Accelerate Monthly — Rethinking Cash: A Rational Approach to Asset Allocation

February 10, 2024 — In 1952, Nobel Prize-winning economist Harry Markowitz introduced the concept of Modern Portfolio Theory, which aimed to maximize return while minimizing risk.

Modern Portfolio Theory formalizes the concept of diversification, showcasing that an investor can achieve an optimal portfolio with the maximum expected return for a given level of risk by spreading one’s portfolio across uncorrelated assets. The theory emphasizes the importance of the portfolio’s overall risk and return, rather than focusing on the attributes of individual assets.

Markowitz’s key insight is that the risk of a portfolio can be reduced more effectively through diversification if the returns of the assets included are uncorrelated. In other words, by combining investments whose returns do not move in tandem, a portfolio can yield higher returns for a given level of risk or lower risk for a given level of return. This concept is the cornerstone of Modern Portfolio Theory and underpins the rationale for diversification.

Markowitz famously summarized the essence of this theory with the quote, “diversification is the only free lunch in investing,” implying that diversification across uncorrelated asset classes and strategies allows investors to reduce their risk without a corresponding decrease in expected returns. This “free lunch” is achieved by exploiting the benefits of combining different assets to enhance return potential relative to risk.

For example, if an investor adds one uncorrelated asset to a portfolio (two assets now held), portfolio risk would be reduced by 29%. If a one-asset portfolio were diversified to six uncorrelated assets, the portfolio’s risk would decline by nearly 60%.

Source: Ray Dalio, Principles (New York: Simon & Schuster, 2017).

Interestingly, even adding a risky asset to a portfolio can reduce overall portfolio risk if it is uncorrelated or negatively correlated, despite its high volatility. In contrast, adding 50 tech stocks to a 10 tech stock portfolio would achieve very little, if anything, for portfolio diversification, given these additional assets are all highly correlated.

Under Modern Portfolio Theory, all investment decisions are to be taken from a portfolio level, with attention paid to asset correlation.

Historically, the traditional “balanced” portfolio of stocks and bonds was deemed a diversified asset allocation framework.

However, throughout most of modern history, stocks and bonds have been positively correlated, making bonds a poor stock portfolio diversifier, save for the twenty years before 2022.

Investors relearned this lesson in 2022, when stocks and bonds both fell by double digits, seemingly in unison.

A new approach is needed because investors can generate the same or greater return with far less risk through diversification. The stock market has generated excellent returns for investors over the long term, but allocators have unnecessarily had to stomach some gut-wrenching volatility. Why not utilize a more diversified approach with the goal of generating the same or better returns, with far lower risk?

With that, Accelerate is debuting its global multi-asset model.

The Accelerate Global Multi-Asset solution focuses on positive expected return-producing assets while diversifying across 10+ asset classes. The objective is to maximize returns while diversifying risk to optimize risk-adjusted returns. This solution is Modern Portfolio Theory in practice.

The Global Multi-Asset solution contains:

• U.S. equities
• International equities
• Government bonds
• T-bills
• Corporate bonds
• Real assets (real estate and infrastructure)
• Absolute return
• Global Macro
• Inflation protection (gold and commodities)
• Long short equity
• Private credit

Source: Accelerate

By focusing on the inclusion of 10+ asset classes and optimizing risk-adjusted returns, we believe allocators would be set up with the highest probability of investment success.

The debate regarding long-term asset allocation under Modern Portfolio Theory warrants a discussion on cash (T-bills or money market funds).

There are two valid reasons to hold cash:

1. If you need short-term liquidity and require certainty of (nominal) value.
2. Under a diversified asset allocation framework, Modern Portfolio Theory indicates that cash justifies a reasonable place in a portfolio, such as a 5% weighting.

However, the strategic asset allocation weight is affected by the yield on cash compared to that of other asset classes. Given that the yield curve is still inverted, a 5% weighting to cash remains justifiable (since it yields higher than longer-dated paper).

Nonetheless, as cash yields fall this year and into 2025 as expected, the asset class becomes less attractive, and investors should consider adjusting their asset allocation by reallocating to higher-yielding asset classes.

In late 2023, risk assets staged a tremendous Santa Claus rally, as market participants bid up stocks and bonds in unison (remember, they’re highly correlated) as they had visions of rapid Fed rate cuts dancing in their heads. At the beginning of 2024, market participants were pricing in a decent chance of seven rate cuts over the following twelve months.

Unsurprisingly, this bullish rate cut forecast, which caused speculative securities to surge in December, proved irrationally exuberant. Strong economic figures over the first five weeks of 2024 have provided the Federal Reserve with the ammo it needs to keep rates higher for longer. Fed Chair Jerome Powell has used recent air time to throw cold water on expectations of a March rate cut, while at the same time indicating that cuts are likely to commence in the middle of the year.

Nevertheless, the market has recalibrated its expectations, now pricing in 5 rate cuts in 2024 as most probable, beginning in May.

Source: CME Group

As of the Federal Open Market Committee’s latest projections, the consensus at the Fed calls for three rate cuts. The central bank and market participants are aligned in that both expect several interest rate cuts this year, however, they differ in magnitude.

One certainty is that one, or likely both, will be wrong. Over the past twenty years, the market consensus forecast of the fed funds rate has been notoriously incorrect.

As they say, nothing is certain but the uncertain. But given the spectrum of scenarios, we believe we will see rate cuts this year, likely three or four. As these rate cuts play out, cash yields declining to a 3-handle start to get unattractive for investors, especially if half of that yield goes to the government.

With that, investors should have a plan on where to reallocate cash as interest rates fall this year. For investors who follow a diversified approach, with the objective of maximizing returns while minimizing risk, the menu of asset classes presented by the above Global Multi-Asset Solution is an excellent place to start.

Accelerate manages four alternative ETFs, each with a specific mandate:

• Accelerate Arbitrage Fund (TSX: ARB): Cash Plus
• Accelerate Absolute Return Hedge Fund (TSX: HDGE): Portfolio Protector
• Accelerate OneChoice Alternative Portfolio ETF (TSX: ONEC): Portfolio Stabilizer
• Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Canadian 150/50

Please see below for fund performance and manager commentary.

ARB gained 0.5% in January, which was a busy month for merger activity.

Throughout the month, 27 M&A deals worth an aggregate of nearly $130 billion were announced in North America. The portfolio management team added six merger arbitrage investments to the ARB portfolio. Merger arbitrage yields have widened significantly over the past several weeks, starting the year at 11% and rising to 16% currently. The merger risk premium is its highest since the Covid panic of Q1 2020. It is fair to say that the current merger arbitrage opportunity set is relatively attractive.

In contrast, the SPAC market remains slow, with just one IPO in January. The Fund participated in this IPO, JVSPAC Acquisition, which raised $57.5 million at $10.00 per unit and offered investors 1 share + 1 right to receive one-fourth of a share. This packaged unit was well-received by the market, with the units currently trading at $10.18. We see SPAC IPO activity increasing after a slow start to the year, with two new issues IPOing already in February.

The Fund remains fully deployed with 148.4% long, 12.9% short, and 161.3% gross exposure. Strategically, the Fund has been migrating to more merger arbitrage in the portfolio, with a lower emphasis on SPACs, aiming to harvest the attractive double-digit returns offered in traditional merger arbitrage. ARB’s portfolio currently has a weighted average arbitrage yield above 8%.

After December’s drubbing, rational investing made a comeback with all long short factor portfolios generating positive alpha, leading HDGE to start the year with a 7.2% gain.

The majority of January’s performance was generated from the short side. As is typically the case, after a “squeezy” month like December, in which junk stocks surged, we usually see a mean reversion shortly after. For example, overvalued stocks dropped -9.6% on average, and low-quality junk stocks fell -10.5%. Undervalued and high-quality shares were relatively flat.

Given the Fund’s systematic positioning that is approximately beta-neutral, HDGE has generated positive returns without equity market exposure. Since its inception, HDGE has had a 0.08 correlation with stocks and a -0.09 correlation with bonds. Returns have been higher over the past couple of years as HDGE is expected to deliver greater performance when interest rates are higher, due to the additional returns generated by the yield on cash from the Fund’s short portfolio.

ONEC serves as a diversification tool for investors. When added to the traditional 60/40 stock and bond portfolio, the Accelerate OneChoice Alternative Portfolio optimizes portfolios by diversifying the typical two-asset portfolio with six alternative asset classes, with the goal of improving returns while reducing risk.

In January, the ONEC portfolio of alternative strategies gained 1.0%. The hedge fund portfolio carried the Fund, with absolute return and long short equity gaining 7.2% and 3.4%, respectively, while arbitrage added 0.5%.

The global macro bucket produced mixed results, with managed futures generating a 2.2% increase and risk parity losing -2.2%, while the performance of the inflation protection allocation was also variable, as commodities ticked up by 0.4% and precious metals fell -0.5%.

The Fund’s credit portfolio was flat. The leveraged loan allocation’s small gain offset the mortgage portfolio’s slight loss.

Real assets had a challenging month. The infrastructure portfolio declined by -1.5% and the real estate portfolio dropped by -2.9%. We believe real assets could continue to struggle in today’s higher interest rate environment.

ATSX gained 3.4% for the month, while its benchmark, the S&P TSX 60 Index, rose 1.7%. The Fund’s 50 long/50 short equity overlay generated 170bps of alpha.

Canadian long-short factor performance was nearly positive across the board, led by the value and trend portfolios.

In January, the long-short value portfolio gained 10.9%, as undervalued Canadian stocks gained 4.8% and overvalued securities fell -6.1%. Stocks with a positive trend returned 6.7%, while those with a negative trend declined -5.0%. Only the operating momentum portfolio generated losses for the month, with its shorts outperforming its longs by 2.1%.

Have questions about Accelerate’s investment strategies? Click below to book a call with me:

-Julian