In his entertaining 2008 book on evolutionary psychology, Risk, the author Dan Gardner argues that, to a greater extent than we might think, our minds are controlled by ancient, atavistic instincts.
Areas of the brain that developed during the millennia we lived in caves are now being asked to fathom the complexities of a globalised world, the wild reaches of the internet and the multiplicity of the financial markets.
It is no wonder that we cling to received opinions so doggedly. Our troglodyte brains find change difficult, relying on knowledge of the past to build visions of the future. As the economist John Maynard Keynes said: “The difficulty lies not so much in developing new ideas, as in escaping from the old ones.”
A recent survey found that 84 per cent of fund managers believe the bond markets to be overvalued. With returns on German Bunds touching 10 basis points earlier this year, and Switzerland being the first government ever to issue 10-year debt with a negative yield, it is hard not to agree.
Corporate bond default rates have, with the exception of a small spike in 2009, remained at strikingly low levels, supported by central bank stimulus. Issuers have become hooked on emergency monetary policy and near-zero interest rates, and while investors recognise that pricing implies the most Panglossian of futures, they need to fill their fixed-income allocations, and so they continue to chase yields lower.
One thing seems clear to us: we are coming to the end of a debt supercycle and bond markets are heading into uncharted waters. The two most fundamental assumptions about bonds — that they are a low-volatility asset class and that they are uncorrelated with the equity markets — will be called into question.
With rising interest rates and an end to stimulus on the horizon, and with “market-event risk” the new watchword, it is hard to presage a future for fixed income that is not dramatically more volatile and significantly more tied to equities than anything we have seen before.
The three-pillar system by which investors divided their portfolios between equities, bonds and “others” with the majority of the allocation split between equities and bonds, will no longer produce the kind of steady returns that investors expect.
As this realisation dawns, we have seen portfolio managers at forward-thinking pension funds and insurance companies turning closer attention to the “others” portion of their allocations.
One of the less-remarked phenomena of recent years has been the quiet revolution in the risk/return profiles of hedge funds, typical components of the others bucket.
In the popular press, the hedge fund name still carries a whiff of cavalier excess, but the industry is a broad church and many hedge funds have more in common with bonds than equities from a volatility point of view.
As large institutions have increasingly become the hedge fund industry’s principal investors, we have seen products offering limited risk and low correlation to both bonds and equities gain traction.
We are witnessing a historical inflection point in the credit markets. The best and the brightest recognise that the world is changing, that deep secular shifts are taking place in the drivers of asset class performance, that portfolios must be adjusted prospectively, rather than retrospectively. As Warren Buffett said: “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.”
Everyone knows that the bond markets face a rocky road ahead, that the extraordinary low-interest rate environment driven by dramatic and sustained government intervention must come to an end.
The question is what to do about it? We think the answer lies in leaving behind our troglodyte obsession with long-held convictions and embracing the sometimes overlooked pillar of the three-pillar strategy: “others”.
Pierre Lagrange is the managing director of Man GLG. Simon Savage is co-head of GLG’s European and global long/short strategies
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