What is an All-Weather Fund?
As the name suggests, an all-weather fund performs well across economic cycles. The weather, in this case, means economic and market conditions. The up-cycle of the economy is marked by economic growth, earnings growth of the corporates, reduced unemployment, amongst other factors. On the contrary, the down-cycle is marked by stagnation of the economy, impacting corporate earnings and increasing unemployment. An all-weather fund gives stable returns compared to a fund with a specific asset class (For example, an equity-oriented fund) irrespective of economic or market conditions.
Asset & Sector Allocation
Asset allocation is an essential factor to consider in an all-weather fund. An all-weather fund has the leeway to allocate its funds across various asset classes. Different asset classes include equities, fixed income securities, derivatives, alternate assets, commodities, etc. Each of the asset classes performs a distinguished function so as to provide better returns across economic cycles. The investment philosophies & strategies allow these funds to invest across various asset classes. The fund achieves returns across investing environments through various asset allocation strategies.
Along with the asset allocation, all-weather funds also invest in various sectors following cyclical movements. The allocation of the sector depends upon the economic conditions. Rejig in sector allocation is done to gain a favourable outcome for the fund and manage risks associated with the investments and changing market conditions.
The Origin of the Concept
The origin of this concept dates back to 1975. Ray Dalio founded Bridgewater Associates – which is currently one of the largest hedge funds in the world. He and his partner created a portfolio that would stay indifferent through all economic conditions and surprises. They understood that assets behave in a predicted and understandable manner in response to a particular economic environment. Assigning different weights to different asset classes can minimize the impact of uncertainties providing stable returns.
They opined that each return stream could be broken down into components. For example, a bond’s price can be broken down into nominal interest rate and inflation rate components. Similarly, the price of a corporate bond can be broken down into components like the benchmark rate and the spread over the benchmark rate based on the creditworthiness of the corporate. If these assets can be broken down into components, a portfolio constituting these assets can also be broken down into components. They tried to create a passive portfolio based on this simple observation.
Constructing a Portfolio
We now know that different assets move in a particular direction due to changes in the economic environment. For example, stocks perform better during the high growth period. On the contrary, a bond would perform better during the disinflationary recession. To hedge an all-equity portfolio during expected economic stagnation or disinflationary recession would be to buy long-term bonds. The reason is quite simple. Equities do not perform well during economic stagnation, whereas long-term fixed income securities/bonds provide better returns during such periods. A portfolio consisting of stocks and a long bond position would provide returns regardless of unexpected economic movements.
Contrary to this situation, during economic expansion and growth, a long position on equities would take care of the returns to hedge long debt portfolios.
Countering Inflation
We saw that common equities and bonds could offset each other during the disinflationary recession, expansion, and growth. However, there are still specific environmental changes that affect both equities and bonds. One such factor is rising inflation because the value of investments is determined by the volume of economic activity (growth) and the pricing (inflation). To counter inflation, one can use inflation-linked securities. Such securities are linked to the rate of inflation. Pay-out from such securities would be dependent on the rate of inflation plus some real returns.
Taking Care of Extreme Situations
The significant economic and market conditions are factored in the above discussion. However, there are extreme scenarios where tangible assets become more valuable than paper assets. Consider a scenario of war or a severe epidemic/pandemic. In these extreme situations, tangible assets such as gold find their value. These commodities do not derive their value from the underlying but instead have their intrinsic value. Assets such as equities and bonds do not generate any returns during such a situation. A component of valuable commodities in the portfolio would wither away any uncertainty on the returns from the portfolio as a whole.
Options to the Investors
Balanced Funds
A balanced fund allocates total investments into equities and fixed income securities depending upon the expected market environment. A fixed percentage allocation strategy would invest a fixed amount into equities and fixed income securities. These funds are managed passively, with re-balancing happening at a regular interval.
A variation to this strategy is asset allocation without any specified percentage. This strategy enables fund managers to actively manage assets depending upon the economic and market environment, considering various risk factors. Generally, the equities portion is actively managed, whereas the fixed income portfolio remains relatively constant.
Long & Short Strategy
Long & Short is a typical strategy employed by hedge funds. A fund manager would take a long position (buy) securities that are expected to grow and leverage his position to take short position (sell) securities expected to fall. Funds deploying long & short strategies tend to perform better during economic stagnation as the short position takes care of the portfolio’s returns.
Market Neutral
As the name suggests, a market-neutral strategy does not keep any open exposure but rather stays neutral in the market. The strategy tends to exploit the arbitrage opportunities arising out of mispricing of assets or other factors. Investors can earn returns irrespective of market or economic conditions using derivatives and other products.
What can Retail Investors Do?
Retail investors can manage their portfolios through allocation weights to different asset classes. Since the strategies are complex, professional investors with experience can undertake their portfolio management. A common way for investors to earn stable returns through economic cycles is to invest in balanced mutual funds. These funds are managed by professionals and charge a small fee to the investors. HNIs and UHNIs can invest in hedge funds employing long/short strategies to ride the ups and downs of the economic cycle.
