Understanding the role of risk-off factors in absolute return

Focus on risk factors, not what’s risky versus what’s safe

When a bear market looks likely and fears of recession are widespread, it’s only natural that investors would feel the urge to get up and run: Their instincts are telling them to limit their losses.

When this happens to many investors at once, it can translate into a disorderly rush to get out of the market and go all in on conservative, risk-mitigating bonds, if not straight to cash. We know this can do more harm than good, as experience has frequently shown that fleeing the market—particularly when you think it may be falling—can mean locking in losses that will be much harder to overcome without significant future market gains.

This behavioral trap is what a risk premia-driven strategy that focuses on absolute return aims to help investors avoid.

A risk premia-driven strategy is designed to provide close to neutral returns during the worst periods of bear market pain. By design, it’s a strategy that seeks to be a protective element in a portfolio precisely when macro risks prove to be too great, potentially driving deep and widespread market declines.

The two elements of risk balancing

One key to a risk premia-driven approach is perspective. Instead of focusing myopically on asset classes and sectors as inherently risky or safe, this strategy seeks to isolate and combine exposures to risk factors divided into two categories—risk-on and risk-off.

1 Risk-on return drivers—These are aggressive in nature and are expected to perform better during economic recoveries and bull markets.

2 Risk-off return drivers—These are defensive in nature and are generally expected to perform better in down markets and periods of economic uncertainty and outright bear markets.

Three risk-off factors that may help stabilize portfolio returns

The investment philosophy underlying our approach implies that we must always seek to pair risk-on and risk-off factors based on our conviction that risk balancing is the key to pursuing more stable returns.

Building exposures to risk-off factors amid the advent of major turbulence in global markets, along with rising correlations of different asset classes, can be achieved in several ways, which we highlight here.

1 Low risk

This strategy seeks to gain exposure to defensive risk premia across a range of developed- and emerging-market low-risk equities, which we sometimes refer to as capturing the low-risk anomaly.

This allocation—which often makes up the largest weight among our risk-off factors—combines stocks representing a variety of styles and may traditionally be regarded as lower risk, high quality, and/or value. Volatility risk can be higher in this strategy; therefore, we hedge out equity beta by short-selling a basket of futures that replicates, for example, the MSCI World Index.

As more attractively priced stocks have tended to show lower downside capture ratios during stressed market environments, we apply a valuation overlay to make sure we don’t overpay for the stable characteristics of these stocks. One important aspect of the strategy is its relatively low interest-rate sensitivity, given the stocks’ lower dependence on long-term cash flows, and strong and sustainable fundamentals, such as earnings, dividends, and free cash flow yield.

2 Anti-beta

Beta measures a security’s, portfolio’s, or strategy’s volatility relative to the overall market. The beta of the market (as represented by a benchmark) is 1.00. Accordingly, a fund with a 1.10 beta is expected to have 10% more volatility than the market. Anti-beta measures the volatility of a position that should move contrary to the overall market. Anti-beta is a desired characteristic when the broad equity market endures steep declines.

This strategy is dynamic and aims to capture short-term intraday correlation patterns relative to equities. It’s expressed using fixed-income holdings and related derivatives, including long and short high-quality government bond futures and highly liquid G10 currency forwards. The strategy’s aim is to reduce volatility and drawdowns resulting from any equity and credit exposures.

3 FX valuation and quality

This strategy aims to identify currency pairs within the G10 currency universe that have low correlations—or are negatively correlated—to equity markets and that can provide downside protection as well as positive returns in bear markets.

For example, a long position in a defensive currency, such as the Japanese yen, may be paired with a short position in a commodity-linked currency, such as the Australian dollar. The resulting long/short trade tends to have negative beta when risk assets sell off. A valuation overlay is also applied to improve diversification during a sell-off and help compensate for negative carry that these pairs trades tend to exhibit.

Balancing risk factors is the art of absolute return

In our 15+ years of experience managing risk premia-driven strategies, we’ve found that the optimal combination of risk factors changes over time based on the balance of risk-on versus risk-off market sentiment. Carefully maintaining this combination essentially liberates the strategy from needing to make a call on the short- or long-term economic trajectory. If economic conditions improve and markets begin to rebound from bearish sentiment, risk-on return drivers help to stabilize the drag of risk-off factors; however, if a recession materializes and markets continue to decline, risk-off factors may help neutralize the drawdown—and potentially produce positive absolute returns.