Strategies which have as their benchmark non-investable, cash-plus targets, such as absolute-return and diversified growth funds (DGFs), have in recent years become part of the institutional investment landscape, gaining particular popularity in the wake of the 2007-08 global financial crisis.

Such strategies encompass a disparate range of approaches: some are managed more like hedge funds; others are relatively complex vehicles with derivatives and synthetic exposures; others are more akin to traditional balanced portfolios. They typically share an objective of seeking to participate to some extent at times of rising asset prices, while limiting drawdowns and volatility.

Indeed, the premise of our own Real Return strategy, which was launched before the DGF category came into being, was that future expected returns were likely to be more muted and that clients would no longer be able to rely on the equity market ‘trend being their friend’. This necessitated an active, flexible approach to investment management and a focus on an upward-only target rather than a relative benchmark where capital preservation is typically not an aim. A key attribute of the strategy is its asymmetric design, which seeks to capture significant upside while limiting the downside risk of falling markets, which can be so damaging for long-term returns through market cycles.

Recently, absolute-return strategies have attracted increasing scrutiny, with questions being asked about their role in clients’ portfolios. In this context we discuss whether these strategies do indeed continue to have a role and, more specifically, whether the Newton Real Return strategy’s target of LIBOR +4% continues to be relevant and achievable over a reasonable time horizon.

An extended cycle

In considering why investors thought that absolute-return strategies were a useful addition to their asset distribution, one needs to recall that, a decade ago, it looked as if the investment world had changed irrevocably. As it turned out, it did not, and the credit crisis was the catalyst for more (much more) of the same. Low interest rates, no interest rates, negative interest rates and quantitative easing have suppressed the yields of traditional ‘safe-haven’ bond investments, encouraging investors to migrate into riskier assets, with policymakers hoping that this would reflate the real economy.

Against this backdrop of a relentless ‘hunt for yield’, and despite a number of subsequent scares, investors in risk assets have enjoyed one of the longest economic cycles in history, with strong returns available from a portfolio of global risk assets, particularly when viewed from a weak currency base such as sterling. For example, the MSCI All Countries World index has returned 13.1% per annum in sterling terms over the last decade, but such asset-price inflation has not been limited to equities.1 High-yield credit has experienced similarly robust returns over the same period, while various bubbles have formed in assets such as property, commodities, and even cryptocurrencies. Given this recent ‘supernormal’ return experience, it is perhaps not surprising that investors question the utility of strategies which aim to limit risk of capital loss and target a cash-plus return.

Expansion and contraction of valuation in line with investors’ expectations about the future is a key driver of stock-market cycles.

Can returns be sustained?

The fact that yields are low, inflation is low, GDP growth is low and valuations are high unsurprisingly creates a problem for expected returns. To explain, it is possible to decompose historic equity returns, for example, into a starting yield, an inflation component, a growth element and a measure of the change in valuation (the price/earnings (PE) ratio), the latter reflecting whether the market has been rerated or derated. Plugging in some expectations about the future can allow us to make a stab at likely prospective returns.

Relative low growth and low inflation, when compared to the last 50 years, is, we believe, structural and here to stay. Real GDP growth of say 1%-2% is likely to be the norm for now in mature economies. If we add (say) 1.5% growth to the dividend yield of the US equity market (S&P 500) of 2%, it gives us a real expected return of 3.5%, while adding in a typical central-bank inflation target of 2% takes the nominal return to 5.5%. This is substantially less than investors have become used to in recent years, and some way short of the long-term (100-year) real return on equities of 5%-6%. A similar calculation for the UK, using the same growth and inflation assumptions, produces a much more acceptable 8.3%, because of the UK market’s hefty dividend yield of 4.1%.

There is a further problem in that valuations have been elevated by the hunt for yield (and thus not strictly comparable with a long-term average), so it is more accurate to say that we could expect 5.5% from US equities if the PE ratio stays the same. This is important, because over time equity valuations have a tendency to revert to the mean (and thus paying a high valuation will tend to produce lower than average returns and vice versa). This expansion and contraction of valuation in line with investors’ expectations about the future is a key driver of stock-market cycles; that valuation tends to shrink just as margins and profits turn down explains why an average of 75% of the gain seen in the boom is given up as the cycle subsequently completes.2

Although the prospect of lower returns may not be especially appetising, there remains an attractive opportunity set for active managers who can employ bottom-up analysis in seeking to capitalise on opportunities both between and within asset classes, and even more so if the mandate allows full flexibility.

1 Source: Newton, 31 March 2019.
2 Source: Shiller, 2018, based on 146 years of data.

Where are we now?

We have been clear that the backdrop has a ‘late-cycle’ feel. This is generally the phase when vested interests pronounce that ‘this time is different’. Well this time is certainly unusual, in that monetary support for markets has become a permanent feature and has spawned some ‘new era’-type thinking. If the zeitgeist of the bubble of two decades ago was the potential for a ‘technological revolution’, and a decade later it was the finance sector’s mastery of leverage, the current boom is based on central bank policy always being on hand to support asset prices on any signs of market distress – the Bernanke/Draghi/Powell ‘put’.

Our thesis remains that it is highly unlikely that the cycle has been abolished, and that the persistent stimulus over an extended period has magnified the feedback loop between the economy and the financial system. A combination of ever-increasing debt levels (and the misallocation of capital that this implies), high valuations (implying low expected returns as noted above) and investors who have been encouraged to take on too much risk as well as constrained underlying liquidity suggests that even a relatively mild cyclical downturn could have an oversized adverse impact on financial markets.

Returning to expected returns, clearly further stimulus from policymakers could expand valuations further – and the same could be said for credit spreads. However, such stimulus is only likely if growth were to slow further which of course would ordinarily be a drag. If growth stalls badly or becomes recessionary then risk assets de-rate. If we are right about the distortions in financial markets, this throws up the prospect of much lower (or even negative) returns in the short term, but would also present opportunities and significantly improve the longer-term expected return for those investors who can preserve capital and be patient.

The case for absolute return

The challenge for the absolute strategy is to beat an upward-only target (which, importantly, is not investable in passive terms) in the longer term. Because of this, the key difference between absolute and relative investment approaches is their tolerance for losses in absolute terms. Whereas relative investors will tend to be fully committed at all times, the absolute strategy will attempt to balance participation (in a whole range of asset classes) and capital preservation in a dynamic way through the cycle. The key aim is to create an asymmetric return profile by capturing some upside and dampening the drawdowns that are so damaging to the arithmetic of longer-term returns. We would argue that asymmetry is always desirable, and the fact that cash-plus mandates encourage a focus on this is valuable for portfolios as both a stabilising element and a diversifier, without giving up the optionality on sizeable capital growth through the cycle.

The key aim is to create an asymmetric return profile by capturing some upside and dampening the drawdowns that are so damaging to the arithmetic of longer-term returns.

Defining the target

Cash plus what? That is a trickier question. LIBOR +4% has a longer-term history of being an attractive return that would satisfy most reasonable aspirations. It is only in this last decade that cash rates have collapsed and financial repression has boosted returns from risk assets. The fact that cash rates reflect the weak growth outlook suggests that this kind of target is still relevant. In addition, the fact that LIBOR +4% (which currently equates to around 5% in the UK) is on a par with the simplistic estimate of expected returns from equities – which are still likely to be the highest-returning asset class – suggests that it remains a challenging target.

An achievable target?

Despite the issues of low expected returns from equities and generally low yields, we believe that LIBOR +4% is also an achievable target; the time frame is, however, key. If absolute strategies lag bull phases as they have done in this cycle, how long is it reasonable to ask investors to wait?

Without a crystal ball it is of course impossible to say; activist monetary policy on this scale is relatively new – we have no idea whether extended cycles are now the norm. Set against that, as noted above, we strongly believe that persistent cheap money has ‘costs’ in terms of distortions, which means the ‘opportunity’ in dampening the coming down leg of this cycle could be very significant. Ideally, our investors would judge us on a ‘through the cycle’ basis, and on that basis, we believe we have enough tools available within the Real Return strategy to beat the target.

The tools in the toolbox

In our view, the challenge for all investors’ returns remains how this cycle ultimately resolves. Being ‘patient’ has been difficult, but we have made the case that cushioning the inevitable drawdown is likely to be crucially important to return.

Through a dynamic investment process, the Real Return strategy’s asymmetric design aims to maximise the upside potential when markets rise, while limiting the downside risks when they fall. It is structured around a stable core of predominantly traditional return-seeking assets with a capacity to generate capital and income, and an insulating layer of ‘stabilising’ assets – aiming to hedge perceived risks and dampen volatility. The strategy does not borrow in order to leverage returns, or sell stocks short.

In our view, the challenge for all investors’ returns remains how this cycle ultimately resolves.

Exhibit 1: Newton Real Return – a simple structure, balancing participation with capital preservation

stabilising layer

The Real Return Strategy has consistently shown that it preserves its clients’capital when things get difficult.

Exhibit 2: Newton Real Return – performance during MSCI AC World drawdowns

drawdowns

Source: Lipper, midday prices, total return, income reinvested, net of 1.0% annual management charge, GBP Inc share class, in GBP. 31 Dec ‘18. Comparisons are made to demonstrate correlation only and are for illustrative purposes only.
The representative portfolio adheres to the same investment approach as the Newton Real Return strategy.
3 MSCI AC World NDR performance calculated using underlying local currency returns for constituents.

While it is stating the obvious to say that an investment strategy cannot simultaneously be highly defensive and capture all available returns, Newton Real Return, being an unconstrained multi-asset, global and highly active strategy, has the ability to be tactically flexible and opportunistic in a way that most investors and funds cannot. Indeed, flexibility has always been a key feature of the strategy compared to those strategies that rely principally on passive diversification. It is important to discriminate flexibility from simple ‘trading’: although flexibility can indeed be tactical, our investment philosophy and process derives perspective from a framework of investment themes. This is very much a dynamic view of the world, attempting to tease out the important trends that drive change and create both opportunity and risk.

This is very much a dynamic view of the world, attempting to tease out the important trends that drive change and create both opportunity and risk.

Exhibit 3: Newton Real Return – evolution of positioning since inception4

evolution of positioning

Source: Newton, 31 March 2019.
The representative portfolio adheres to the same investment approach as Newton Investment Management Ltd.’s Real Return strategy.
4 Inception: 31 March 2004 (close of business).
5 Net positions, factoring in derivative exposure on a delta-adjusted basis.
6 Beta: factor multiplied x 10, rolling 3 years.

This flexibility is not just apparent at the asset distribution level; because we largely invest in underlying securities, we can alter the ‘style’ or characteristics of positions the strategy owns in an asset class as the backdrop changes, rather than just the weights. The fact that we can create a portfolio in each asset class that is very different from the index means we can seek to improve on the kind of expected-return headwinds described above. This can be demonstrated in the strategy’s stock-selection results since inception.

Exhibit 4: Newton Real Return – core equities (ex. gold mining) – long-term returns since inception7

core-equities

Source: Newton, close of business prices, total return, income reinvested, gross of fees, in GBP, 31 March 2019.
Performance is stated gross of management fees. The impact of management fees can be material. A fee schedule providing further detail is available on request. Comparisons are made to demonstrate volatility and correlation and are for illustrative purposes only.
The representative portfolio adheres to the same investment approach as the Newton Real Return strategy.
7 Inception 31 March 2004 (close of business).

Flexibility relies on the ability to act quickly. Real Return is run by a focused team who constantly interact and are all located in a single office in London. We maintain ‘wish lists’ of attractive securities that can be activated when price levels change. Derivatives are also used to change portfolio risks rapidly. Although the strategy’s net equity position may be relatively low (currently sub-20%),8 it is not true to say that the strategy is avoiding all risks for which it can be rewarded. Real Return is exposed to a broad range of assets in the ‘risk space’. As well as global equity risk, the strategy is exposed to duration, corporate credit, emerging-market sovereigns, precious metals and ‘alternative’ sources of equity. Although the three and five-year numbers remain cyclically challenged when measured against growth assets, these exposures have been sufficient to see the strategy preserve capital in what was a difficult 2018.

The Newton Real Return strategy has shown a positive return (gross of fees) in every calendar year since inception in 2004, as well as producing a return of +4.4% in the three months to 31 March 2019, and +7.7% over the 12 months to 31 March 2019.9

We believe the strategy’s LIBOR +4% objective, while challenging, remains realistic, as does its rolling five-year time frame.

Exhibit 5: Newton Real Return – risk versus return since inception10

risk versus returns

Asset class statistics relate to the following measures:
UK equities = FTSE All Share; Global Equities = MSCI AC World; UK Govt bonds = FTSE Brit. Gov’t Fixed All Stocks;
UK Index-linked bonds = FTSE Brit. Gov’t Index IL All Mats; Global bonds = JPM Global Gov’t Bond; Property = IPD All Properties;
Cash = LIBOR 1 Month.

Source: Newton, composite performance calculated as total return, income reinvested, gross of fees, in GBP, 31 March 2019.
Performance is stated gross of management fees. The impact of management fees can be material. A fee schedule providing further detail is available on request. Comparisons are made to demonstrate volatility and correlation and are for illustrative purposes only. Please see composite disclosures at the back of this document. This is supplemental information to the GIPS® compliant information.

8 Source: Newton, 31 March 2019.
9 Source: Newton, composite performance calculated as total return, income reinvested, gross of fees, in GBP, 31 March 2019. Performance is stated gross of management fees. The impact of management fees can be material. A fee schedule providing further detail is available on request. Please see composite disclosures at the back of this document. This is supplemental information to the GIPS® compliant information.
10 Inception 31 March 2004 (close of business).

Newton Real Return strategy – key investment risks

Past performance is not a guide to future performance. Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.

  • The performance aim is not a guarantee, may not be achieved and a capital loss may occur. Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for the returns to be significantly different than
  • This strategy invests in global markets which means it is exposed to changes in currency rates which could affect the value of the strat
  • The strategy may use derivatives to generate returns as well as to reduce costs and/or the overall risk of the strateg Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
  • Investments in bonds are affected by interest rates and inflation trends which may affect the value of the strateg
  • The strategy holds bonds with a low credit rating that have a greater risk of default. These investments may affect the value of the strateg
  • The strategy may invest in emerging market These markets have additional risks due to less developed market practices.
  • The strategy may invest in investments that are not traded regularly and are therefore subject to greater fluctuations in price.

Newton Real Return strategy – annualised returns to 31 March 2019

1 year 3 years 5 years
Newton Real Return composite
(gross of fees)
7.7 3.1 3.6
Newton Real Return composite
(net of fees)
6.9 2.3 2.8
Cash
(1 month GBP LIBOR +4%)
4.7 4.5 4.5

Newton Real Return strategy – 12-month returns

Mar 18
to
Mar 19

%
Mar 17
to
Mar 18

%
Mar 16
to
Mar 17

%
Mar 15
to
Mar 16

%
Mar 14
to
Mar 15

%
Newton Real Return composite
(gross of fees)
7.7 -1.1 2.8 1.9 6.9
Newton Real Return composite
(net of fees)
6.9 -1.8 2.0 1.1 6.1
Cash
(1 month GBP LIBOR +4%)
4.7 4.4 4.4 4.5 4.4

Source: Newton, composite performance calculated as total return, income reinvested, gross and net of fees, in GBP, 31 March 2019.

Please see composite information at the end of this document. This is supplemental information to the GIPS® compliant information. The strategy aims to deliver a minimum return of cash (one-month sterling LIBOR) +4% per annum over 5 years before fees. In doing so, the strategy aims to achieve a positive return on a rolling 3-year basis. However, a positive return is not guaranteed and a capital loss may occur.

Important information

This is a financial promotion. This document is for professional investors only. These opinions should not be construed as investment or any other advice and are subject to change. This document is for information purposes only. Newton claims compliance with the Global Investment Performance Standards (GIPS®).

Newton, the firm, includes all the assets managed by Newton Investment Management Limited and Newton Investment Management (North America) Limited, which are wholly owned subsidiaries of The Bank of New York Mellon Corporation. To receive a complete list and description of Newton composites and a presentation that adheres to GIPS standards, please contact Newton via telephone on +44 (0)20 7163 9000 or via email to contact@newtonim.com.

The Newton Real Return composite contains fully discretionary portfolios which have an unconstrained multi-asset investment mandate which has an absolute return style performance aim, while seeking to preserve capital, through security selection, diversification and simple hedging strategies and for comparison purposes is measured against 1-month sterling LIBOR +4% per annum. Returns include the effect of foreign currency exchange rates.

Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell investments in those countries or sectors. Please note that portfolio holdings and positioning are subject to change without notice and should not be construed as investment recommendations.