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David Coombs: Gold and US Treasuries stand out in static markets

Range-bound markets mean managers are having to look further afield for the investments able to generate returns

David Coombs MM blog

In such range-bound markets, there are several strategies that we believe investors may find useful when it comes to portfolio diversification. Of course, none of these should be viewed in isolation to the investment objective.

For those not familiar with our portfolios, we work on the principle that risk and correlation can move away from historic norms for extended periods, which is why we actively asset allocate.

Gold is a good example of this interplay and is an asset class that we are considering revisiting.

In recent months gold has behaved less like a safe haven asset and more like a risk asset. Indeed, it continues to display an unusually high correlation with European equities. Worries over the eurozone led investors into the US dollar – still viewed as the only real reserve currency – which pushed down the gold price.

On a longer-term basis, we believe gold remains a sensible hedge against downside risks and may well outperform risk assets if markets turn truly risk-off.

In February, we bought US Treasuries in place of gold as a partial hedge following a significant rally in equity markets during the first quarter. We sold them in July at a double-digit profit. Again, this type of short-term return from Treasuries seems abnormal, and perfectly illustrates how historic precedents may no longer hold. It is possible that a break-up in the eurozone could result in both gold and the dollar rising and breaking the long-term negative correlation – so we see the appeal of possibly holding both as portfolio hedges.

Structured products are designed to produce a tailored risk and return, and also have the ability to generate positive returns in flat or range-bound markets. Generally, they are constructed using a bond and an option, or other derivative, to create a single vehicle with a particular pay-off and a fixed term.

Structured products are useful for investors because their pay-off is determined at the outset. This allows the investor to know how their investment might perform in certain scenarios.

For example, at maturity an ‘autocall’ may offer the opportunity to receive a 10 per cent defined annual return if the FTSE is at, or above, a pre-specified level on an anniversary date. The product will be called and will mature early on the first anniversary that the FTSE is above this level.

If the product has not been called, and at maturity the index is 50 per cent or more from its initial level, then capital will be reduced exactly in line with the performance of the underlying index. If at maturity the index has fallen by less than 50 per cent, they may receive their initial capital but no capital appreciation. Thus, structured products can offer a greater degree of precision than actively managed strategies or passive investments and can allow investors to skew the risks they are taking to better reflect their market views.

Finally, discretionary macro trading strategies have the ability to generate positive returns in flat and falling equity markets.

A preferred play, BH Macro, trades interest rate, government bonds and currency markets, which offer diversification away from equity risk.

Trading strategies tend to be long volatility and can, therefore, take advantage of dislocated markets where there is scope to capitalise on pricing anomalies and cheap options. Stringent risk control and discipline are central to the investment process, remuneration structure and business model. While traders are remunerated to back their conviction, they are penalised if they make losses. Liquidity risk is also managed tightly. This is to reduce the possibility of being forced to sell positions at unfavourable prices through margin calls in a liquidity squeeze.

David Coombs is head of multi-asset investment at Rathbone Unit Trust Management


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