Mutual fund bond investors have reached an unwelcome crossroads. With interest rates at historic lows, they have spent much of their post-crisis existence cautiously ascending the risk ladder in search of yield. Over time, each step up has offered less compensation for incremental risk, but investors have been unwilling—or too fearful—to abandon their positions and sacrifice hard-sought, often meager, returns. And while the liquid alternative space has been touted as fertile ground for diversification and non-correlated returns, it has actually fallen short of delivering the kind of liquidity and diversification today’s retail investor really needs.
That risk ladder dynamic is an unfortunate, but somewhat desired, result of monetary policy set by the Federal Reserve, which has rendered fixed income unattractive and left only a handful of asset classes capable of generating any return. Bonds, for their part, are no longer a trusted source of negative correlation. They once provided a defined, modest cash flow and the ability to manage liquidity needs while offering protection from marketplace pricing whims. Monetary policy has culminated in a dangerous precedent for risk concentration and a lack of diversification as investors have been herded into high-risk assets in the form of public equity, private equity, and high-yield. And it has become exceedingly difficult to liquefy or diversify as banks no longer have the financial capital, nor the intellectual capital, to purchase those assets and efficiently remove investors from those positions, reducing the magnitude of losses and market volatility.
These forces have driven mutual fund investors to lurch from asset class to asset class, chasing investments that have most recently generated the highest returns. But they do so in a vacuum, making decisions based on the anxiety of the moment and not on any meaningful macroeconomic forecasts. Such behavior has created a need to re-imagine the role of liquidity and diversification, once the domain of traditional fixed income investments.
The Impatient Driver
Let’s consider, for a moment, how that investor behavior would play out in a different setting. Envision the proclivities of an impatient driver on a congested highway, darting from one lane to the next, reacting to any sign of movement in bumper-to-bumper traffic. The driver feverishly changes lanes based on the perception that he can reach his destination more quickly by following the kinetic energy. But his decisions are not based on any material knowledge of the road ahead, which is obscured by other vehicles. Ultimately, the driver ends up achieving little while expending much physical and mental energy before crashing into another driver.
This is an apt comparison to retail mutual fund investors who chase returns with the same random logic, shifting money from one asset class to the next based on a deceptive psychology of recent price movement. In the end, price-driven investors become unwitting victims of their own naiveté and impatience as their transaction costs accumulate and they are rendered helpless in their battle to maintain diversification. Without thoughtful research and in-depth market insights, their frequent asset reallocations inevitably lead to suboptimal performance at best and a portfolio accident at worst.
In the same way an anxious driver can misinterpret road conditions, an uninformed mutual fund investor can overlook the importance of diversification and the role of liquidity in portfolio management. If investors had perfect foresight with respect to future asset returns, then investing would be simple. Investors would concentrate their portfolios into the single asset class known to have the best outcomes. But investors are not clairvoyant and need investment diversification to offset the risk of the unknown.
Liquidity is equally important and serves the dual purpose of weathering market turmoil and providing the “dry powder” to seize new investment opportunities. A well-constructed portfolio with appropriate liquidity should have investments that are uncorrelated with other portfolio holdings, ideally eliminating the need to sell holdings at adverse prices in stressed financial markets. In addition to insulating investors from the need to sell those holdings, liquidity should also provide the ability to profit prospectively in distressed markets—by allocating cash when attractive opportunities arise. The well-diversified and liquid portfolio should be capable of thriving, and not crashing, during an adverse event.
Picking a Lane
Traditionally, the fixed income component within a well-diversified portfolio serves three primary purposes: liquidity, negative correlation to risky assets, and potential for moderate income. Today, however, most fixed income investments are unable to provide investors this comprehensive array of traditional benefits. So, where should mutual fund investors turn to satisfy these three objectives?
Many investors have embraced liquid alts. These products emerged as a popular remedy for volatility after the 2008 financial crisis and quickly proliferated in response to retail investors’ craving for diversification and non-correlated returns. Liquid alts generally seek high absolute returns and superficially appear to be an ideal fit for those investors striving to maintain investment returns without inching up the risk ladder. The typical liquid alt fund seeks to replicate a hedge fund strategy—but ultimately implements it in a diluted form, largely as a result of mutual fund regulation.
Like hedge funds, there are liquid alt funds that will perform as advertised and those that will not. Caution must be exercised when evaluating alternatives for investors searching for the three objectives.
A fund touting the typical low-volatility and higher expected return scenario may fail to perform during times of stress when correlations converge to 1.0. Many strategies fail to hedge significant downside exposures, and often may exacerbate them. Investors need a source of liquidity when they require cash. And when they don’t, they need to be able to allocate capital to other low risk, fundamentally-sound, and potentially higher-yielding assets. To restore the integrity of today’s historically risky asset allocation, they may want total return with low correlation to broad financial markets in ordinary markets, but strong negative correlation in periods of market distress.
A Clear Vision
In retrospect, the recent financial crisis has taught investors the value of diversification and patience. Revisiting our driving analogy, while the erratic driver crashed and had to pull over to the side of the road to assess damage, the patient driver who committed to one lane passed the accident when the congestion cleared. This driver is analogous to the investor who remained committed during the financial crisis and times of significant loss. Not only was this investor able to recover losses, but he managed to realize significant levels of return while those who frenetically shifted between asset classes more than likely fared less well.
However, there is another twist to this story line. Investors often develop a comfort for historical precedent, and are prone to making decisions by extrapolating experiences from the most recent cycle. Predicating an investment strategy on the expectation of a government response to a future crisis similar to the policy actions during the Great Recession could be a strategic folly. Investors who reaped significant returns did so primarily as a result of an extraordinary and unprecedented event in the form of a $700 billion government bailout plus $4 trillion of financial support from the Federal Reserve. They might be ill-advised to expect that same level of taxpayer capital to be poured into the financial markets again.
There’s no way to know with certainty when a market crisis will unfold and volatility will spike. The question of when to rely on historical precedent can be nuanced. While we can confidently expect that an adverse event will happen, it’s difficult to know when, or what ultimately will be the trigger. What we can do is manage a portfolio based on that reality. Certainly no one wants to see equity markets implode, but to ignore the possibility an implosion could happen is fanciful. While there is little doubt “if” that day will come, “when” it will occur is highly uncertain.
The predicament of today’s mutual fund investor is not unique; institutional investors are experiencing the same challenges and similar risks. With monetary policy pushing everyone toward the same asset allocation, both have slipped into a pattern and their portfolios have started to look alike. As they’ve all crowded around a single focus, they’ve headed down a collectively risky path. They need to know how to diversify, how to deploy capital before a crisis occurs, and how to redeploy it once the crisis has hit. And, they need to know how to resist the inherent desire to be where the action is.
Douglas Dachille is Chief Investment Officer of American International Group, Inc. and Mark Alexandridis is Chief Investment Officer of First Principles Capital Management, LLC, an institutional fixed income manager based in New York City. First Principles Capital Management, LLC (FPCM) is a wholly-owned subsidiary of American International Group, Inc. (AIG).
