We wrote last year about the challenges facing core fixed income and the need for a reexamination of the traditional “40” side of a portfolio. With the potential for interest rates to rise further, increasing correlation between stocks and bonds, and inflation concerns permeating markets, we believe the challenges investors face are far from over. Yet while there appears to be consensus around the problem, choosing a fixed income alternative has been particularly vexing. Given their goal of generating positive returns regardless of market environment with low correlation to traditional investments and moderate volatility, we believe absolute return funds are a compelling option to replace or complement what has become a very challenged “40.”
Absolute return investments aim to deliver positive, uncorrelated returns with low volatility, regardless of broader market performance. Unlike many traditional funds which are designed to access certain asset classes or employ certain investment strategies, absolute return funds are designed to achieve specific outcomes. Their performance is evaluated on a standalone—or absolute—basis against this stated objective. Given this outcome orientation, the construction of absolute return funds can and often does vary. These investments are unconstrained, meaning they can invest across many different asset classes, use derivatives and invest both long and short. While they may look different, little broad market correlation and low volatility are key tenets across absolute return strategies. Absolute return funds’ ability to invest outside the realm of traditional asset classes (i.e., beyond stocks and bonds) allows them to generate truly differentiated returns while their ability to invest both long and short offers the potential to not just mitigate downside risk, but to profit from declining markets as well.
- The traditional “40” has struggled lately as interest rates have risen, and it faces further challenges going forward.
- We believe we have entered a new regime in which stocks and bonds will remain positively correlated, diminishing the diversifying power of fixed income.
- Absolute return funds exhibit many characteristics traditionally sought in core fixed income and, we believe, are an attractive bond alternative.