Strategy note

The 60/40: Still toast—Demystifying multi-strategy investing, part 2

A new strategy note from Chief Market Strategist Troy Gayeski

Troy A. Gayeski
August 25, 2022 | 15 minute read

The 60/40 portfolio is still toast: 60/40 allocations were highly problematic coming into this year but after the past six weeks’ gains in equities and past eight weeks’ gains in bonds, we still cannot come to any other rational conclusion. The time for alts is now!

  1. As equity markets continue to rally back from their June lows, all signs point to a classic bear market rally: Slowing economy + slowing revenue growth + lower corporate margins + lower-than-expected future earnings growth + still elevated valuations + tighter monetary policy + quantitative tightening just starting to ramp up + already contracting/stagnant money supply growth + escalating geopolitical risks = Tough times ahead for equity markets. Take advantage of this bear market rally and rebalance to more resilient total return and/or income streams.
  2. In Duration Sensitive Fixed Income (Bonds), yields are still exceptionally low with paltry income streams and elevated duration.1 Maturely accept the fact that collecting income through vanilla fixed income is a relic of the past and find low duration/low beta alternatives that can fill this gaping void in one’s portfolio.
  3. For more key points about our 2022 equity and fixed income bear market survival guide, please see my August 3 strategy note.
  4. With those investment community service points made, let us turn our attention to another timely topic—demystifying multi-strategy fund investments (remember part 1). As you read through this strategy example, think about how multi-strategy funds with a small portion of their portfolio invested in strategies with a differentiated approach and differentiated exposures may lead to differentiated performance.
  5. Strategy example: Short European Interest Rate Volatility vs. Long U.S. Interest Rate Volatility—a differentiated exposure that could lead to differentiated performance for multi-strategy funds.

Historical backdrop

  • European interest rates: For close to a decade since the Eurozone Crisis, the European Central Bank (ECB) has kept interest rates exceptionally low (actually negative—what a raw deal for savers) and embarked on various quantitative easing strategies in order to support growth and eventually spur inflation (or at least avoid a deflationary economic death spiral).
  • The yield-hungry sell interest rate volatility: Since yield or income on European Sovereign Debt has been so low for so long, and there did not appear to be any hope that the European economy could grow fast enough any time soon to drive a change in ECB policy, the yield-hungry chose to sell interest rate volatility in order to modestly enhance return—a perfectly logical way to enhance return given the fact and circumstances for close to a decade.
  • Meanwhile, in the U.S.: While the U.S. Fed has had similar problems as the ECB, stronger U.S. growth and inflation concerns at least drove the Fed to tighten modestly from 2015 through 2018. Additionally, over the past decade, there has always been a higher degree of confidence that the U.S. would eventually see inflation increase enough to drive another tightening cycle.
  • Interest rate volatility higher, consistently: So, over the past decade, interest rate volatility has been consistently higher in the U.S. than in Europe.2
  • Fast forward to the past three months: As it has become clearer to markets that the ECB would in fact begin to tighten policy driven by elevated inflation in the Eurozone, market participants who had sold interest rate volatility began to buy it back in earnest to avoid taking losses on those positions. This has driven European interest rate volatility to more expensive levels than U.S. interest rate volatility for the first time since the Eurozone crisis.
  • Fundamentally, this phenomenon makes no sense at all: Clearly, the Fed has the scope and the mandate to tighten much more aggressively than the ECB and they already have done so. Furthermore, even as the U.S. economy has weakened materially recently, the Eurozone economy is in freefall,3 which gives the ECB far less scope to tighten further compared to the Fed going forward.

Strategy example
Here is how the strategy may work within a multi-strategy fund:

  • Sell Europe, Buy U.S.: Since European interest rate volatility is now more expensive than U.S. interest rate volatility for the first time since the Eurozone crisis, the trade setup is very simple: Sell European interest rate volatility and buy U.S. interest rate volatility (short expensive vol/buy cheaper vol).
  • The exposure/trade is Positive Carry: This means if the environment remains the same, investors have the potential to benefit from holding the U.S. interest rate volatility.
  • The other mean reversion: The strategy is expecting to benefit from a possible “mean reversion” (not to be confused with the galactic mean reversion) between U.S. interest rate vol and European interest rate vol one way or another:4
  • Fed continues to hike at a rapid pace
  • ECB must stop tightening as European economy rolls over
  • The recent frenetic bid for long European volatility to cover or close out old short positions fades away

The bottom line: Short European/Long U.S. Interest Rate Volatility is a differentiated exposure with the potential to generate differentiated performance.

In closing, a multi-strategy alternative toolkit is one key piece of any investor’s 2022 equity and bond bear market survival kit. A differentiated approach leads to differentiated exposures (like the Sell Europe, Buy U.S, strategy example), which ultimately has the potential to lead to differentiated performance. And just like the majority of our investment solutions at FS Investments, you don’t have to be a sovereign wealth fund, an Ivy League Endowment, a multi-hundred-billion-dollar state pension plan, or a multibillion-dollar family office to participate. Our mission to democratize alternative investments continues and the progress is accelerating. The time for alts is now!

  • Duration is used to measure how a bond or portfolio of bonds will react to interest rate changes. The longer (positive) the duration, the more sensitive the bond is to interest-rate fluctuations. A negative duration should appreciate in value if interest rates rise.

  • Bloomberg Finance, L.P., as of July 29, 2022.

  • https://www.ft.com/content/afa84401-05c6-41f8-b8f6-2ded251178f8

  • The theory of Mean reversion indicates that, after a significant price move, asset prices tend to return to normal or average levels. Prices routinely oscillate around the mean or average price but have a tendency to return to that same average price over and over. Mean reversion applies to asset prices, and also is applied to volatility, earnings, earnings growth rates and interest rates.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Troy A. Gayeski, CFA

Chief Market Strategist

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