CIO Report - Investing in a World without Credit Spreads


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CIO Report - Investing in a World without Credit Spreads

  1. 1. Summary  Many asset allocations over the last five years are based on taking advantage of credit spreads that may not be available in the future  If credit spreads decline to a low level, asset allocation is going be more dependent on liquid markets where returns are uncertain  This uncertainty can be managed but not removed by four approaches: o risk based asset allocation o diversification between asset classes o diversification within asset classes o manager skill  A combination of the four approaches will give the largest improvement in risk/return but varying the mix or leaving out one or two approaches will still leave most of the improvement in place Credit Spreads are Compressing For the past five years, many asset allocations have relied on the returns available by taking exposure to two (correlated and not always distinct) risk premia: (i) Credit spread risk which is the compensation for taking credit default risk and credit spread volatility (ii) Illiquidity risk which is the additional spread earned for investing in credit assets that are more illiquid than corporate bonds These two risk premia have the advantage that at least for investment grade credit on a hold to maturity basis they should give a fairly certain return, absent a level of defaults that has not been seen in recent history in a diversified portfolio (of course it has been seen in non- diversified ones). However in recent months both credit and illiquidity spreads have reduced significantly and are now below the required returns for many clients. If credit and illiquidity spreads revert to levels closer to where they were pre the credit crunch, credit as a core asset allocation would no longer be particularly attractive. Indeed in the past there were long periods often associated with low defaults where credit was not an attractive asset class unless leveraged, a strategy which clearly came unstuck in 2008. Therefore, in looking to evolve our asset allocation strategies, we should prepare for a world where asset allocations are centred around liquid markets that offer returns that are far less certain over a given time horizon. CIO Report: Asset Allocation in a World without Credit Spreads 12th August 2014 Philip Rose, CIO – Strategy & Risk
  2. 2. Asset Allocation in a World of Uncertain Returns Liquid markets offer many risk premia which historically have provided positive returns in exchange for taking market risk. However there are significant drawbacks: (i) Individual risk premia can fail to provide excess returns for years or even decades so relying on a small number of risk premia may not meet flight plan targets (ii) Some risk premia are much cheaper to access than others in terms of management fees (iii) Risk premia may be transient and will not endure in the future (iv) Some risk premia may incur substantial transaction and balance sheet costs In building an asset allocation there are four techniques that can be used to help partially mitigate but not remove these drawbacks. Risk Driven Asset Allocation Rather than allocating to an asset on the basis of amount, risk driven asset allocation seeks to allocate according to the risk of the asset (with risk being measured as volatility). This means that as an asset becomes more volatile less is allocated to it and as it becomes more volatile more is allocated to it. This approach has historically improved the risk/return ratio for many asset classes and has the added benefit of substantially reducing the cost of buying downside protection in the form of put options. This approach can be applied solely in the risk premia that is cheapest to access, namely equity risk or across multiple asset classes. Example: Volatility Controlled Equity with Put Option Diversification between Asset Classes Asset classes such as government bonds and commodities can provide exposure to risk premia that have historically provided positive returns combined with performance in economic scenarios where equities can perform poorly. For example, government bonds have often performed well when equities have fallen and commodities have performed well in periods of high inflation. These characteristics may not continue in the future in line with any other risk premia but combined with a risk driven asset allocation they can provide attractive potential returns. Example: Risk Parity Diversification within Asset Classes Risk premia within asset classes, such as value (buying assets that are “cheap” relative to their fundamental vale and selling “expensive” assets) and momentum (buying assets that outperformed their peers and selling those that recently underperformed) can be accessed via long short strategies in individual asset classes. These risk premia are based on the implementation of a systematic investment process, not manager skill, but do require both trading and the ability to be easily long or short an individual asset. This means that transaction and balance sheet costs (costs of financing a position) can be quite substantial. Example: Style Premia Fund
  3. 3. Manager Skill Manager skill is the return left over once the market “betas” for both individual asset classes and systematic strategies within and between asset classes have been removed. True manager skill or “alpha” is often expensive to access and runs the same risk of non- persistence as any other risk premia. However, in recent years, a lot of the strategies that were the preserve of “2 and 20” macro hedge funds have become available in much lower cost funds. Example: Relative Value DGF A combination of these four approaches will produce the best expected risk/return characteristics but changing the mix or leaving out one or two approaches will still leave most of the risk/return improvement in place. Contact If you would like further information on this report, please do get in touch. Philip Rose CIO – Strategy & Risk Disclaimer In preparing this document we may have relied upon information supplied by third parties. Whilst reasonable care has been taken to gauge the reliability of this information, this document carries no guarantee of accuracy or completeness and Redington Limited cannot be held accountable for the misrepresentation of any information by third parties involved. This document is for investment professionals only and is for discussion purposes only. This document is based on data/information available to Redington Limited at the date of the document and takes no account of subsequent developments after that date. It may not be copied modified or provided by you, the Recipient, to any other party without Redington Limited’s prior written permission. It may also not be disclosed by the Recipients to any other party without Redington Limited’s prior written permission except as may be required by law. Redington Limited accepts no responsibility for any consequences arising from you or any third party relying on this document or the opinions we have expressed. This document is not intended by Redington Limited to form a basis of any decision by you or a third party to do or omit to do anything. Registered Office: Austin Friars House, 2-6 Austin Friars, London EC2N 2HD. Redington Limited (reg no 6660006) is a company authorised and regulated by the Financial Conduct Authority and registered in England and Wales. © Redington Limited 2014. All rights reserved. 1