Absolute return managers fixated on volatility and correlation may be caught out if a sudden shock such as a recession were to happen, according to Investec Asset Management’s John Stopford. 
Stopford (pictured), co-head of multi-asset at Investec Asset Management, said a tightening of monetary policy and the winding down of quantitative easing (QE) by central banks such as the Federal Reserve and Bank of England could see risk assets become more closely correlated.
However, the co-manager of the £539.8m Investec Diversified Income fund said some absolute return managers have become increasingly fixated on correlation, which like volatility, is just “noise” or a “blunt” measure.
“Correlation is an average statistic, it’s blunt. It’s just telling you the average and not how it evolved through time,” said Stopford. “Volatility is [also] a blunt measure, it just tells you about noise not about direction.”
He added: “The problem with the Targeted Absolute Return sector is that it just focuses on those two characteristics – not on generating returns.”
A narrow focus on correlation to the market could become a problem if central banks continue to pursue policies of rate tightening and the withdrawal of stimulus.
As the chart below shows, in the decade since the global financial crisis the MSCI World index has risen by 32.24 per cent, without dividends reinvested and in US dollars, while the Bloomberg Barclays Global Aggregate index by 29.29 per cent.
Performance of indices over 10yrs
Source: FE Analytics
Central banks around the world slashed interest rates in the aftermath of the global financial crisis and implemented extraordinary quantitative easing programmes to support the economy. However, this also flooded the market with cash and pushed asset prices higher.
As the withdrawal of that stimulus now begun and central banks beginning to consider raising rates, questions over the sustainability of the post-crisis bull run in markets have been raised.
“QE has dominated monetary policy for the past few years if you think the rising tide lifts all boats it’s been a great environment, not just for equities but for most fixed income assets also,” said the Investec manager.
“The danger is that as the tide begins to ebb and that becomes less desire for QE to be implemented by central banks that actually it will impact all assets. The danger is that all uncorrelated assets become more correlated.”
As such, the next challenge will not be for managers making money in a “bog-standard bull market” said Stopford, but in generating returns through the end of the cycle.
He explained: “Valuations are probably more about the medium-term trade-off between return and risk which has deteriorated but is not necessarily a short-term signal [for a bear market].
“Ultimately you need a catalyst to start a bear market and monetary policy can historically be one of those. The question is: how much and how long does that need to go on for to crash things?”
Stopford said the Federal Reserve has long been accused of causing recessions through policy and its commitment to two years of interest rate tightening could coincide with another recession in 2020.
“The really big one is the risk of recession,” he explained. “Ultimately, uncertainty and the level of cash flows into growth assets could come into question.”
Stopford added: “The good news is that it looks quite unlikely to happen this year and it doesn’t look that likely we will get a recession next year, although the risk is building.
“If you look at things that have traditionally deteriorated ahead of a recession and how much they have deteriorated so far, they are increasingly consistent with a recession about two years in the future, so about 2020.”
As such, Stopford said that equities and other growth assets have probably another six to 12 months of positive returns left before the market starts to turn.
To limit exposure to market shocks in the Investec Diversified Income fund, Stopford and co-manager Jason Borbora take a more diversified approach building a portfolio of 250-300 securities – from a universe of 25,000 – falling into growth, defensive and uncorrelated buckets.
The multi-asset managers aim to provide income – with an annual target yield of 4-6 per cent – with ‘bond-like’ volatility and the opportunity for long-term growth.
While the ability to deliver a sustainable income is one of the most sought-after qualities in holdings, along with the upside capital potential, there are several other attributes the managers look for.
While security selection is bottom-up, the managers also take a top-down view in terms of portfolio construction and risk management. This helps the diversification of the portfolio, something that the managers are also keen to emphasise.
“At every stage of the process we’re thinking can we get some upside but also how do we protect the downside,” said Stopford. “Top-down diversification does that naturally, it limits volatility.”
The pair said it was important that they understand how holdings interact with the business cycle to gain a complete understanding of the risk within the portfolio.
“What we really like to do is recognise that volatility is essentially just noise and actually most of our investors don’t mind a little bit of noise to the upside but they don’t particularly want noise to the downside,” Stopford said.
“If we can produce a positive skew and capture more positive performance and less negative performance we will compound returns more consistently through time.”
The managers use several methods to actively manage risk with the portfolio: by using options, adding hedges, and by selling underlying positions.
“As markets drop we’ll be less exposed,” said Stopford. “As they improve again we’ll just dial it back up. Alternatively, if the market has a jump can discuss whether to dial risk up anyway.”
As such, while Investec Diversified Income sits in the IA Mixed Investment 0-35% Shares sector, Stopford said it considers absolute return funds or strategic bond sector as peers given its active approach to monitoring risk in the portfolio.
He said how it views risk and diversification is similar to funds in the IA Targeted Absolute Return sector, while its income focus made it comparable to some strategic bond funds.
“The peers you could compare us to are quite varied and in addition because we are approaching in very different ways to others – bottom up very global thinking about diversification differently thinking about downside risk management more – I think we’re very complementary to those peers,” said the Investec manager.
“We’re doing something different but producing similar outcomes.”
Performance of fund vs sector under Stopford
Source: FE Analytics
Since Stopford joined the £539.8m fund in July 2012, it has delivered a total return of 32.91 per cent compared with a gain of 28.11 per cent for the average IA Mixed Investment 0-35% Shares peer.
Investec Diversified Income has a yield of 4.49 per cent and an ongoing charges figure (OCF) of 0.75 per cent.