Lessons from a decade in absolute return investing

Royal London launched its Absolute Return Government Bond strategy a decade ago – with markets seeing notable highs and lows since then. In this interview, fund manager Paul Rayner discusses how the strategy started and how it has evolved over 10 years.

The fund launched in 2014 – what was the thinking behind it?

I would point to several factors: first, and most importantly, clients were interested in a product, that in a low interest rate environment could provide positive absolute returns without being reliant on market direction. Second, we felt that our approach to government bond markets was suited to this strategy – we’ve always believed that sovereign markets were less efficient than many think, and that there were elements of our existing approach that would help us to exploit those.

How easy was it to adjust the existing approach?

In one sense it was simple: we already looked for inefficiencies in sovereign markets, but at times couldn’t exploit them all because our existing strategies were long-only. For example, as an index linked manager, I could not go ‘overweight’ inflation as my benchmark was already 100% inflation.

However, once we set up the fund, not only did it allow us to implement all our best ideas it also helped evolve the overall approach we took as a team – in effect becoming the focus of the team’s idea generation. It is a genuine best ideas vehicle that all members of the team can contribute to equally: those ideas are used in the fund, and individual managers can also then implement ideas that suit their long-only funds as appropriate. In my view, it has broadened our global markets knowledge base and enhanced the overall performance of all Royal London funds by encouraging a team-based strategy.

How has the Absolute Return Fund's performance evolved over time?

The fund objective is to target absolute positive capital growth. Within this it has two key performance objectives; the portfolio seeks to outperform its benchmark (SONIA) by 2.5% per annum over rolling three-year periods and aims for positive performance over rolling 12-month periods.

The fund has evolved significantly since its launch. Initially at time of launch, with market volatility and interest rates so low, a fund like ours had to take more risk than we would have preferred to achieve the stated performance targets. In general, our risk-aware approach looks at return coming from two key components – a foundation based on cash returns, then an ‘alpha’ element to generate the rest of the required performance. Naturally, when interest rates are very low or declining, those cash-based contributions are much smaller, and when volatility is equally low, risk positioning sizing has to be much greater – reflecting a reliance on the increased alpha required to generate all the returns in a low volatility world.

Over time, cash returns have significantly increased as interest rates have risen, as has market volatility. That now means we can expect a larger contribution from foundational cash positions and in turn require smaller risk position sizing. This helps to achieve the objective of positive capital growth. So understanding the environment you are in and what that means for your risk management is vital. By understanding risk sizing and market volatility, we have managed to outperform in a variety of market conditions with what I think is relatively low volatility. This approach has also benefited our long-only funds we manage within the Rates & Cash team, as we have become more aware of value and total return rather than just relative return.

What were some of the key events and challenges faced by the Absolute Return Government Bond Fund?

One of the toughest times for the fund was during Covid. It was a period where we were all working in isolation, and the positions in the fund were not set for a global pandemic. We had thought that global growth would pick up and that inflation breakevens were cheap and would increase. Obviously when Covid struck, inflation dropped like a stone – it caused a significant drawdown for the fund.

This is where our risk management approach really proved itself. A traditional risk approach might have observed the drawdown and forced us to stop out of these positions. But we looked at how other positions within the funds were performing – such as a long duration stance which mitigated the impact – meaning we could continue to run our inflation position for longer. In fact, due to our high conviction that Covid was ultimately inflationary we actually increased our breakeven position and ultimately benefited from a significant bounceback in inflation pricing.

So how did this work during the LDI crisis in 2022?

Similarly to Covid, we had large curve positions in the UK – we felt that the UK short end was too cheap and long end too expensive, so the yield curve would steepen. When yields spiked and LDI clients started selling to meet margin calls, both nominal and real yield curves flattened aggressively and impacted performance. But again, our risk management process meant that we continued to run the positions, as we had offsetting global cross market positions – which meant that we were essentially short the UK versus an overweight in US and Australia. This global position performed very well in that period and again not being stopped out was vital – within weeks the negative impact of UK curve positions had almost all reversed as markets calmed down – and once again we avoided crystalising that loss. Our approach is focused on risk but also on managing the overall performance of the fund.  

What’s next for this fund?

I think we are now in a more favourable environment than we had 10 years ago! That may sound counterintuitive when we all know there are lots of risks for bond investors to consider – budget deficits are high across most developed markets and geopolitical risk continues to simmer. But as we mentioned earlier, overall bond yields are higher, which means that this fund can benefit from a strong ‘foundation’ through returns from cash and cash-like products. With regards alpha generation, bond volatility is high and I think is likely to remain high for a number of years. This allows us to implement multiple diversified strategies on a best ideas basis and utilising our careful risk management approach we aim to add incremental positive returns with minimal drawdown.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.