during market drawdowns.
While government bonds are unlikely to offer the same source of returns and diversification that they have been offering over the past decade, they remain a crucial part of an asset allocator’s defensive toolkit.
However, in the current market environment, investors need the latitude to implement investment opportunities across different asset classes, strategies and time horizons to provide alternative sources of returns and necessary diversification.
Nabeel Abdoula is a partner and deputy chief investment officer at Fulcrum Asset Management