investment viewpoints
Optimising asymmetric returns
An asymmetric return profile - offering upside potential while mitigating downside exposure - tends to be a highly desirable feature for investors. Yet the means to this end can differ vastly. Indeed, the many paths leading to asymmetry vary both in terms of method and cost.
While our solutions approach asymmetry1 from different angles, they are united in their goal of maximising it for good value. Our solutions range from instruments such as convertible bonds, to structural construction with derivatives in our alternatives portfolios, and downside protection techniques2 in our multi-asset portfolios.
Fruitful, long-term investing requires successfully achieving two objectives. Firstly, it means taking the right (or profitable) investment decisions more often than taking the wrong ones. Secondly, and equally importantly, it means earning more on profitable investments than what is lost on unprofitable ones3.
While our solutions approach asymmetry from different angles, they are united in their goal of maximising it for good value.
Building better asymmetry of returns into a portfolio is a key element of value-added and long-term outperformance, and especially suits institutional investors looking to offset a negatively convex profile emanating from their liabilities. For instance, insurance companies have negative convexity woven into the fabric of their business. To compensate, they need a systematic approach that adds convexity, as well as helping to safeguard their capital position.
Ingrained complexity
We believe that the more complex and hard to price an instrument, the more likely it is to be positively convex with potentially cheap carry. A convertible bond, for instance, combines various instruments and options, and its longer-dated nature means the underlying instrument is more likely to be mispriced and thus potentially cheap.
Indeed, convertible bonds have an asymmetric return profile at their core. That means convexity is an innate outcome that is not readily available for purchase in the market and gives a typical 3-5 year profile. The equity option embedded in the bonds gives the investor unlimited potential to invest in the upside of equities. Conversely, the bond element provides something of a buffer should the underlying equity fail to increase in value. Combining participation in rising equities but defence when equity markets are declining, convertibles naturally offer long-term, positive convexity.
Asymmetry can also be built structurally, whereby the consequence is limited or with no negative cost of carry. Our alternatives team’s highly bespoke approach filters through the market for mispriced trades that, once they are combined, provide a convex return profile. Such trades can result from complacency in the market for instance, or from illiquidity. Broad investment expertise and bespoke systems are needed to construct a truly convex profile in this manner, as well as a flexible investment mandate. In such a capacity-constrained strategy, implementation is key.
Our strategies seek to optimise asymmetry in the most cost-effective way possible.
Our multi-asset strategy is oriented to reducing downside risk at a reasonable cost. Our proprietary dynamic drawdown management (DDM) process looks at four key components – realized drawdowns, risk appetite, robustness and relative drawdown – to determine how to best deploy risk. We believe taking into account these components improves portfolio efficiency, while addressing some of the pitfalls of option-based strategies. Careful design is crucial, however, to optimise cost efficiency.
Many roads can lead to an asymmetric return profile. Our strategies seek to optimise it in the most cost-effective way possible.
Please find key terms in glossary.
Sources
[1] Asymmetry is also referred to as convexity, with both signifying an investment that has upside potential while mitigating downside potential.
[2] Downside protection represents a portfolio construction goal and cannot be guaranteed.
[3] We note that some successful strategies, such as trend-following strategies, do not require being right more often than being wrong. In fact, they may be wrong more often. But the gains made from being right outweigh the losses from being wrong, meaning the overall strategy is profitable.
