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Ruffer’s Dannatt: How we sidestepped the market crash

24 March 2020

Multi-asset specialist Bertie Dannatt said that only certain types of derivatives have proved useful at protecting investors in the sell-off.

By Anthony Luzio,

Editor, Trustnet Magazine

The distortive impact of quantitative easing on markets over the past decade meant that conventional portfolio-protection assets such as bonds did little to shield investors from the crash this month.

Instead, investors have been forced to make a call on the direction of indices and individual assets via derivatives in order to sidestep the market collapse – and it is exposure to these assets to which Ruffer investment director Bertie Dannatt has attributed his group’s outstanding performance since the sell-off began.

The LF Ruffer Total Return fund is down just 3.71 per cent so far this year, compared with losses of 15.96 per cent from its IA Mixed Investment 20-60% Shares sector and 34.34 per cent from the FTSE All Share.

Performance of fund vs sector and index over 2020

  Source: FE Analytics

While Dannatt did not predict the exact cause of the crash, Ruffer has long been positioned cautiously due to the belief that loose monetary policy has left the market vulnerable to a shock.

“It is the overarching context that financial markets have been manipulated by central bank policies for the last decade, which has had the distorting effect of pushing all conventional asset prices up to near record highs almost wherever you look, in bonds, equities – even in fine wine – while concurrently moving volatility down to record lows,” he said.

“What we’ve observed is there’s nowhere left to hide, because all traditional asset classes have been caught up in this distortion.

“Given that context, I think what you’re now starting to see is signs of the market internalising exogenous shocks into an endogenous event and how this instability stemming from central bank policies has created the potential for this market to be avalanche prone.”

To cope with these conditions, the LF Total Return fund has been split into three strategies. The first of these is a 30 per cent exposure to equities, which allowed the fund to make money when markets were rising.

“This was the part of the portfolio that was trying to generate a return for us while we waited for the avalanche-prone conditions to be triggered,” Dannatt continued.

“We didn’t know what the trigger was going to be. And what an extraordinarily sad trigger it was. But what we absolutely could see were the risks building up, that wall of snow above the slope.”

As expected, the equities side of the portfolio has offered no protection in the turmoil of the past few weeks and has largely fallen in line with the rest of the market.

The second strategy is an allocation to conventional protection assets, itself made up of two components, the first of which is US and UK index-linked bonds.

Dannatt said the allocation to index-linked bonds is a play on the long-held view that the next crisis in markets will be met by a fiscal rather than a monetary response.

“It is that physical response that we are now seeing start to come through, which we think will be the moment in the sun for those index linked-bonds,” he explained.

“The index-linked gilts and bonds have been fine over the last three or four weeks, they mildly appreciated in value and have benefited from global yields plunging.

“The second input to their pricing is they price off the market expectations for future inflation. And right now, this is a very disinflationary event. So that part of their pricing has been hampered, but overall, they’ve been a small positive to the portfolio, because that compression in bond yields has outweighed the inflationary input.”

The second conventional protective asset is gold, which makes up about 8 per cent of the portfolio. This has disappointed in the recent crash – it saw double-digit losses in a matter of days (in dollar terms) as the crisis unfolded. However, like index-linked bonds, Dannatt said gold’s time is still to come.

“It is interesting to observe 2008 as a template in that gold peaked in the spring of that year, and then fell some 30 per cent to its floor in November,” he explained. “It shed value all the way through the Lehmans moment, but from that low in 2008 to its peak in 2011, it actually appreciated 130 per cent.

“What happens with gold is it gets caught up in the general de-risking move in the shock, but once investors get through that, they start wondering where they’re going to place their capital. They look at the fact that interest rates are now at zero around the world, but there’s still a lot of fear around and they look at the inflationary response to come. Gold could and should have its moment and there are signs that is starting to happen. In the last couple of days, gold mining stocks have been up very strongly indeed.”

However, it is the third part of the portfolio, the unconventional assets, that Dannatt said has done the “heavy lifting” in the sell-off.

Three short-dated options in particular have done well, the first of which are long-volatility options. The second are put options (which give the owner the right but not the obligation to sell an asset at a pre-determined price and date) on the major indices such as the FTSE All Share, Euro 50 and S&P 500.

Next and perhaps most surprisingly are call options (which give the owner the right but not the obligation to buy an asset at a pre-determined price and date) on the euro.

“The euro was used as a carry currency when risk appetite was on,” explained Dannatt.

“What do I mean by that? Investors were borrowing money in euros at negative interest rates and then investing that money in more interesting risk-on beneficiaries globally.

“When the risk appetite turned – as odd as it may seem given Italy is currently the epicentre of the Covid-19 tragedy playing out in front of us – we’ve witnessed money return to the euro and those long risk-on trades have been unwound and those positions closed out to the euro up until the last couple of days. Those options have served us well. So, short-dated options have been a great help.”

Another play that has done well has been in credit default swaps that increased in value as the credit spread between the lowest- and highest-rated forms of investment grade debt widened.

“In less jargony terms, this refers to the fact that as investors anticipate that BBB-rated companies are now deemed more likely to default than the highest-rated form of investment grade, then these instruments which make up circa 8 per cent of the portfolio appreciated sharply in value,” Dannatt added.

“And that has been a very good place to be in the year to date.”

Looking forward, he said Ruffer is not looking to make any major changes to the portfolio – in a previous article published on Trustnet, he warned this crisis still has a long way to go.

However, while Dannatt dismissed the idea of a V-shaped economic rebound, he said there will be opportunities on the way to the eventual recovery.

“I think gold mining equities look interesting, because gold’s moment in the sun is yet to come. But it’s really about making small adjustments to the portfolio at this juncture and seeing how events play out,” he finished.

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