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Advisors staring into the abyss of a bear market are finding that conventional approaches to diversification, such as increasing allocations to fixed income, may not work in today’s environment.

Another option to fixed income is offered by absolute return mutual funds.  These are not hedge funds, and they do not invest in hedge funds, but they strive to offer the benefit of low volatility and low correlation to conventional asset classes – especially to equities.

We spoke with Brian Hlidek and Jay Compson, with Absolute Investment Advisors, whose mutual fund offers such a strategy.

Ominous Signs for Fixed Income

Hlidek and Compson illustrate the problem with fixed income in the history of 10 year bond yields over the last 43 years:

“Most advisors just remember the last 20 years - the gilded age – when rates came down dramatically,” says Hlidek, adding “there were a few hiccups along the way, but they were short lived.”  He believes treasury yields are now very likely near secular lows.  Yale, Harvard and other endowments have been aggressively trimming down fixed income in recent years.   The typical endowment has an average fixed income allocation of 10%.  Yale’s is 4%, and almost no institution has an allocation over 20%. 

To further illustrate the risks in today’s fixed income markets, ten year Treasuries now yield approximately 3.5%.  Looking at a three year holding period, a 75 basis point increase in yields would reduce total return to 2%.  A 100 basis point increase translates to a 1% return, and a 225 basis point increase (roughly the amount yields have dropped in the last seven months) sends returns into negative territory.

Adding to the danger of rising yields are corporate spreads, which tightened from 2003 to 2007, and played a big role in strong returns for the Lehman AGG over this time period.  Compson says investors now face a “double whammy” - low yields and record low corporate defaults.  

Although the bond market has performed acceptably in last six months, Hlidek suggests lightening up on fixed income as part of the rebalancing discipline.

The Diversification Dilemma

The beta (relative to the S&P 500) of many asset classes has increased over the last several years:

Some asset classes are significantly above one.  Compson believes hedge fund betas have spiked as they have taken on more assets, forcing them to take on more market risk.  “Correlation of asset classes has created a diversification dilemma, and there is no easy way out of this” says Compson.

A recent study by Richard Bernstein, chief investment strategist at Merrill Lynch, shows a pattern of increasing correlation between various asset classes and the S&P 500 over the last eight years:

The data shows rolling five-year correlations to the S&P 500 of rolling 12-month returns.  Bernstein’s analysis does not include absolute return strategies.  He notes that “our analysis continues to show that 2000's non-correlated asset classes are now often highly correlated to the S&P 500, and their diversification benefits now seem to be greatly reduced, if not completely eliminated.”  Bonds and cash are identified as the assets with powerful diversifying benefits, and we would add commodities and absolute return strategies to this list.

Compson notes that absolute return investing should not be confused with risky investing.  “Broadly speaking, this is a big mistake made by many advisors,” he says.  Some alternative strategies are specifically designed to reduce risks.  Compson notes that “compared to a typical portfolio with huge systematic risk, they are not risky.  The struggle for advisors is to accept being different.”

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