The hunt for uncorrelated returns in 2023
Last year it felt like diversification broke, with major asset classes following together. But were there any sources of genuine diversification exposed by the crisis and where can we find more in 2023?
Tom Boyle, Fund Manager
Derivatives are rather unique in what they offer to investors. Setting aside for a moment the various payoffs and access that they allow, they offer a spectrum of outcomes depending on what you want to use them for. This naturally brings with it complexity, but also opportunity.
Let’s take an equity investor – I don’t know a single one who’ll buy stocks with the expectation that they will fall in value. However, I know a number of investors in the derivatives market where that is the explicit aim of an options strategy. This is namely found in hedging portfolios, where managers allocate a specific cost each year to protect against other assets in their portfolio falling in value. An example of a hedger would be insurance companies who invest in risky assets hoping to earn an excess return over and above what they will pay out in claims. All being well they will not need the insurance they have bought and will lose the money they used to hedge. Losing money is actually the base case for some. Regulators in several regions in the world force investors such as insurance companies to buy protection, in Europe that law is called Solvency II.
Investors who are forced to buy something become what we call ‘non-economic’ participants in the derivatives. They no longer care what the price is because they will have to purchase whatever that underlying is anyway. Investors who can study these non-economic players can generate returns from them, often in ways which have little relation to what is going on elsewhere in the market. These are uncorrelated returns, which is an important difference to negatively correlated returns.
This year, these forced buyers have been particularly relevant in the credit markets. Many banks loaned money to private equity funds and other companies to purchase other firms or invest in technology companies. Given the performance of tech firms this year, banks are left with a choice when looking at the loans they have on the books. Sell them to other investors, at a loss or hold them and purchase some form of protection against them. The latter has been the case for many banks who have entered the credit market to purchase options on credit risk going up even further from where it has already moved to today. Given the alternative is to take a loss, those lenders have been purchasing insurance at almost any price.
Source: Bloomberg, Atlantic House at 30 September 2022
This non-economic buyer provides an interesting opportunity. As the price is so high, we can sell these investors the insurance but hedge out the directional exposure. If credit risk rises too quickly, we run the risk of being under hedged, but a grind higher will leave us in profit.
The performance of this strategy this year has been resilient. It sits as one of the strategies within the Atlantic House Uncorrelated Strategies Fund and has added 100 bps to performance at a fund level so far. The ‘grind’ higher in risk (lower in price) has suited the strategy particularly well. The added benefit is the strategy does not have the duration risk which would normally be associated with purchasing bonds themselves.
Credit is not the only market where these non-economic buyers exist, but is just one example of how harnessing the differing utility amongst investors can be used to generate uncorrelated sources of return to traditional risk assets.