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Alternative Risk Premia: Defensive ARP portfolio construction

Market Commentary

The Art of Knowing is Knowing what to Ignore. This has been the theme of the last month with markets ignoring the noise of a disputed election and looking through to the growth and economic nirvana of a calm White House and a split government. The lack of new regulations combined with the need to spend fiscally means that the economic tailwinds are strong and the markets in both the US and Australia have had some of their best months on record. The S&P and ASX both rose 10%+ in the month! Clearly the bond markets also know what to ignore as the Greek 10 Year Government Bond yields 0.65% while the 10 Year US Treasury yields 0.84%:

Morgan Stanley published an interesting piece looking at the drivers of the markets in the next 12 months and a major one which we haven’t seen much press on is the $1.3 trillion of Treasury cash which will need to be spent over the next 8 months. The Treasury cash balance is $1.5 trillion and there is a law which says it must be under $200bn by August 2021 because of the debt ceiling and therefore there are only 2 options….spend it through a massive congressionally approved stimulus program or pay down maturing t-bills which will inject a huge amount of liquidity into the banking system which will need to be deployed to riskier assets.

In Australia, we are seeing a similar story with large amounts of fiscal stimulus being pumped into the system and the RBA stepping in to purchase all the federal and state debt to facilitate the spending. As trade spats heat up with China and tourism is slow for the next 6-12 months, we can see how the governments will continue to stimulate the economy and drive the housing wealth effect. This has begun in certain areas and is also being seen with a huge rally in bank stocks.

All of these measures will likely further drive risk assets for the two major exposures in the equity part of superannuation portfolios but all of this fiscal and monetary stimulus could also bring volatility as markets try to predict how to get the last chair in the largest game of musical chairs ever played. Volatility in the portfolio when bond rates are low creates the potential for underperformance of the traditional protection provided by bonds. We continue the theme this month of examining the potential for a defensive Alternative Risk Premia portfolio to replace a piece of the government bond duration portfolio by examining how these portfolios behave in volatile (both up and down) equity markets.

We traditionally take a break from publishing the monthly commentary in January and therefore we wish
everyone a happy new year and look forward to speaking in 2021.

Defensive ARP Portfolios
Last month we highlighted the attractive correlation profile of the constituent factors within our defensive ARP
portfolio. The correlations highlighted four favourable characteristics of the portfolio:
1) The factors exhibit either neutral (low correlation) or defensive (negative correlation) behaviour relative to equities
2) Convexity is provided as these correlations become more negative in crisis periods
3) Correlations between factors were either low or negative, highlighting the diversification benefits of well selected factors in an ARP portfolio
4) Some factors exhibited negative correlations to both bonds and equities. These factors are therefore a value-add from a portfolio diversification standpoint

Performance during extreme periods
While the correlation profiles are encouraging, the diversifying effect of a well selected defensive ARP profile is most clear during extreme market events. Table 1 shows the factor performances in the ten worst months for MSCI ACWI1 since 2012. With rates at low absolute levels, the potential for bonds to perform their defensive role has been reduced. A similar dynamic does not exist in ARP and we expect this to continue. Looking at Table 1 in more detail, we can see that although some factors are negative in equity down months, the overall portfolio effect creates positive outcomes. The neutral factors exhibit reliably uncorrelated outcomes with a positive drift, while the defensive factors pay off during these risk-off periods.

Table 1

1 Our ARP portfolios are in unhedged AUD terms, we use the MSCIACWI Net TR AUD index as comparison

Similarly, we now focus on the ten best months for ACWI since 2012 (Table 2). The factors of the defensive ARP portfolio are mostly flat during these months, or down slightly. The neutral factors are again uncorrelated to equities, whilst maintaining positive drift. The performance of these factors in part contribute to the strong performance of the overall portfolio, which delivered a positive return in 8 of these 10 months.

Table 2

Moving forward, a defensive ARP portfolio can provide the convexity and defensive characteristics that fixed income will be less able to, while not burdening the portfolio with significant bleed during risk-on periods, unlike traditional hedge strategies such as options. In the current context, a defensive ARP portfolio can provide a value-add to an overall fund, and complements the broader portfolio nicely.

Options Commentary
Volatility in options markets has continued to decline as markets approached new highs in the US and rallied in
Australia. The VIX briefly traded below 20 for the first time since February as markets digested the election results and further risk of disputes and legal cases declines.
However, as volatility has declined, skew has increased as the markets are pricing increased risk of a move to the downside or a correction in the short term. Finally, it is interesting to note that despite the markets reverting to new highs, the VIX has stubbornly remained above 20 as the markets maintain a risk premium to option-based protection.

Pricing & Performance
Put Pricing

Alternative Risk Premia Performance
Recent performance of investible alternative risk premia indices.

Swap Pricing
We outline below swap pricing for the major indices based on a size of $100m:

It is worth noting the importance of getting pricing from a variety of banks as the variance in rates can be as high as 15bps depending on the Index being priced. ASX and EM equity are shown as shorts to facilitate moving equity exposure from domestic to international or emerging to developed markets using swaps rather than moving money physically.

The Solutions Team
The Solutions team provides derivative overlay and risk management fiduciary services to Asset Owners and Managers in Australia. Our goal is to provide asset owners and managers with an experienced overlay advisory
and execution service to improve portfolio outcomes and cost efficiency.

Important notice
Financial services provided by Challenger Investment Solutions Management Pty Ltd (ABN 63 130 035 353 AFSL 487354) (CIP Asset Management, CIPAM). The material in this document is general background information about Challenger’s Investment Solutions activities and is current at the date of this document. It is information given in summary form and does not purport to be complete. It is not intended to be relied upon as advice to investors or potential investors and does not take into account the investment objectives, financial situation or needs of any particular investor. These individual circumstances should be considered with professional advice when deciding if an investment is appropriate. Nothing in this document should be considered a solicitation, offer or invitation to buy, subscribe or sell any, or a recommendation of, financial products. All reasonable care has been taken to ensure that the facts stated and opinions given in this document are fair and accurate. To the maximum extent permitted by law, the recipient releases each member of the Challenger Limited group of companies, their directors, officers, employees, representatives and advisers from any liability (including, without limitation, in respect of direct, indirect or consequential loss or damage or loss or damage arising by negligence) arising in relation to any recipient relying on anything contained in or omitted from this document. Any forward looking statements included in this presentation involve subjective judgment and analysis and are subject to significant uncertainties, risks and contingencies, many of which are outside the control of, and are unknown to, Challenger. In particular, they speak only as of the date of these materials, and they are subject to significant regulatory, business, competitive and economic uncertainties and risks. Actual future events may vary materially from forward looking statements and assumptions on which those statements are based. Given these uncertainties, recipients are cautioned not to place undue reliance on such forward looking statements. Any past performance information provided in this presentation is not a reliable indication of future performance. This document is not audited.