In recent years, investors have increasingly questioned whether a relative or an absolute return approach should be used for their investing.
Is it better to invest for the sake of making money and achieving real yield, rather than following the benchmark?
Is relative return appropriate for all asset classes?
EG Capital Advisors’ Dimitry Griko believes that return does not necessarily need to be compared to a benchmark, when some benchmarks and asset classes, by their historically inherited structure, can lack “real” diversification and pose more risks than a properly diversified portfolio within the same asset class.
Levered nature
A vivid example of such an asset class is emerging markets external corporate high yield.
This is an asset class that, by its nature, has significant exposure to the financial sector and a regional overweight to China.
As a result, the direction of the asset class’s performance is highly dependent on the direction of financial and Chinese corporates.
Current weights are 26% and 17.5%, respectively, based on the JPM CEMBI HY index.
Given that financials are quite non-transparent (we cannot be sure what kind of risks they carry on their books); very sensitive to economic downturns; and, because of the levered nature of the business, have close to 0% recoveries in case of defaults, it is quite hard to be convinced that this is the type of risk one would allocate 30%.
A similar statement can be made in regard of the allocation to Chinese corporates, which do have transparency concerns and mostly consist of over-levered and overvalued real estate issuers.
Lingering opacity
In our view, it is important to note that, though improving, a big part of the EM corporate market still lacks transparency.
The risks associated with issuers with low transparency can and should be avoided to achieve absolute returns.
The keys to managing risk and achieving absolute returns are factors not currently present in today’s market structure; such as real diversification and understandable and transparent issuers.
The market, with its huge number of countries, industries and individual issuers, does allow for it though, as well as for diversification away from a lot of the currently present developed market risks.
Getting rid of disproportionate allocations not only reduces the risk of the portfolio by providing a correctly diversified structure, but also significantly reduces the volatility of performance.
This allows it to exploit the attractiveness of an already undervalued asset class in a more conservative fashion, as well as lowering correlation to other risky asset classes.
Poor incentives
A further approach to gaining absolute returns is high emphasis on downside analysis.
For fixed income funds we know the upside from the very beginning, and it is quite limited: the coupons to be received and the principal repayment at the end.
The downside, however, can vary significantly.
Recovery values for some issuers in worst case scenarios can be equal to nothing, when there are others where full recoveries can be expected.
By managing downside properly and concentrating on individual issuer selection, we have the ability to improve the risk/reward profile of the portfolio.
This exploits the attractiveness of the asset class and limits the downside, with the aim of achieving significant absolute return, with manageable risk.
This is a key differentiator from a relative value approach, as with the need to outperform the benchmark, comes the incentive to take on unjustified risk.
This article was written for Expert Investor by Dimitry Griko, chief investment officer, fixed income, at EG Capital Advisors.
