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!
- 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.
- 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.
- For more key points about our 2022 equity and fixed income bear market survival guide, please see my August 3 strategy note.
- 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.
- 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.
- 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.
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!