Diversification has become harder to achieve in an inflationary environment where equities and bonds have become positively correlated. But liquid alternative strategies that are not biased to holding long positions in equities and bonds, such as trend following, macro and market-neutral equity, can provide some relief, CFM says.
It is sometimes said diversification is the only free lunch. But diversification in the post-global financial crisis (GFC) market environment has become harder to achieve.
The response to the GFC, including the various quantitative easing programs, has showered financial markets with cheap capital and pushed up equity prices. This rally has made it difficult for institutional investors to diversify away from the equity premium.
“You’ve got this sort of self-fulfilling prophecy of equities that keep going up and it gets to a point where allocators find it difficult to allocate away from equities,” Philip Seager, Head of Absolute Return at Capital Fund Management (CFM), says in an interview with [i3] Insights.
“So I think the allocators have it in the back of their minds that they do need to diversify, but then it becomes almost a career risk to actually diversify because you’re missing out. There is some FOMO (fear of missing out).”
Many institutional investors have sought to diversify into private markets, including private equity, venture capital, infrastructure and property, but Seager questions whether this is true diversification or merely an allocation to a form of leveraged equity.
You've got this sort of self-fulfilling prophecy of equities that keep going up, and it gets to a point where allocators find it difficult to allocate away from equities. So I think the allocators have it in the back of their minds that they do need to diversify, but then it becomes almost a career risk to actually diversify, because you're missing out
“What people refer to as alternatives, I’m not sure that it is all that alternative because there is a very heavy equity premium in private markets, mixed in with a liquidity premium. I don’t think that you’re actually diversifying, but to the contrary you are adding more to your core bet and very similar risk factors,” he says.
Today’s investment environment, where interest rates are rising again and inflation has returned, has made diversification even more difficult. Whereas investors previously could rely on the negative correlation between bonds and equities, in an inflationary environment this correlation has inverted.
“We previously wrote that with inflationary pressures rising, the correlation between bonds and equities could go from being negative to positive, and we’ve now seen that happen,” Seager says.
“You used to be able to get some diversification from holding bonds and equities, but that correlation has flipped and they are losing money at the same time. You’re getting even fewer diversification possibilities in your traditional asset portfolio.”
Trend Following
One solution to the diversification problem is including liquid alternative strategies that are not biased to holding long positions in equities or bonds, such as trend following, macro and market-neutral equity. During the GFC, trend following strategies, including commodity trading advisers (CTA), proved quite successful and institutional investors took note. In the United States, it even led to the development of a crisis risk offset model, which relied heavily on trend following for diversification, among a series of other strategies.
What helped CTAs during the GFC was that it was a relatively protracted crisis and a clear trend could be established.
“We saw that CTAs made a lot of money in the GFC and that was because the GFC was a long drawn-out [crisis] on a time scale of about a year and a half. That is why you had very good performance from CTAs.”
This is also the reason why trend following had mixed results during the onset of the coronavirus pandemic in early 2020 as markets fell sharply and then bounced back relatively quickly as fiscal and monetary policy drove asset prices up.
Another benefit to trend following is that in an inflationary environment it tends to do well as it can form a hedge against inflation.
We feel that the liquidity provision in these markets could destroy the trending behaviour over shorter time scales, because as you get liquidity providers in the market, such as high frequency trading (HFT) shops, they act as a buffer to prices breaking out
“Inflation is correlated with commodities. If you regress all of the instruments in the CTA universe against inflation, then what you see is that commodities really dominate here, which is actually quite intuitive,” Seager says.
“So if you are trend following on commodities, in the same way as you get that convexity or protection on equity markets, you will also get some protection from inflation. It’s another tick in the box for trend following as being a great diversifier for institutional portfolios.”
But while trend following has proven to work well over longer time frames of at least several months, over shorter-term time frames it tends to struggle, especially as momentum is building up in certain trades and investors with very short time frames enter the market.
“We feel that the liquidity provision in these markets could destroy the trending behaviour over shorter time scales, because as you get liquidity providers in the market, such as high frequency trading (HFT) shops, they act as a buffer to prices breaking out,” Seager says.
“Volume builds up at the bid and the ask, and a lot of trading happens around those levels so volatility is reduced and you don’t get the development of a trend on these shorter time scales.
“We’ve experienced it ourselves first hand. We have shorter-term strategies that we employ, not HFT strategies, but shorter-term strategies to diversify our flagship funds, and what you see is that trend following effects on time scales of hours have diminished – you do have to innovate a lot on those shorter time scales.”
Innovation
Markets have changed dramatically over the past 20 years and CFM has shifted its portfolios away from a heavy focus on trend following towards more innovative strategies that look at less obvious correlations.
“You have to do many other things, not just trend following. We don’t do a lot of plain vanilla trend following in our flagship programs,” Seager says.
An example of CFM’s research into new potential investment ideas is a recent study into the mid-term elections in the US and the effect on financial markets.
“We’ve just done a study on the US Congress, where we look at what is called the ideological score of the members, based on their historical voting records. You can attribute how liberal or conservative they are and then look at the statistics of the make-up of the House and the Senate,” Seager says.
Any changes in the make-up of both houses could provide some insights into the direction of the market in the year after the elections.
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“There is this idea of buying the markets after the mid-terms and we had some very interesting results,” Seager says.
“If you buy the market the year after the mid-term elections, what you see is a borderline statistically significant result that markets do perform in that year post mid-term elections.”
Although the study provided some interesting results, the observed effect was not strong enough to make it into the portfolio.
“There is an effect, but it’s not a very strong effect and it has flattened out recently. So in terms of our rather demanding requirements of statistical significance, it’s not something that we traded,” Seager says.
Short Selling
Finally, institutional investors can also improve their diversification and move away from the dominance of the equity risk premium by not only investing long, but also maintaining a portfolio of shorts, Seager argues.
By investing most of their portfolios in long-only strategies, investors are heavily exposed to the riskiest part of the market. But by introducing short selling they can achieve a better balance, Seager says.
“You have much less diversification in a portfolio where you are long everything, which is the case for most institutional portfolios. They’re long equities, they’re long bonds, they’re long real estate and they’re long infrastructure; they’re long everything,” he says.
The problem with being long and having that constraint is that these long positions are pointing in the direction of where there is the most risk
“The problem with being long and having that constraint is that these long positions are pointing in the direction of where there is the most risk.”
This risk is heightened by not only the positive correlation between bonds and equities in the current environment, but also by the correlation between individual equities.
“The problem is that all stocks have this residual correlation between them. They’re all positively correlated to each other, so when you are allocating across them, your ability to diversify is limited,” Seager says.
“So beyond a certain number of stocks, adding extra stocks is not reducing the risk of your portfolio and your ability to diversify is actually killed by the fact that you’ve got this common correlation and it is driving the most risk in that universe.
“The only way to get around that problem and be genuinely diversified is to introduce short positions and to have a long/short portfolio.”
This article is sponsored by Capital Fund Management (CFM). As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.