Vincent Benguigui, Portfolio manager
Diversification: still on the menu?
Harry Markowitz, the Nobel Prize winning economist and godfather of modern portfolio theory, famously remarked that diversification is “the only free lunch in investing” – and although multi-asset credit benefits from decorrelation across sub-asset classes, the rise in correlations[1] have eroded the impact of diversification in recent years (see figure 1).
Figure 1. Don’t depend on diversification
Fixed income asset class correlation (36m rolling v US government bond)
Source: Federated Hermes, Bloomberg and Bank of America Merrill Lynch as at 31 July 2019. Note: the R coefficient is a numerical output used as a correlation measure tool between two variables.
Of course, there is value in adding diversifying sources of return by investing across different sub-asset classes but, given rising correlations, diversification alone should not be considered an adequate source of downside protection.
Dynamism is vital
To successfully manage downside risk, we believe dynamism is vital. Dynamic and flexible allocation allows us to respond to market changes with greater flexibility and security – that is, adjusting our portfolios to seek optimal sources of value throughout the cycle.
Another way in which we aim to preserve capital is through our ability to access a broad spectrum of liquid credit. This allows us to leverage our credit view across all debt instruments, gives us the ability to diversify our sources of alpha generation, and respond to changes in the market. We exploit relative value through high-conviction name- and security-selection.
We also believe in active management predicated upon bottom-up, fundamental stock picking within a top-down framework. The discipline of assessing and pricing credit, ESG and liquidity risks is deeply ingrained in our investment process. ESG integration is a valuable tool for both downside protection and alpha generation through engagement on key issues that can impact the enterprise value and cash flows.
Broadening the toolbox
We aim to protect capital and enhance convexity by using an expanded set of tools: these include single-name credit default swaps (CDSs), index CDSs and options on the index.
Indeed, within our credit team, we express a myriad of different views, and our views of the market will inform whether we use just one or a combination of these products to seek capital preservation during broad, adverse market moves and to exploit opportunities when they arise.
Effective risk management is also an integral part of the investment process and so, using a centralised hub to manage portfolio risk is essential.
Every day, we review our portfolio hedges using a proprietary dynamic duration-management tool that calculates the suggested hedge by currency and part of the curve based on current positioning, market environment, shape of the interest rates curve and correlations. We subsequently review the results and adjust the hedge as appropriate.
Fighting risk with risk
Naturally investors will want to protect themselves from extreme scenarios. By simulating the performance of the global high yield market (which is long-only by definition) compared to a global high-yield portfolio that uses options and index shorts as a hedge, it suggests that the latter will outperform the benchmark if spreads widen in the wake of a market correction thanks to the convexity provided by options (see figure 2).
Such a simulation demonstrates the potential benefit of embedding options- and index-based strategies into our portfolios and highlights that options exposure can reduce the impact of market shock.
Figure 2. Scenario analysis: the appeal of downside protection.
Source: Federated Hermes as at January 2020. For illustrative purposes only.
Indeed, adopting such a flexible approach enables us to mitigate risk more effectively than solely relying on rates and diversification – and it may also enhance upside growth too.
For more information on our flexible-credit capabilities, click here.
The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.
[1] A rise in correlations limit the ability of fixed-income instruments to preserve capital in periods of volatility.
