All strategies work – until they don’t. While the hottest ticket in town is still private credit, is it everything it’s cracked up to be?
In Cliff Asness’ latest missive, a fictional asset allocator from the future looks back on the decade to 2035 to figure out which assets helped their performance and which hurt it.
Offshore assets drive need for true diversification: Atlantic House
Investors with long horizons shouldn’t have to worry about big drawdowns. They’ve got years to repair the damage, and usually the investment nous to do it.
But time doesn’t heal all wounds – especially when those wounds also herald a wholesale change in the way that investors protect themselves against whatever inflicted them.
“In the last few years, we’ve had two very, very different drawdowns – during Covid and immediately afterwards,” Tom Boyle, lead manager of Atlantic House’s uncorrelated strategies fund, tells ISN. “You had the sharp fall of equities during Covid, a drawdown that’s very uncomfortable even for an investor with a time horizon of decades. And then you had a very slow drawdown in 2022, which is much more difficult to hedge, because what could you have done?
“You could have moved into short-term bonds – but if you move the base rate up 300-400 basis points, short-term bonds also have a mark-to-market loss. So how can you use different strategies that benefit from that slower drawdown and that faster drawdown without giving up, during the good times, a significant insurance premium cost?”
Given the big change in bond/equity correlation seen over the last few years, investors have realised that “diversification is based on a correlation assumption that is no longer the case”. That’s where tail risk hedging comes in.
“You can think of tail risk hedging as providing two things: an offset, which reduces your volatility, and/or liquidity, to give you cash for investing in the market when it’s significantly oversold, or for another need,” Boyle says. “Running a tail risk strategy is a very strange emotional journey because you want the world to end – except on a basic human level, where you don’t.”
Super funds have guaranteed inflows, which fulfill part of the role of a tail risk program by providing liquidity to buy the market at the bottom – and on the way to it – without the associated hedging costs. But, Boyle says, that’s only one part of the equation when funds have an increasingly internationalised asset base.
“If you have FX, particularly if you have large foreign assets, which a lot of super funds do, you need to meet those liquidity requirements in that drawdown. The other thing is that the currencies tend to be high beta currencies in regards to risk – you get this double whammy of your assets selling off, and also losing money at the same time on your currency hedging.
“You need something to offset that. And now there’s a reasonable rate differential across their world and you’re going into a period where you’re having quite a lot of monetary dispersion. Currencies have moved around more.”
Tail, like every strategy, has its hot periods. And like all of those strategies, the hot period is usually the wrong time to buy them. The cost of portfolio protection almost always goes up right after it’s come in handy. But the Atlantic House product blends tail with diversifying strategies that aim to mitigate some of the bleed associated with hedging costs and prevent it from becoming a “material drag” on the portfolio.
“This year we’ve had what looks like the beginning of a couple of tail risk events. We had a reasonable drawdown in summer and that huge spike in volatility in August. And if you don’t have that continued drawdown it’s not a product that’s going to provide a massive amount of return.
“If you look at a tail risk fund benchmark a lot of them went up and then went straight back down. But you have to look at the future, not the past… If it does very, very well I hope that we’d lose money and people would put that money in equities. But I think what will happen is we’ll get money because of that mentality.”
