The Art of the Possible

Image from Wikemedia – by Neide José Paixão

Looking at Absolute Return – Can it be Done?

A wise old hand once told me that all investors want is protection from inflation; do that, earn your fees and your job’s done. But there are many paths to that nirvana. One is the idea, popular during the low inflation decade, that you ensure you never lose money. Absolute capital protection was more important than anything.

This can be approached in two ways, either you take minimal risk, and stay in bonds, like the Vontobel fund discussed below, which since inception has returned just +1.75%, or +0.42% over the latest five years, both annualised; it accumulates interest, so there have been no pay outs to compensate for that meagre recent return.

Another approach is that you hedge out all the downside risk, so net/net the fund should never fall in value, by the clever use of derivatives. Sounds easy, but we believe it can’t be done, because the fortune you spend on your daily self-destroying umbrella, far exceeds the cost of the occasional shower ruining your clothes.

Approaches to achieving absolute returns

There are two absolute return funds, within the VT-GTRF which we advise, one is the Vontobel TwentyFour Absolute Return Credit, the other is LF Brook Absolute Return. They are like chalk and cheese.

From this FT site – see the full picture online

The LF Brook fund hedges to prevent severe (or long tail) storms, but otherwise accepts occasional losses. Its returns for the last five years are, +12.4%, -2.4%, +24.5%, +33.8%, +3.9%. Now that looks like inflation protection to us. Yes, you could say, but it had a down year (and indeed down months), which is true, and it could do so again. But as last year showed the boring fund that made just +0.42% annualised over five years, has those too. And because it does so little positive in good times, those down months really hurt.

There are many other asset mixtures, but we firmly believe, to beat inflation, the ability to generate great harvests when the sun shines matters more than trying to achieve perfect loss protection. If you just focus on the latter, in real terms, losses are almost inevitable.

The MonograM Model as a low-cost systemic model.

Both of those funds are actively managed, another option is a passive momentum fund.

By contrast the beauty of systemic models is they can apparently ‘see over the hill’. An active manager reacts either to fundamentals (or we suspect quite frequently) to what everyone else is doing – so often it is to stale news. Whereas the momentum approach offers little coherent real time narrative. That is why some call them black boxes. So, for example our MonograM model could see the end of China’s zero COVID policy quite clearly, in an indicated switch into Far Eastern equity markets, well before we knew what real life event triggered that move.

On the other hand low cost long only equity models, are likely to cause anxiety, when they experience extreme volatility. That itself is probably a feature of too much liquidity, which we suspect is a semi-permanent feature of modern society. The populist urge to spend by governments, even it seems by China, always finally overwhelms the practical need to save and invest. So, creating excess liquidity.

Aggregation without explanation

A momentum model will aggregate all actions, all the trades, all the hopes and fears of a market, coming from thousands of individual transactions. So, when, at some level the Chinese re-opening started, that knowledge leaked into those trades, and then onto the tape. It flashed a regional buy signal on our model, regardless of all the official Chinese denials and misinformation to the contrary. Our MomentuM model is not unique – many big private offices will have similar ones, although we do turn that signal very quickly into a few simple low-cost trades.

And of course, maddeningly, although we try myriad ways to keep the signal clean, we fail. Signals are like a neon light, flickering before they fully illuminate the scene. But with hindsight, they are seldom wrong. They can be late, but on the major indicators, for example getting out of the NASDAQ in autumn 2021, before its long decline, and getting back into the Far East in autumn 2022, they were right – good early, fundamental, calls. The model followed and gained from both signals. Far East please note, not China, so while China caused the surge, you did not need to actually buy Chinese stocks to benefit.

Risk aversion stays with us.

In the defensive part of the MonograM model (where that Absolute Return trait is), for GBP investors, despite all the political noise, the signal told us to hold onto USD High Yield Bonds throughout 2022. This enabled a superior yield to be harvested throughout, also aiding performance. Active managers were dancing in and out of those bond positions all year, and we do accept currency helped the returns. But the model just saw no reason to sell and after all the noise, was right.

The gap between media noise, often politically inspired, and reality can be very stark. This causes markets to oscillate violently – look at Facebook/Meta jumping 62% YTD (that is in five weeks), Bitcoin soaring nearly 50% from its lows (42% YTD) and the speculative ARK Innovation ETF levitating spectacularly (41% YTD) – either something is unhinged, or what was somehow obvious to the market in Q4 was clearly just wrong. The media then follows it all with gusto. This is noise which a systemic model simply ignores.

Not forgetting the fundamentals nor the movements of the collective

Although we do also keep track of the fundamentals – we have consistently said that interest rates will be staying higher for longer and any recession is both mild and not going to hurt the consumer much. It feels odd how that still seems to surprise so many and cause such extreme market shifts.

So, quietly below the politically motivated negativity, in the real world, those myriad daily transactions can tell a different, cleaner story, one that now has the UK FTSE100 finally break out to a new all-time high. Just listen to the transactions, not to the doom mongers.

So, within the vast ‘Absolute Return’ space, if you can’t face the higher costs of active managers, a momentum model can achieve much of the same effect.

Unlike active managers it is not right or wrong, it just is, quietly harvesting the wisdom of those millions of transactions of real people, in real time.