Where can investors find truly differentiated sources of alpha?

In this Q&A, David Elms, Head of Diversified Alternatives, gives insight into the role that alternatives can play in an investor’s portfolio, and considers the change in pricing of volatility as a result of COVID-19.

  Key takeaways:

• For the past two decades, bonds have acted as a hedge during periods of stock market uncertainty. Alternatives appear well placed to also provide diversification benefits.
• Arguably, volatility was significantly underpriced at the start of 2020, but the speed and breadth of the spread of COVID-19 in February and March saw a significant and sharp repricing. While there are still opportunities to buy volatility, the trade is unlikely to be the ‘slam dunk’ it was.
• There remains a disconnect between financial market pricing and the real world. Stimulus measures have kept markets buoyant, while many industries continue to struggle with the ongoing fallout from COVID-19.

Bonds have traditionally been held for income, capital preservation and diversification benefits. Can alternatives play a similar role?

For the past two decades, the negative correlation between equities and bonds has been a gift for investors looking to build natural diversification into their portfolios. Bonds have acted as a hedge during periods of stock market uncertainty; weakening sentiment usually coinciding with falling expectations for interest rates and a consequent flight to quality. This mechanism hinges on the ability of yields to move so that bonds can achieve capital gains. However, with yields at such low levels and little room for further interest rate cuts, the room for further compression is limited.

Persistently low levels of inflation have also contributed to the negative correlation between bonds and equities. Should current monetary stimulus measures feed through into higher inflation, without an equivalent level of growth, this could indicate that something is fundamentally changing. The behaviour of markets is not fixed, although it can take a while for investors to change their habits.

We believe that alternatives are well placed to perform a similar role for investors, in terms of offering a route to diversification across a portfolio, with the potential to deliver uncorrelated performance throughout the market cycle. There are many options within the ‘alternatives’ arena that could provide an attractive alternative to a traditional bond/equity allocation, diversifying a portfolio with a greater range of potential sources of alpha.

In your 2020 outlook you stated that you thought volatility was underpriced and could rise. Given the impact of COVID-19 on markets, and the consequent re-pricing of risk, had the volatility trade run its course by the start of 2021?

Volatility is never a one‑way bet but it was our view at the end of 2019 that it had been significantly underpriced for some time due to the prevalence of systematic volatility selling programmes. At the start of 2020 we believed markets were underappreciating and under-pricing risk ― bordering on complacency. As it was, the speed and breadth of the spread of COVID-19 in February and March was a significant exogenous event that resulted in a significant and sharp repricing of volatility, with markets understandably stressed and illiquid as economies around the world ground to a halt.

While we still see some opportunities to buy volatility, the trade is no longer the ‘slam dunk’ it was at the start of 2020. Markets are always evolving and the cost of carry on a long volatility position strategy has risen commensurately with the level of current uncertainty. This raises an interesting question about what other strategies can systematically provide uncorrelated returns during periods of high cost of carry for long volatility.

What is the biggest risk in the market right now that you do not think has been accurately priced in?

It is apparent to us that there is a disconnect between financial market pricing and what is going on in the real world. Governments and central banks have been complicit in creating this problem, with stimulus measures that have kept markets buoyant, while many industries continue to struggle with the ongoing fallout from COVID-19.

One risk that does not seem correctly priced into markets is the potential for stimulus measures to gain more traction than expected, feeding through to higher inflation, with a consequent impact on bond yields. Given that we have been in a secular bull market since the early 1980s, there is limited first-hand experience of what a bear market for fixed income looks like and how to weather it.