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All-weather investors have to go to some surprising places, shows Ruffer

All-weather investing has a simple aim – consistent positive returns, regardless of how the financial markets perform. It follows that all-weather investors typically have highly flexible investment strategies, that allow them not only to diversify across asset classes, but back their judgment in a wide range of areas to manage for – and benefit from – changing market conditions.

When it comes to hedging and risk management, an all-weather investor’s scope for movement – and its toolkit – can extend well beyond diversification and derivatives, and into niches of hyper-specific, insight-driven thematic market exposure.

That is certainly the case for London-based Ruffer LLP, which has been involved with institutional clients in Australia for the last decade. More recently it came onto Australian wholesale investors’ radar screens launching, in January 2021, its Total Return International – Australia Fund, a local unit trust that invests into the firm’s master trust.

Ruffer’s process is based on an unconstrained active approach and a dynamic asset allocation, but the extent to which it mines the market for insight beyond even these philosophies has been fascinatingly set out in a paper the firm published in January, titled “The Madness of Crowds.”

The paper points out that, like many investors, Ruffer had benefited from the large and prolonged fall in real interest rates; with the natural corollary that this left the portfolios vulnerable to a reversal of that trend, in which real interest rates began to rise in response to inflationary concerns. Ruffer has long held inflation-linked bonds and gold as a protection against the financial repression and inflation it sees as inevitable.

Ruffer portfolios have direct exposure to real interest rates through holdings of inflation-linked bonds, making them potentially vulnerable to increases in real yields. To defend against rising rates, the firm has typically been using rate “swaptions,” which provide payoffs when yields are rising. This helped drive positive returns throughout 2021 and so far this year.

But rising real interest rates are also bad news for equity markets, mostly because rising real interest rates necessarily push up discount rates, which feed through into lower stock valuations.

As the firm puts it, in The Madness of Crowds, the role of real interest rates is “especially salient in an equity market where low dividend yield and stretched valuations combine to produce near-record-high duration. This increase has been driven by tech and tech-adjacent stocks, the engine of equity indices in the past few years, which are particularly vulnerable to tightening liquidity and rising discount rates. This is due to the nature of their balance sheets and earning profiles, with little in the way of tangible assets, much discounted future growth and low dividend yields – (such stocks) effectively act as long-dated zero-coupon bonds.” Ruffer has no exposure to tech.

Ruffer has historically used standard index puts for equity protection, along with measures more focused on volatility, like VIX calls. In terms of interest-rate risk, the firm has usually employed short corporate credit positions and “payer swaptions,” where the purchaser has the right (but not the obligation) to enter into a swap contract where it becomes the fixed-rate payer and the floating-rate receiver.

But rising real interest rates presented Ruffer with a particular conundrum. “Unlike nominal rates, there is no liquid swaption market on real interest rates, which forces us to consider other avenues to find this protection,” the firm writes in “The Madness of Crowds.”

Ruffer’s approach was to interrogate the market for insights it could use.

The research team looked at what the market was giving it – the rise of the big tech and tech-adjacent stocks, to, in some cases, absurd over-valuations.

Ruffer discerned that the inherent characteristics of these stocks, and the way the market was treating them, made them as a group – and “especially the most egregiously overvalued” of them – “increasingly sensitive to moves in real interest rates.”

That was the first insight.

The second was that the concept of “crowding” – which, in its simplest definition, describes “the overlap between holdings in the investor community” – could, especially in an environment of tightening liquidity, indicate the presence of heightened risk. And in so doing, “crowding” could generate stock candidates over which Ruffer could buy put options.

The overlap for which Ruffer was looking was between passive funds – in which it felt inflows were generally driven by investors demonstrating poor market timing – and a bespoke list of quantitative hedge funds, drawn from that group of such funds that typically employ highly leveraged strategies. Ruffer reasoned that these strategies are particularly dangerous in large concentrations; such stocks are vulnerable to self-reinforcing feedback in left-tail liquidity events, where these investors can become forced sellers as they seek to reduce their leverage.

For Ruffer’s purposes, however, this combination was not quite enough. This is where the third insight came in.

This was that the aftermath of the Covid Crash of February-March 2020 had driven a marked increase in single-stock trading, principally driven by retail investors, as chronicled in the infamous r/wallstreetbets group on reddit.com. To this group, momentum – both on the upside and downside – was everything.

When combined, these insights helped Ruffer to identify a group of stocks which have been beneficiaries of recent excess liquidity, which may hamper their future relative performance, as well as having an “avalanche prone” shareholder register, which could produce outsized downside moves. The manager could buy puts over these stocks, with the result being a hedging strategy that not only suited the idiosyncratic market environment, but offered convex payoff possibility that could specifically counter the increasingly negative skew and fat-tailed risk that Ruffer observed.

Usually, single-stock options are both more expensive than options on the index and significantly less liquid, restricting Ruffer’s list of potential targets.

But the three insights described above meant that a basket of puts on these “avalanche prone” stocks can outperform a “vanilla” NASDAQ index put, despite being more expensive to buy.

As a result, these put formed (necessarily limited) part of the protective solution for portfolios sitting alongside the short corporate credit and swaption positions that Ruffer has held historically. Having a range of protective strategies permits the use of discretion in determining which mix is best-suited to protect portfolios at a given moment in time.

In other words, this is precisely the kind of portfolio tweaking that an investor should expect from a conscientious investor determined to do what the label “all-weather” requires. In an absence of traditional protection, convexity and flexibility of mind will be essential.