The definitive guide to finding "relative value" in a noisy market

They're doing things for hedging purposes or matching liabilities, central banks for policy purposes. As they come into the market and they buy and sell, they create temporary demand-supply imbalances. That is what creates a situation where two securities that are very closely related and have very similar underlying risk characteristics become priced inconsistently with each other. 

What we do is we take advantage of that - buy the cheap one, sell the more expensive one, and wait for those prices to align to a more consistent type of framework and do that in a way that's market neutral. We're not trying to take a view on what's going to happen to the bond market or the economy or anything like that. We want to very precisely isolate just these relative price differentials.

Karunakaran: That's exactly right. And the key is repetition. So, each time you do this, you're not going to make very much, these are small mispricings. But the key is to do it over and over again. So, it's turnover, it's velocity, and doing it repeatedly through time.

How relative value differs

Lee: That leads nicely to the next question that I have. How is relative value, as a concept, different from the more conventional methods we're used to when we talk about fixed income investing like duration and credit?

Most fixed income portfolios are a combination of those two levers, and most of your return is coming from holding the bonds, earning the income, and having exposure to either interest rate duration, risk or credit risk. 

We think of relative value or pure relative value as being a third lever in fixed income, not as well known, but crucially different. So, it's not dependent on the level of rates, it's not sensitive to duration, it's not involving credit. So, it's something different, not better or worse, different. And why the difference matters is the difference is what unlocks diversification.

Lee: When you think about conventional fixed income, I just think during the last two years we've seen such a massive surge in volatility, I think of how bond markets can now move on one word from a central bank speaker or I think of the SVB and Credit Suisse crisis and the massive fiscal deficits being run after COVID. 

How have you dealt with this volatility as an investment house, and does it make it more challenging for you to generate that alpha?

So, volatility control is crucial and there are two ways that we control volatility in those more challenging markets. What we don't do is try to take a view. We don't try to say, "Oh, well things are looking bad. Let's do X or Y," because we just have no competitive advantage doing that. 

We use portfolio construction and what we do specifically is first we diversify risk in our portfolio.

So, just size your bets small is the basic idea. Lots of small independent bets and use the power of diversification. The second thing that is a bit more nuanced is this concept called risk balance. And this involves, without getting too technical, buying interest rate options and other things like that, that will do well in that stressed environment. 

What we try to do with our portfolios is always have that bit of a balance there, where in a stressed environment, some of the things are going to not go well, but you've got these other things that are biased to go well. 

If you get that balance right, then your portfolios should be able to sail through those. And that's the experience we've had. If you look at 2020 during COVID and 2022 during inflation, the portfolios held up pretty well.

ETF

ActiveX Ardea Real Outcome Bond Fund (Managed Fund) (XARO)

Global Fixed Income

View

Managed Fund

Ardea Real Outcome Fund

Australian Fixed Income

View