Key Points

  • The old regime of low interest rates, quantitative easing and loose monetary policy has given way to a new regime of higher interest rates, inflation and tighter monetary policy.
  • Institutional investors may find it difficult to achieve return targets with market beta alone.
  • We believe that dispersion in interest rates, central-bank policy and business cycles are reverting to the pre-financial-crisis period.
  • In our view, relative-value strategies, which seeks to generate a return that is uncorrelated with the broader market, can benefit in the new regime while overcoming the hurdle of high cash rates.

The market environment following 2008’s global financial crisis was characterized by an abundance of liquidity, effectively zero cash rates and negative correlation between stocks and bonds. With investors sensing that the central-bank ‘put’ was firmly in place to underpin markets, risky assets moved inexorably higher. Waves of central-bank quantitative easing (QE) created an inherent fragility in financial markets, with the abundant liquidity driving asset prices higher and rendering relative-value strategies less effective.

In 2020, the Covid-19 pandemic created such turbulence that inflation surged. Cash rates rose to more than 5%, eroding risk premiums and setting a high hurdle for risky assets. Traditional hedges such as government bonds did not provide diversification.

New Regime, New Challenges

This drastic change created new challenges for client portfolios. Not only did diversification diminish as correlations between asset classes became less negative or outright positive, but inflation became a risk, particularly given its uncertain trajectory. Moreover, the shift into private-market strategies during the QE era created an unintentional bias towards illiquid assets. Furthermore, high cash rates mean the net present value of long-term cash flows is now lower than during the period of QE.

Is your portfolio prepared for this new regime? Questions and uncertainty abound.

  • Will the same portfolio succeed in this very different market environment?
  • How should we navigate this new, less synchronous market regime?
  • How should portfolios adjust to compete with a high cash rate and lower risk premiums?
  • Has your portfolio compensated for the fact that bonds are now less diversifying?

One attractive solution is to use market-neutral, relative-value strategies, whose long/short structure is immune to funding costs and can offer a return stream that is uncorrelated with directional, beta strategies. These strategies are also ideally placed to exploit the richer opportunity set from the post-Covid regime of greater dispersion and heightened volatility, and are less reliant on the direction of asset-class prices owing to their flexible, long/short nature. Further, a set of measures informing long/short decisions—including carry, value, and macro fundamentals—can quickly adapt to changing conditions and provide diversification.

Alpha Diversification Opportunities

Greater dispersion across asset classes can provide attractive alpha opportunities for both long and short positions. In our view, alpha diversification is more reliable across various macro regimes than beta diversification, making relative-value decisions more resilient to macro shocks. Of course, they are not immune to idiosyncratic shocks within an asset class, but it is our expectation that any such shocks are likely to be contained and not affect relative-value opportunities in other asset classes.

Another advantage of relative-value strategies is that they can be implemented in a cash-efficient manner through highly liquid derivatives that are listed and traded on exchanges. Long and short exposures can also be achieved in synthetic form through a total-return swap. These relative-value strategies also allow investors to ‘port’ the alpha streams on top of the cash used to collateralize the derivative exposures, thereby benefiting from higher cash rates.

Recipe for a Well-Constructed Portfolio

In summary, markets and trading instruments have evolved considerably in recent years, offering enhanced liquidity, greater capital efficiency and higher capacity. Diversified relative-value alpha streams, implemented through derivatives, can help investors adapt to this new market regime by providing attractive and scalable risk-adjusted return potential with market-neutral implementation. Instead of viewing higher cash rates as a hurdle, harnessing strategies that work with cash rather than against cash makes sense, particularly in the context of a new regime where cash rates are more elevated. Deploying the right instruments in the right context with the right intent is, in fact, a recipe for a well-constructed portfolio which we believe can weather this new, more challenging market regime.

Authors

Dimitri Curtil

Dimitri Curtil

Global head of multi-asset solutions

Catherine Doyle

Catherine Doyle

Investment specialist

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