Fixed income: capturing credit opportunities, prudently
Volatility appears set to remain for the foreseeable future, causing ongoing market distortions and creating low visibility on the impact of the crisis. However, current credit spreads are now at levels that could compensate investors for volatility and extreme default scenario, in our view.
We believe active management and rigorous bottom-up analysis are crucial to surviving this unusual and unprecedented environment. We continue to focus on (i) credit risk by identifying vulnerable sectors and issuers (ii) diversification by holding broad portfolios of bonds: this protects well against a single-issuer event.
Meanwhile, current market conditions are providing interesting opportunities for relative value trades to be implemented in fixed income, and enhance portfolio returns.
Last but not least, the Federal Reserve’s aggressive quantitative easing is extremely supportive for corporate credit markets, and especially fallen angels – we believe our positioning in the crossover segment stands to benefit both from central bank purchases as well as a potential market recovery.
Asia fixed income: getting ready for gradual but nuanced recovery
Asian and emerging credit markets have partially retraced from the extreme dislocations and drawdowns seen in March, although the recovery is lagging that of developed markets. This recovery is nuanced by countries being in different stages of lockdowns, as well as differing external sovereign financing needs for fiscal demands and varying ratings downgrade pressure.
Notwithstanding that, the region is now partially reopening from a total state of lockdown. Domestic central banks continue to inject liquidity and credit into their systems, with additional aid provided to key sectors in the form of lower or deferred taxes, royalties and debt moratoriums. This is allowing corporates to regain their liquidity. We are now witnessing a recovery in electricity consumption, traffic resumption and labour usage in various markets.
We believe this process is progressive but gradual, and will last well into Q3. We expect companies to relax their cash hoards as they regain liquidity, which will in turn breathe life into the respective economies. We believe this should result in the gradual reduction in credits spreads in the public bond markets. We are carefully positioning for this by holding onto our allocations, and increasing allocations in large countries such as India, which currently offers attractive long-term valuations and is emerging from a total lockdown.
For a white paper about our highly selective approach to Asia during the COVID-19 crisis, please click here.
Equities: the duality of volatility
Volatility has the potential to be both a blessing and a curse, in our view. Our first line of defence against the potential for harm has always been the quality of companies in which we are investing. We aim to select those companies with the strongest financials; those that can create value across business cycles by being capital efficient, free cash flow generative and having limited dependency on capital markets to fund their growth.
In addition, we aim to invest in companies that are more exposed to secular trends as opposed to cyclical ones, with a full understanding of key sustainability challenges. This investment focus helps build investment strategies that are more resilient in volatile times.
Volatility can also prove a blessing. This stems from market moves which, by being erratic, create investment opportunities by impacting the valuation of attractive business models. With a strong and focused investment process, volatility can then be embraced to capture these attractive entry points.
Convertibles: volatility brings opportunity
In uncertain times, convertible bonds come into their own. The asymmetric return profile of convertibles offers investors the potential to participate in equity performance, while also providing protection1 from equity downside due to the bond element.
Overall, in today’s environment of increased volatility and ambiguity, the outlook for convertible bonds is quite positive and can help investors weather uncertain times. The high bond floor of converts can shield investors and let them sit out the volatility.
Additionally, we are currently witnessing a price discount opportunity in convertible bonds. As such, convertibles potentially offer a rare value proposition for investors at the moment. Dislocations have gradually corrected and in general, better quality credit will correct more quickly. This means windows of opportunity can close just as fast as they opened, and these current dislocations may not last long.
Multi-asset: getting the balance right
The ground becomes solid after a heavy rain, says an old proverb. The trick is to know when the rain stops. In our diversified portfolios, we apply numerous forms of protection1, hoping to shelter our investors from storms yet to come. We also try and benefit should the rain clear and the good days return.
One such example is our use of trend-following signals to guide tactical asset allocation. Asset price movements have historically shown a tendency to persist. Thus a storm (markets falling) calls for defence (underweight risky assets) while clear skies (equities rising) lead to offence (overweight risky assets). This approach will not always work, nor will it call the bottom of the market. But it helps shelter our portfolios from a potential second leg down without precluding benefiting from a positive turn of events.
Alternatives: our three-fold approach to risk management
There are really only three drivers of risk management in our minds: convexity at the position level, portfolio construction and drawdown management.
Convexity means having much more upside when right, than downside when wrong. For most managers, this means taking the fundamental view that an investment is convex. As hedge fund managers, we enjoy the freedom of using many different tools to exploit market inefficiencies, effectively constructing convex investments.
Portfolio construction focuses on diversification. When only parts of a portfolio suffer losses, rather than cutting and realising losses, diversification enables the portfolio to weather the storm and perhaps add to positions that have been oversold. In our hedge fund portfolios, we focus on strategies that operate in areas where there is less competition and we seek truly differentiated sources of returns. The direct result is that we are typically not sensitive to market direction nor crowdedness (other market participants all increasing or reducing risks at the same time).
Finally, drawdown management is the last line of defence implemented in all our funds. Despite the structural advantages hedge funds have in weathering storms, drawdowns happen. When they do, as a function of the extent of the drawdown, we seek to limit losses by implementing an orderly reduction of risk and exposure until the fund starts performing again.
For our latest paper on alternative data trends during the COVID-19 crisis, please click here.
Risk management: a disciplined and defined approach
Amid pronounced volatility and the rising risk of defaults, today’s COVID-19 crisis has highlighted the critical importance of risk management. Our process is highly disciplined and defined, relying on bespoke policies and limit frameworks that are continually refined.
Risk teams are closely integrated with investment teams to present the added value of an independent point of view. We have implemented Tableau software to help visualise and understand our data, which improves our ability to detect unintended exposures across our portfolios.
We engage in three strategic areas: supervision, support and communication.
Our supervision checks that portfolios conform to their stated investment style and strategy, remain true to investor expectations, and mitigate risks that arise. For fixed income, we are currently emphasizing corporate liquidity. For equities, the focus is on sector, sub-sector, and high quality companies with strong balance sheets.
In our support role, we ensure that LOIM reporting, analytics and discussions produce succinct and actionable results.
We facilitate communication to senior management, the board of directors and regulators so they understand the risks and positioning within portfolios.