Pursuing defined returns in 2023
Expectations for the Defined Returns Fund
Tom Boyle, Fund Manager
The Defined Returns Fund aims to provide investors with a high probability of returning 7% to 8% over the medium to long term in a clear and transparent fashion. By the end of 2021, the Fund had done this over its eight year life. 2022 has also seen the Fund rise in value, albeit by only 1%, in a year when most traditional assets have struggled.
We believe the Fund is better positioned now, than it ever has been to continue delivering its long-term target return given the increase in interest rates and volatility this year, and how the Fund has been able to capitalise on these moves, meaning that the Fund’s expected returns from here are higher than usual, but with less uncertainty than previously.
The Fund has lived through a period of falling interest rates since it launched in 2013 until the end of 2021. In isolation, lower interest rates lead to the Fund either needing to take more risk to offer the same potential return, or sacrificing some potential return to maintain the same level of defensiveness. The benign interest rate environment popped dramatically in 2022 leaving many traditional portfolios struggling. However, the Fund was well positioned to take advantage of this rate rise, in addition to being able to capitalise on another market feature that also rose – volatility.
As times become more uncertain, expected levels of future market volatility increase. Intuitively this should make sense – if investors are less sure about what will happen next, with new information continuously coming round the corner, markets exhibit more volatility. Strange as it may sound, derivative markets implicitly and explicitly trade market uncertainty in the form of “implied volatility”, which is an option pricing input.
How has the Fund taken advantage of increases in both interest rates and future volatility expectations?
In the main, the Fund employs a buy-and-hold strategy. One can view the investments within the Fund as quasi-fixed return instruments with distinct maturity dates. For the Fund to take advantage of any changes in markets therefore, it needs to have cash to spend. As the Fund is always fully invested, for us to have cash to spend, investments in the Fund need to be maturing. The maturing investments can then be recycled into new investments.
At the start of 2022, the Fund was positioned such that many of its investments were likely to mature in 2022 as long as markets did not deteriorate very sharply and deeply. Even though markets did fall, they did not fall sufficiently for many of those seasoned investments to miss their maturity triggers. This is perhaps best explained using the case study below.
On 28th November 2019, we traded the investments below:
Market exposure: US, UK, Europe. Source: Atlantic House Group - 30th November 2022.
Given the falls in the market in 2020, the markets were not high enough for the investments above to mature in November 2020 or November 2021. However, by November 2022, all markets were above their start levels in November 2019, so the investment matured paying a positive return of 24%. The increase in interest rates between November 2019 and November 2022 enabled the Fund to replace this investment with one that differs from it in the following ways:
Source: Atlantic House Group - 30 September 2022
The Fund has rolled approximately 40% of its positions this year, and in every single case the new investment has better risk/return parameters than its predecessor, meaning that the Fund is well placed to deliver on its long-term aims with a higher degree of certainty than at any time since its launch.