Uncorrelated assets help diversify the portfolio
When asset classes synchronize, as bonds and stocks did in 2008 and 2020, investors seek new, uncorrelated assets to truly diversify their portfolios, fund managers say.
Michael Sandigursky, Partner at Whitecroft Capital Management and Head of Portfolio Manager, said that since its inception in 2016, the firm has focused solely on Credit Risk Sharing (CRS) strategy, becoming the main player in the $50 billion industry.
“Up to 30 banks are now using CRS transactions around the world, sharing with investors the economic risks of their loan portfolios to major customers. In return for accepting these risks, investors receive a premium from the banks,” he said.
“Conceptually, it’s a lot like insurance,” Sandigursky told Investment MagazineConference on absolute returns.
“The main benefit for banks to do these transactions is to get relief from regulatory capital…in this context, the capital we’re talking about is the regulatory capital that banks are required to set aside for each loan that they emit.”
After the GFC, the subsequent implementation of the Basel III framework significantly increased the capital requirements of banks and therefore bank capital became a scarce resource.
“Since then, banks have had a persistent negative operating gap, meaning their return on equity is lower than their cost of equity,” Sandigursky said.
“Obviously this is not optimal for shareholders and banks have been busy restructuring their operations ever since. regulation on banks does not seem to be easing either.
“There are more and more initiatives being pushed forward by regulators globally up to 2024 and even beyond.”
Sandigursky said the credit quality of these CRS books was generally “very strong”, ranging from A to BB with defaults consistently lower than those of the S&P index, thus the strategy has a low correlation with other credit classes. assets.
“The main benefits of CRS are portfolio diversification, attractive returns and specialized alpha that we can extract as well as stable cash flows, low volatility and correlation and, more recently with rising rates, the interest rate nature variable coupons,” he said.
Over the past decade, the market has grown significantly with 50-60 transactions issued each year, which equates to US$10-15 billion in new capital being invested each year. This allows large investors like European, Canadian, Australian and US pension funds to get meaningfully involved.
“CRS coupons are quite stable over time and vary between LIBOR plus 8-12%,” he said. “In current markets that would be around 10-15%, we think that’s very attractive on a risk-adjusted basis.”
“A key factor in a CRS strategy is the diversification and granularity of portfolio exposures. For example, Whitecroft’s flagship fund has exposure to 25 portfolios referencing the core businesses of 11 banks,” he said.
“This represents more than 16,000 different debtors in 37 sectors and 70 countries. I think it’s hard to find such diversification elsewhere. The portfolio has excellent credit quality, with 70% being equivalent to investment grade.
Sandigursky said CRS’ strategy was truly unique. Whitecroft’s philosophy is that the CRS strategy is not a pure credit strategy. The main component of returns is that banks pay for the utility of having access to regulatory capital.
“So harvesting that bounty is the main objective of CRS’ strategy,” he said.
“That’s about three-quarters of the risk distribution that we receive. Of course, there is also credit risk, which can be divided into two parts. The idiosyncratic component can be diversified to a large extent, while the macro systematic part cannot be diversified, but can be mitigated through the use of macro hedges.
Sandigursky summed up by saying, “Given the above, it is not surprising that a properly implemented CRS strategy results in lower correlation with traditional asset classes and, as such, should be part of the portfolio of institutional investors”.
Meanwhile, Rishabh Bhandari, senior portfolio manager at Capstone Investment Advisors, a $9.5 billion alternative asset manager based in New York, said the firm has an array of strategies that take advantage of the volatility and derivatives to diversify.
“When constructed and executed correctly and effectively, volatility strategies can often be risk strategies, so that they make money in benign markets, but they can also be mitigation strategies and of risk,” Bhandari said.
He said diversification can be a mix of options, relative value arbitrage and short volatility strategies that attempt to take advantage of the option premium or volatility risk premium.
“Each of these strategies can be used as an overlay in an investor’s portfolio and can serve an important purpose,” Bhandari said.
“The interesting thing about options is that trading them is not a zero-sum game. Depending on how different participants use the same option in their portfolio…a buyer and seller of the same option can both win or lose at the same time.
“What he does is [make it] desirable to trade a combination of these strategies and to use options in different ways and to use them as a diversified and diversifying stream of return.
He said investors should view volatility not just as a risk-seeking asset class, but also as a diversifying and risk-reducing asset class.
“As well as a way to build a unique stream of return that can allow investors to design the profile they seek in this changing market environment.”