In recent years, nearly every asset owner I have spoken with has had questions about their fixed income allocations: With yields as low as they are, can a traditional fixed income allocation still serve as an “all-in-one” diversifier? Should I be worried about risks in the credit market? What role should alternatives play in filling gaps in my portfolio?
The pandemic only added to the questions. It created an unusual level of disruption in capital markets, leaving diversification, the bedrock of strategic asset allocation, in short supply. At the same time, asset owners have had to contend with unprecedented market narrowness and structure issues, and the risks of monetary and fiscal policy experiments. And the likelihood of continued low yields (despite the recent uptick) suggests that traditional fixed income will struggle to produce the total return that many have come to expect and may offer less protection from volatility. While I still see a role for government bonds as ballast, I think complementary allocations need to be considered.
An alternative path to diversification
For many asset owners, the first option that comes to mind is private credit. But while private credit may well support return-seeking objectives, I don’t think it does much to bolster the risk-mitigating side of a portfolio. It may be possible to shift the odds of success by thinking more broadly about diversifying strategies. One possible path is complementing duration with active risk via long/short risk-mitigating strategies with a low-beta or market-neutral profile. A growing number of endowments, for example, are charting just such a course, according to the 2020 NACUBO Endowment Survey — particularly given the current interest-rate regime.1
Among the options in this space are long/short credit strategies and credit relative-value strategies. Such idiosyncratic, uncorrelated strategies may help lend stability to portfolios during periods of increased volatility and reduce the opportunity cost of holding low-yielding government bonds.
Market-neutral and relative-value strategies offer several potential advantages over core bonds. In applying an absolute return mindset, they seek to be impervious to the market environment by dynamically managing exposures across a broad opportunity set while aiming to maximize the risk/reward outcome. This echoes Grinold and Kahn’s “Fundamental Law of Active Management,” which argues that skilled managers (as defined by the information coefficient of selection skill) provided with an expansive opportunity set (breadth or number of investment opportunities) maximize the information ratio.2
These strategies seem well suited to the current market environment. Long/short credit strategies, for example, may benefit from the dispersion and dysfunction that have characterized credit markets since the COVID-19 crisis began. I believe this backdrop will persist, potentially benefiting strategies seeking situations where credit risk is too high (cheap), creating an opportunity to go long, or too low (rich), creating an opportunity to go short.
This environment may also be attractive to relative-value managers who seek to identify short-term price anomalies in public credit markets. Structural inefficiencies in the market (e.g., dealers’ reduced market-making capacity) have left it increasingly prone to outsized price moves (Figure 1). Diversifying strategies designed to take advantage of rising volatility by navigating rates, credit, and currencies may allow allocators to be on their front foot when downside surprises strike.
For more on the role of long/short strategies, see my recent paper, “Mission critical: The vital role of alternatives in pursuing investment success.” My colleagues also consider the role of these strategies in credit portfolios in their recent piece, “Bridging the gap in credit portfolios with a long/short strategy.”
1National Association of College and University Business Officers, March 2021.
2Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk, Richard Grinold and Ronald Kahn, 1999.