The start of 2022 has upended expectations of lower-for-longer interest rates and sent shockwaves through global equity markets. As central banks begin to tighten policy in a bid to head off rising inflation, will traditional allocation strategies continue to perform for investors?
“For decades, government bonds have performed a dual role in multi-asset portfolios,” says Etienne Grisey, Head of Equity Derivatives Structuring, Asia Pacific at BNP Paribas. “They provide a reliable return and prevent downside losses when equities falter.”
But the Covid-19 response has driven bond yields so low that returns are no longer attractive – and the only way for yields is up. Having languished below 1% in early 2021, the US 10-year Treasury yield has already retraced to 2% by mid-February.
At the same time, the liquidity injected by economic stimulus schemes has boosted equity valuations. But many investors feel stocks may be approaching an inflection point as central banks step up the fight against inflation.
If the outlook for both equities and bonds is equally uncertain, this poses a conundrum for conventional investment strategies.
Historically investors have applied balanced portfolio rules in their liquid investments, such as the 60/40 allocation rule. The aim for their fixed income investment is to achieve two elements: firstly to generate positive carry, and secondly act as a downside hedge in times of equity sell-off.
In the current market environment these investors are looking for alternative products to help navigate this challenging duality. Where do they invest?
“When bonds fail to offer adequate diversification, the traditional options include commodities, cash, or alternative investments – but these all pose problems of their own,” commented Grisey. “A high cash allocation will dent real returns. Commodities can offer great diversification during inflation periods, but lie outside many investors’ mandates.”
Similarly, alternative investments can be difficult to access and illiquid – a particular bugbear for investors.
Searching for solutions
In these challenging circumstances, QIS present an attractive alternative for some investors. At their core, QIS aim to harvest returns from market patterns that have been well documented by academic research.
Through structured products, warrants, certificates, structured deposits or over-the-counter (OTC) derivatives, investors can gain exposure to different themes and various asset classes with a single investment.
“QIS provide an efficient way for investors to access a diversified portfolio of assets,” said Grisey. “For investors who lack the capacity to assemble a range of thematically linked shares and bonds, buying a derivative based on a basket of these assets provides the same result.”
Diversifying the investor base
Grisey observed that the types of investors accessing QIS are becoming more diverse.
“A quantitative, data-driven approach that offers stability and counter-cyclical returns in volatile markets clearly appeals to both institutional and high-net-worth investors,” he said.
“Hedge funds, which haven’t previously been interested in structured products, are also increasingly catching on thanks to the flexibility and the daily liquidity they can offer.”
In Asia, in particular, investors seeking an escape from the negative returns generated by excessive cash in their portfolios are turning to structured products to enhance their yield.
“This is especially true in Japan, where we have seen the biggest growth in inflows in recent years,” said Grisey. “Investors also gain confidence from products that are stable and resilient during times of volatility.”
Hamzah Kahloon, Head of Structuring and Solutions, Asia Pacific at BNP Paribas, added: “Careful structuring can create a package with known upside and risk parameters, which takes some of the guesswork out of alternative investing. The growing interest in QIS shows that investors are expecting to work hard to generate above-market returns in 2022. Accessing yield enhancement opportunities combined with a proportionate degree of risk protection is an attractive proposition at this point in the cycle.”
The growing interest in QIS shows that investors are expecting to work hard to generate above-market returns in 2022.Hamzah Kahloon
Head of structuring and solutions, Asia Pacific at BNP Paribas
The BNP Paribas Approach
BNP Paribas creates Quantitative Investment Strategies in partnership with top universities globally, including Monash University in Australia. A carefully crafted selection can allow investors to express their market views, hedge at limited costs or tilt the profile of their portfolio.
For example, academic research has found that short term rates are guided by Central Banks and tend to follow patterns over long periods of time. The BNP Paribas Kinetis strategy monetises the momentum of those short term rates, getting a long exposure to money markets futures as rates decrease, and a short exposure when they increase.
This algorithm has outperformed the market by 6% in 2022 during very difficult market conditions. It also managed to perform very well during the previous period of accommodating central bank policies when bonds performed very well.
Another popular strategy in the region is BNP Paribas’ Artificial Intelligence model, as it is able to perform when all assets are suffering. It takes long or short positions on equity, bonds and commodities, drawing on a scorecard of today’s market based on 42 technical indicators (including trend, mean reversion and volatility etc). It then compares it to the scorecards of all previous days during the last 25 years.
This strategy can be thought of as a seasoned trader, but with a perfect memory – it remembers what the market did previously and takes the adequate position. This strategy has performed very well since its launch three years ago, delivering an average of 7% annualised returns. We have also isolated a portfolio of strategies adapted to High Inflation, Stagflation or Reflation. Commodity Carry, Cross-Asset Momentum or FX value strategies are delivering strong returns this year.