'Our goal was to build a hedge without a hedge'

“It all started about two years ago. We were approached by a sophisticated US allocator willing to use exposure to factor premiums solely for diversification purposes, instead of the more common return purposes. They were looking for asset managers who could design a solution using exposures to established factors to curtail losses in down markets.”

“In other words, they wanted to use factors such as value, quality, and low risk, across a wide range of asset classes, in such a way that the resulting strategy would aim for positive returns in down markets while accepting a negative return in up markets. Meanwhile, the expected return over a full business cycle would only be slightly positive.”

“Ultimately, the goal was to build a hedge without the cost of a hedge. Indeed, investors can typically hedge their positions using an options overlay or directly shorting the markets. However, hedging strategies may become overly complex and costly, and are not necessarily easy to implement in practice.”

“Institutional investors typically have large exposures to global equity and bond markets. Unfortunately, the diversification benefits of these two asset classes are not always reliable. Investors try to mitigate risk further through broad diversification within the two asset classes, and – to some extent – alternative asset classes, like real estate and private equity and debt.”

“But the last decades have shown that this type of set up often yields limited diversification benefits in periods of pronounced market turmoil. Alternative asset classes like hedge funds, real estate, private equity and debt, are – to a large extent – driven by the same equity and bond market risk premiums. So, there is a strong demand for solutions that really achieve returns negatively correlated with equity and bond markets.”

“Not exactly. A group of US researchers have already investigated this idea quite thoroughly.¹ And their findings show that you can indeed build a strongly diversifying portfolio with an expected return of zero. The paper was published last year in the Financial Analysts Journal.”

“In a nutshell, the underlying concept is to take a broad set of factor strategies, say 25, across various asset classes, and rank them monthly based on their correlation to an investor’s portfolio. Some will show a high correlation, some a neutral correlation, others still will show a negative correlation.”

“Then, it is about going long, or ‘turning on’, the negatively correlated strategies and shorting, or going against, the highest correlated strategies. The group of factors in the middle of the ranking is turned off as they don’t help diversification properties. The correlation of such a strategy with a classic 60-40 equity-bond portfolio is on average -0.5.”

“This is very low compared to other classic alternative investments, such as real estate, commodities, or hedge funds, which tend to run average correlations north of +0.5. At the same time, expected return over the full economic cycle is around zero as the strategies that are turned on offset performance drag of the strategies that we go against.”

“Yes, implementing this kind of strategy in an efficient way requires extensive knowhow, and we are one of the only three asset managers to have been selected for this project. In this case, we followed the factor correlations idea but added a Robeco touch to it with our time-tested Global Conservative Equities and Global Conservative Credits strategies.”

“These two strategies have a long track record of limiting losses in rough periods and only slightly lagging the market during recovery phases. In this specific context, we hedge them to make them market neutral and then use them to manage the cash pocket of the overall strategy.”

“Then, there is the derivative pocket of the portfolio, in which we follow the idea developed by the researchers I just mentioned by implementing a broad set of factor strategies using derivatives. In the end, we designed a unique two-engine solution based on both award-winning research and years of practical experience with real portfolios.”

“Robeco is a Rotterdam-based investment manager and that was a differentiating point in the process since most competitors were US firms. Dutch people tend to be known for being straightforward and, perhaps, a bit blunt sometimes. But in a scientific research context, I think this can be helpful.”

“The US allocator indicated that they appreciated our frank and critical approach – we asked questions that other parties involved were not asking – and that helped them improve the quality of the solutions. My colleague Martin Martens was the lead researcher for this project and did a great job addressing and substantiating some contentious issues during the research phase.”

“Investment guidelines are ready, and the investment management agreement is almost signed. We expect to start the tryout phase this summer. We’ll begin with USD 200 million of assets under management. What is expected from us is to achieve negative correlations without hurting returns, over the full market cycle.”

“For Robeco this project has implied a huge effort in terms of preparatory work. Managing a large institutional mandate implementing over-the-counter derivatives in the US required registering as a full-fledged asset manager with the SEC. The exciting additional news is that we are now able to offer our broad ranged fixed income solutions in the US as well.”

Footnote

¹ Cavaglia, S., Fan J. H. and Wang, Z., 2022, “Portable Beta and Total Portfolio Management”, Financial Analysts Journal.