The shock of a pandemic and governments' mandated lockdowns laid bare the leverage-afflicted fragility of the economy in Q1. With valuations having been at stretched levels for some time, the credit cycle quickly toppled as news of Covid-19 spread in February, resulting in panicked deleveraging.
Yet whilst the virus-induced catalyst for deleveraging was a surprise, this abrupt end to the current credit cycle should have been less so. Cycles tend to follow patterns that comprise an expansionary period that peaks and troughs, before a recovery phase sets in.
"We have been writing about the overextended-leverage stage of the credit cycle since Q4 2018," notes Clark Fenton, manager of the RWC Diversified Return Fund. "We could see last year that based on our credit-cycle framework, we were in the overextended leverage phase of the cycle: risk premia was low, credit spreads were very tight and it was apparent that if trouble came it would be acutely felt. As a result, we carried very little markets risk, a lot of liquidity and specific positions/instruments that would benefit from a liquidity crunch."
Rising correlations impact returns
At a time when many funds' diversification elements failed - asset correlations across asset classes rocketed in March meaning even the most diversified portfolios achieved little actual diversification - the RWC Diversified Return Team's approach to monitoring credit cycles as a portfolio construction method is compelling . In addition, the fund, which is managed by Fenton alongside fund manager Charles Crowson and Praveen Kanakamedala who manages the team's quantitative analysis and risk is one of the few multi-strategy funds that has performed well year to date.
"Not only did our fund perform well during the sell-off but the returns also have been positively skewed. Meanwhile, the pattern for equities and even bonds have been fat-tailed and negatively skewed."
Rather than rely solely on asset diversification, the fund strategy uses a credit cycle framework as its principal tool to guide how much and what sort of risk to take in the fund. By monitoring each stage closely, the strategy goes beyond simply reducing the volatility of a portfolio but aims to generate a positive return when investors need it the most, such as the outset of a market sell-off. In essence, the strategy aims to assist investors in achieving genuine diversification when they need it the most.
Fenton explains: "We adapt to different market conditions using our four-part credit cycle framework: so from an overextended-leverage stage, which we saw throughout 2019, to rising volatility and deleveraging, as was the case in February 2020. The next stage of the cycle shifts to balance sheet repair and re-leveraging.
"Using this strategy often eans moving away from the herd, and requires contrarian thinking on our part, alternate exposures and return streams, and more sophisticated construction. During the challenging first quarter of 2020 we brought these components to bear and as a result were able to take gains in each very distinctive month. Going forward, having this full toolkit will be required."
Click here to read more on how the RWC Diversified Return Team aim to take gains at cycle extremes from reversals in market sentiment and provide genuine diversification for investors
The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of RWC Partners Limited. This article does not constitute investment advice and the information shown above is for illustrative purposes only and should not be construed as a recommendation or advice to buy or sell any security. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment