Absolute return investments in rising interest rate environments

Transcription

1 2014 Absolute return investments in rising interest rate environments Todd White, Head of Alternative Investments Joe Mallen, Senior Business Analyst In a balanced portfolio, fixed-income investments have historically been an effective tool for diversifying equity investments, and consequently, those two asset classes compose the majority of the assets in investors portfolios. The United States has experienced a roughly 30-year downward trend in interest rates, resulting in a sustained period of positive returns for fixed-income investments. With interest rates near historically low levels, many investors expect rates will rise. Without attempting to predict the future direction of interest rates, we acknowledge that an increase in interest rates could have significant adverse effects on even the most diversified portfolios. In this environment, investors could benefit from investment alternatives that have the ability to provide positive returns with little or no correlation to equity and fixed-income investments. Absolute return strategies are one such alternative asset class. The benefits of adding absolute return strategies to a portfolio Absolute return investment strategies target positive returns in all market conditions and have little correlation to other major asset classes. As a result, they can help diversify a portfolio of equity and fi xed-income investments, while potentially avoiding the negative implications associated with interest-rate sensitivity. A multi-strategy absolute return investment, as the name implies, generally comprises several absolute return trading styles and can provide an investor with a broader, more diversifi ed portfolio of absolute return investments. The HFRX Macro: Multi-Strategy Index (HFRX MS Index), a commonly cited proxy for alternative investment returns, can be used to illustrate the characteristics of a diversifi ed portfolio of absolute return strategies. Historically, the HFRX MS Index has shown steady gains with less volatility than stocks (Exhibits 1 and 3). Using this index as a proxy, we will discuss the benefi ts of adding a multi-strategy absolute return fund to a traditional portfolio and examine three specifi c trading styles that are commonly found in a multi-strategy investment: > Global trend following/managed futures > Equity market neutral >Long/short currency As shown in Exhibits 1 and 3, from 12/31/04 through 09/30/13, the HFRX MS Index generated returns and volatility (as measured by standard deviation) somewhere between that of stocks and bonds. Risk-adjusted performance, shown by the, also fell in the mid-range. Importantly, the multi-strategy index showed a markedly lower maximum, which represents the largest peak-to-trough decline over the period, providing additional evidence of the asset class s lower volatility.

2 Exhibit 1: The HFRX MS Index has generated returns and volatility comparable to stock and bond indices Return statistics for equities, fi xed-income and absolute return indices (12/31/04 to 09/30/13) S&P 500 Barclays U.S. Aggregate HFRX MS Index return 6.02% 4.72% 5.89% 15.36% 3.33% 6.03% standard deviation (3-month LIBOR) % -3.83% -7.96% Another important measure to consider is correlation. A correlation of 1.0 means the asset prices move in tandem with each other, while a correlation of zero indicates no relationship between asset prices. As Exhibit 2 illustrates, the multi-strategy index price has tended to move independently of stock and bond prices. Exhibit 2: Low correlation to stocks and bonds can enhance diversification benefits Correlations of the HFRX MS Index to equities, bonds and U.S. Treasury yields, % (12/31/04 to 09/30/13) S&P Barclays U.S. Aggregate 0.03 Generic U.S. Treasury yields 2-year year year 0.17 Exhibit 3: The HFRX MS Index has generated steady growth with moderate volatility Growth of $1,000 (12/31/04 to 09/30/13) $ 1,800 1,600 1,400 1,200 1, Dec 04 Jun 05 Dec 05 Jun 06 Dec 06 Jun 07 Dec 07 Jun 08 Dec 08 Jun 09 Dec 09 Jun 10 Dec 10 Jun 11 Dec 11 Jun 12 Dec 12 Jun 13 S&P 500 Barclays U.S. Aggregate HFRX MS Index What happens when the HFRX MS Index is added to a traditional portfolio? We can see in Exhibit 4 the benefi ts of including the HFRX MS Index in a hypothetical 50% equity and 50% fi xed-income portfolio (a 50/50 portfolio). Over the time period from 12/31/04 to 09/30/13, the portfolio s overall annualized return improved by a few basis points when the multi-strategy index was included. However, we see signifi cant improvement in the portfolio s risk statistics as a larger portion of the portfolio was allocated to the HFRX MS Index. When comparing a 50/50 portfolio to another hypothetical portfolio with 35% equity, 35% fi xed income and 30% HFRX MS Index, the annualized standard deviation declined 1.44 percentage points, the Sharpe ratio rose 0.12 and the maximum declined 6.58 percentage points.

3 Exhibit 4: Return and risk improve by adding absolute return to a hypothetical 50/50 portfolio Return statistics (12/31/04 to 09/30/13) return standard deviation (3-month LIBOR) 50% equity/ 50% fixed 0% HFRX 45% equity/ 45% fixed 10% HFRX 40% equity/ 40% fixed 20% HFRX 35% equity/ 35% fixed 30% HFRX 5.69% 5.74% 5.78% 5.82% 7.94% 7.41% 6.93% 6.50% % % % % What does this analysis look like in different interest rate environments? To determine whether the benefi ts of diversifying the 50/50 portfolio with the HFRX MS Index continue to hold up during periods of high and low interest rates, we used the U.S. two-year Treasury note as the proxy. We start with Exhibit 5, illustrating the growth of $1,000 invested in the hypothetical 50/50 portfolio compared with the HRFX MS Index during both high-yield and low-yield environments. Regardless of the level of rates, the index provided fairly steady gains with less volatility than the 50/50 portfolio. Exhibit 5: The HFRX MS Index has generated steady returns with less volatility than a 50/50 portfolio Growth of $1,000 investment $ 1,800 1,600 1,200 1, Dec 04 Jun 05 Dec 05 Jun 06 Dec 06 Jun 07 Dec 07 Jun 08 Dec 08 Jun 09 Dec 09 Jun 10 Dec 10 Jun 11 Dec 11 Jun 12 Dec 12 Jun 13 U.S. two-year yield 50/50 portfolio U.S. two-year yield HFRX MS Index In order to distinguish how a combined portfolio would perform during different rate environments, we examine the two halves of the chart independently. From 12/31/04 through 12/31/08, the average annual yield on the two-year U.S. Treasury bond was 3.70%. In this higher interest rate environment, which mostly preceded the crisis of 2008, the HFRX MS Index had a positive annualized return and, when added to the 50/50 portfolio, improved the portfolio s annualized return, standard deviation and maximum (Exhibit 6) Yield (%)

4 Exhibit 6: Adding the HFRX MS Index to the 50/50 portfolio improved results when rates were higher Return statistics during a higher interest rate environment (12/31/04 to 12/31/08) S&P 500 Barclays U.S. Aggregate HFRX MS Index return -5.21% 4.73% 6.44% 13.83% 3.81% 6.90% standard deviation (3-month LIBOR) % 3.83% -7.96% Exhibit 7: Adding the HFRX MS Index to the 50/50 portfolio improved volatility and when rates were lower Return statistics during a lower interest rate environment (12/31/08 to 09/30/13) S&P 500 Barclays U.S. Aggregate HFRX MS Index return 16.49% 4.71% 5.43% 16.14% 2.90% 5.24% standard deviation (3-month LIBOR) % -3.67% -6.36% 50% equity/ 50% fixed 0% HFRX 45% equity/ 45% fixed 10% HFRX 40% equity/ 40% fixed 20% HFRX 35% equity/ 35% fixed 30% HFRX 50% equity/ 50% fixed 0% HFRX 45% equity/ 45% fixed 10% HFRX 40% equity/ 40% fixed 20% HFRX 35% equity/ 35% fixed 30% HFRX return -0.10% 0.57% 1.23% 1.90% return 10.82% 10.30% 9.77% 9.24% standard deviation 7.41% 6.94% 6.54% 6.22% standard deviation 8.16% 7.62% 7.11% 6.64% (3-month LIBOR) (3-month LIBOR) % % % % -9.91% -8.97% -8.02% -7.07% From 12/31/08 through 09/30/13, the average annual yield on the two-year U.S. Treasury bond was 0.53%. In this lower interest rate environment, driven by accommodative Federal Reserve policy, traditional U.S. equity and fi xedincome portfolios have performed very well. The HFRX MS Index also posted a positive annualized return over the period that was better than the bond index, though not as strong as stocks. When the index was added to the 50/50 portfolio, the annualized return was not as strong, but both the volatility of the return and were reduced (Exhibit 7). It is clear that irrespective of the direction of interest rates, the HFRX MS Index is shown to mitigate risk in a balanced portfolio of stocks and bonds. In addition, over the entire period from 12/31/04 to 09/30/2013 when interest rates were at varying levels, the risk reduction benefi ts of the HFRX MS Index persist.

5 Understanding absolute return trading strategies Below are three strategies commonly found within the HFRX MS Index. Each of the strategies invests in a manner that does not track long-term trends in equities or fi xedincome investments. Furthermore, these strategies would not be expected to be materially impacted by an increase in interest rates. 1. Global trend following/managed futures Global trend following or managed futures strategies employ a wide variety of exchange-traded futures contracts and over-the-counter derivatives. While models can vary drastically by theme, holding period and market exposures, generally these strategies attempt to exploit trends in capital markets by taking long and short positions as dictated by a model or methodology. Common markets for managers to trade are commodities, interest rates, bonds, equity indices and currencies. Through a combination of long and short positions in these markets, managed futures portfolios seek to exploit valuation opportunities and generate returns that are not dependent on long-term trends in equity or fi xed-income markets. Further, because futures markets tend to be liquid, managers have the ability to quickly modify trades, change direction and follow short-term trends where traditional long-only fund strategies cannot. Futures contracts are derivative instruments that don t require a direct cash investment. A portfolio with futures exposure also holds a portion of its investment in cash, as collateral against the futures contracts in the portfolio. This cash has the potential to earn more income as interest rates rise. Given today s near-zero interest rates on cash deposits in brokerage accounts, any increase in short-term rates would result in an increase in returns of the strategy as a whole. 2. Equity market neutral Equity market neutral investment strategies target absolute returns by investing in a portfolio of long equity positions hedged by a similar portfolio of equity positions that are sold short. The combination of positions results in a portfolio that seeks to be insulated from broad equity market movements. The portfolio s return should be independent of bull or bear trends, and should refl ect the difference in returns between the long positions and short positions in the portfolio. For example, a long portfolio consisting of U.S. equities could have its market risk offset by a short position in S&P 500 Index futures. If the long U.S. equities had a return of 12% over a period of time when the S&P 500 also gained 10%, the of the portfolio would equal 2% (12% long 10% short). The reverse would also hold true if the long U.S. equities had a return of -8% compared to -10% on the S&P 500. The return of the portfolio would equal 2% (-8% long (-10%) short). As viewed in these scenarios, the returns of an equity market neutral portfolio are not dependent on the broad equity markets, but rather on the difference between the returns of the long and short sides of the portfolio. The expected return for an equity market neutral strategy equals the return of the relative spread between the long and short positions in the portfolio (either individual equities or index futures) plus interest received from cash holdings. Because the strategy does not depend on equity market beta for returns and relies on short-term cash deposit rates, equity market neutral strategies have an advantage in the event of rising interest rates. 3. Long/short currency Long/short currency managers identify relative value opportunities and execute macro themes through the use of currency pair trades. They may identify trades based on fundamental analysis or technical models. Currency

6 contracts are not necessarily an investment in tangible assets but rather a trade on the valuation of one country s currency relative to another. Models may use macro factors such as interest rates, infl ation expectations, debt levels and trade imbalances to identify currencies that appear to be under- or overvalued. A rise in U.S. and other sovereign interest rates typically impacts currency valuation. However, a manager trading across multiple currencies may not be affected by rate changes in the United States and could remain neutral to the direction of the U.S. dollar. Conclusion Investments that target absolute returns could be an attractive way to diversify a portfolio containing equities and fi xed income. Adding absolute return strategies may produce better risk-adjusted returns. By design, global trend following, equity market neutral and long/short currency managers seek investment gains that are not linked to the typical factors that drive equity and fi xedincome markets, including the rise and fall of prevailing interest rates in the United States. Our study shows that when the HFRX MS Index is added to a hypothetical portfolio of 50% equities and 50% fi xed income, it improves the annualized return over a period of historically elevated interest rates. However, perhaps most importantly, it lowers the portfolio s volatility and improves the maximum loss the portfolio experiences, irrespective of the level of interest rates. Standard deviation is a statistical measure of the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution. The is measure that indicates the average return minus the risk-free return divided by the standard deviation of return on an investment. The maximum is the peak-to-trough decline during a specifi c record period of an investment, fund or commodity. The Barclays Aggregate Bond Index is a market value-weighted index that tracks the daily price, coupon, pay-downs and performance of fi xed-rate, publicly placed, dollar-denominated and non-convertible investment-grade debt issues with at least $250 million par amount outstanding and with at least one year to fi nal maturity. The Standard & Poor s (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks. The HFRX Macro: Multi-Strategy Index employs components of both discretionary and systematic macro strategies, but neither exclusively both. Strategies frequently contain proprietary trading infl uences, and in some cases contain distinct, identifi able sub-strategies, such as equity hedge or equity market neutral, or in some cases a number of sub-strategies are blended together without the capacity for portfolio level disaggregation. Strategies employ an investment process predicated on a systematic, quantitative evaluation of macroeconomic variables in which the portfolio positioning is predicated on convergence of differentials between markets, not necessarily highly correlated with each other, but currently diverging from their historical levels of correlation. Strategies focus on fundamental relationships across geographic areas of focus both inter- and intra-asset classes, and typical holding periods are longer than trend-following or discretionary strategies. Hedge Fund Research, Inc. (HFR) uses a UCITSIII compliant methodology to construct the HFRX Hedge Fund Indices. The methodology is based on defi ned and predetermined rules and objective criteria to select and rebalance components to maximize representation of the Hedge Fund Universe. HFRX Indices use state-of-the-art quantitative techniques and analysis, multi-level screening, cluster analysis, Monte-Carlo simulations and optimization techniques to ensure that each Index is a pure representation of its corresponding investment focus. Diversifi cation does not assure a profi t or protect against loss. Columbia Management, LLC does not offer tax or legal advice. Consult with a tax advisor or attorney. Information provided by third parties is deemed to be reliable but may be derived using methodologies or techniques that are proprietary or specifi c to the third-party source.

7 Important disclosures The views expressed are as of January 1, 2014, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affi liates. Actual investments or investment decisions made by CMIA and its affi liates, whether for its own account or on behalf of clients, will not necessarily refl ect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor s specifi c fi nancial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate. Columbia Management Thought Leadership Columbia Management provides insight on markets, global and economic issues, and investor needs and trends. Our investment team examines the issues from multiple perspectives and we re not afraid to take a strong stand or point out opportunities, even when there is no clear consensus. By turning knowledge into insight, Columbia Management thought leadership can provide: > A deeper understanding of investment themes, trends and opportunities > A framework for more informed fi nancial decision-making Access the insight, intellectual strength and practical wisdom of our experienced team. Find more white papers and commentaries in the market insights section of our website columbiamanagement.com/market-insights For more information from the authors in this book, please visit our blog blog.columbiamanagement.com Columbia Management Investment Distributors, Inc. 225 Franklin Street Boston, MA columbiamanagement.com blog.columbiamanagement.com Columbia Management Investment Advisers, LLC is a U.S. Securities and Exchange Commission registered investment adviser that offers investment products and services under the names Columbia Management Investments, Columbia Management Capital Advisers and Seligman Investments. Advisory services provided by Columbia Management Investment Advisers, LLC Columbia Management Investment Advisers, LLC. All rights reserved. 4296_794313