- ARE GOOD RETURNS POSSIBLE WITHOUT EXCESSIVE RISK?
Terms like the “Search for yield” appear in the financial press almost daily in articles covering flows into asset classes such as equities, high yield bonds and emerging markets. Ben Bernanke even set hearts racing recently commenting the Federal Reserve is monitoring for “investors reaching for yield and other forms of excessive risk taking”.
So why are investors “reaching” so far and why is there a fear this risk is excessive? Well in May the yield on the 10 year US Treasury was 1.76%, about the same as the inflation rate, so zero in real terms. And the search for inflation-beating returns is getting harder and riskier by the day. Single B rated US corporate bond yields recently fell to 6% and the Barclays High Yield Bond Index yield was even lower at 5%, both all-time lows. It’s worth remembering the 10 Year US Treasury yielded this amount just 6 years ago.
So are good yields still achievable without “excessive risk taking” to use Bernanke’s typically dry language?
Firstly let’s see where the traditional forms of yield (or “return”) come from in the liquid investing world.
Risk Free Rate (or Cash)
Currently zero in nominal terms and negative in real terms so not a good starting point.
Government Bond Yield Curve
Higher maturity bonds do yield more than cash (just) but currently the duration risk, or risk of rising interest rates, should be carefully considered. Whilst non-defaulting bond prices will return to par value by maturity even modest rises interest rates will force bond returns underwater for many years and the increased return volatility and left tail risk (which historically was less of an issue) is now a very real “excessive risk” and should not be taken on lightly.
Lower credit quality bonds certainly yield more than cash and inflation but as so much money has gone into this asset class in recent years the risk/reward ratio is at an all-time high. It’s not just the mis-pricing of default risk (historically low yields imply historically and very low default probabilities), it’s the liquidity. If default rates pick up or Bernanke takes his foot off the peddle that drives the QE programme then the exit from credit may leave some musical chair participants without anywhere to sit when the music stops.
Equity Risk Premium
Theory tells us there is a premium to holding risky assets such as equities which can benefit from growing economies. In practice there is certainly evidence for gaining excess returns over cash by holding diversified baskets of equities (to remove individual company risks) however it comes with a roller coaster ride of not only volatility (average risk) but also periods of extreme drawdowns (left tail risk) which makes timing of entry stressful and management of exposure difficult.
Liquid Real Assets
Certain commodities should also carry a risk premium as prices are also linked to growing economies, however they can be very cyclical and extremely volatile making commodities a poor choice for buy-and-hold strategies.
So far the list does not look good in the search for yield, but here are two approaches which do work and are worth a closer look.
Market Timing / Manager Skill / Alpha
Call it what you will but active management can offer what investors are looking for, in simple terms “the right asset class at the right time”. These are not active benchmark oriented strategies which are nothing other than passive products in disguise where any alpha earned is taken by the managers in fees. They are also not fundamental research driven (or value) strategies which claim to buy low and sell high. The trouble with those is they may buy low and watch the price go even lower as the trend goes against long-term pricing logic. The strategies to consider are so-called unconstrained or absolute return strategies in the category often referred to as managed futures or CTA. Many have failed to deliver in the past so it is important to gain transparency on how the strategy works and what the risks actually are (not easy to get at with many managers admittedly) but the best do work and can be combined to diversify away model or manager risk to a good extent.
Still a dirty word perhaps especially when you recall the sheer amount of leverage used by banks and some hedge funds at the height of the financial crisis. However, leverage can be used constructively to boost returns if implemented in a way that exploits the asymmetric properties of active management, combined with a strict risk budgeting approach. This can be considered another form of active management: increasing leverage at times up to a pre-defined maximum exposure to boost returns but decreasing leverage at other times to lower exposure according to a strict set of rules. De-leveraging can even be applied to go below 100% exposure to protect capital, it is actually possible to set a floor on the loss tolerance.
QLAB combines systematic active management (asset selection, market timing and risk management) with a dynamic leverage model to scale up or down the exposure. Both models are transparent and intuitive in how they work and are extremely efficient to implement. The results are shown in the chart below. Spectrum is a proprietary QLAB active strategy with 6% volatility (live now for 3 years) and Spectrum-DL applies leverage dynamically with maximum exposure of 300% and drawdown tolerance set to -15%. Spectrum-DL has a volatility of about 13% and both Spectrum and Spectrum-DL exhibit positive skew or in other words, asymmetry of returns to the upside.
As can be seen, not only are reasonable returns possible but close to or above double digit returns are still possible without excessive market risk or credit risk.
As a comparison the passive portfolio is shown (which is the opportunity set of Spectrum held at maximum exposure: 25% Equities, 25% Commodities, 30% Fixed Income and 20% Currencies). There is evidence for risk premium in this buy-and-hold strategy but also significant left tail risk due to the absence of risk management.
The returns are shown net of 0.3% per annum replication charge to account for the cost of execution (bid/offer spread and brokerage fees) but are gross of management fees which can vary of course. These QLAB strategies are live as individual managed accounts and can easily be wrapped into securitised products on demand.
Performance of the strategy indices can be tracked at www.qlabi.com under the tab INDICES.
Is the “search for yield” over?
DATA AS OF 31-MAY-2013