XARO COVID-19 Response


1. Update on the Fund

Firstly, it’s important to understand how we invest to understand how we are positioned.

  • The Fund invests in the Ardea Real Outcome Fund (“Underlying Fund”). In this report, where we refer to the Fund’s investments we generally do so on a ‘look-through’ basis; that is, we are referring to the underlying assets that the Fund is exposed to through its investment in the Underlying Fund.
  • The Fund applies a ‘relative value’ (RV) investment approach to a global investment universe of high-quality government and semi-government bonds, money market securities, cash and associated derivatives that is benchmark unconstrained, highly liquid and has no exposure to corporate credit risk, foreign exchange (F/X) risk, emerging markets or developed market economies with higher levels of government default risk like Russia, Portugal, Greece, Italy or Spain.
  • While conventional fixed income funds focus on the income earned from holding bonds and predicting the direction of interest rates, Ardea’s RV approach seeks to identify whether an instrument is mispriced relative to other comparable instruments and understand the causes of that mispricing.
  • We can then isolate that mispricing by using a wide range of risk management tools such as interest rate derivatives, to strip out unwanted market risk and profit when the mispricing corrects. This approach is independent of the general level or direction of interest rates.
  • These RV opportunities are continually reassessed as the investment process is repeated over a large and diverse range of such opportunities, to work the Fund’s capital harder.
  • While RV investing is highly technical in practice, the underlying principle is more familiar. For example, you may compare deposit rates to find the best value across a range of seemingly similar options.
  • In the same way, Ardea’s highly experienced investment team scours a global universe of fixed income opportunities to access better return opportunities than available from just placing cash in deposits or buying bonds. The extra effort and resources needed to do this are worthwhile because it opens up a broader range of return sources that conventional approaches miss.
  • While chasing returns by taking more risk is increasingly common in a low rate world, what differentiates Ardea’s approach is risk management. The Fund is managed with tight risk control and includes strategies explicitly designed to profit from extreme negative market movements, prioritise capital preservation and keep the volatility of returns very low.

Please see the ActiveX website here for information about returns, net asset values, portfolio composition and other information. Information on buy-sell spreads applying to applications and redemptions by authorised participants is available here.

2. What we are seeing in markets

Since our last broad communication to you, we have seen enormous amounts of fiscal stimulus injected into the global economy and markets being to assess and price the full extent of the economic and human toll the virus is having on the global economy.

The full on policy panic has now transitioned us from phase 1 of this mini market cycle to phase 2. Bank of America Merrill Lynch (BAML) estimates we’ve so far had $7 trillion of cumulative monetary policy measures and $5 trillion of fiscal policy stimulus, all in the space of 2 weeks. We’ve run out of words to describe this – astonishing, unprecedented are some of the words that come to mind.

Recall, phase 1 was the liquidation driven ‘get me out’ phase, where fundamentals / valuations were irrelevant and forced risk reduction, margin calls, redemptions, deleveraging dominated market activity.

Just one set of statistics to highlight the violence of phase 1:

Inflows to bonds were annualizing almost $1tn in Feb’ 20; but in past 20 trading days bond funds have experienced $243bn of redemptions (annualized $2.5tn) driven by record IG bonds ($128bn), HY bonds ($37bn), EM debt ($46bn), and muni bonds ($22bn).” – US data from Bank of America Merrill, 27 March 2020.

And now we’ve transitioned to phase 2.

The phase 2 price bounce is characterised by hedges/short positions being unwound and the brave marginal buyers committing new money to buy the dip. In the background we still have the remnants of portfolio re-balancing, selling of assets to fund liquidity needs and the like, but it’s no longer the driving force it was in phase 1.

In phase 2, prices across all asset classes start to reflect fundamentals in the context of the range of economic downside scenarios to follow.
The brave are now looking for genuine value, while trying to avoid the value traps. Given the severity of economic downside risks we face, assets that look cheap today could easily fall down a deep recessionary hole from here, ending with bankruptcy and permanent loss of capital.

Regarding economic downside, US jobless claims far exceeded even the most pessimistic forecasts (see chart below) and President Trump abandoned his goal of re-opening America for business by Easter. European governments are also generally talking about extending containment measures.

In Europe, even the largest companies (e.g. Adidas, H&M) are threatening to stop paying rent because of forced store closures. This will have widespread knock-on effects down the chain to the REIT’s that own the properties and subsequent servicing of all the debt that was used to finance their property purchases. A lot of that debt, repackaged into asset backed securities, now sits in ‘diversified fixed income’ funds.

In China, Bloomberg News reports of rapidly rising consumer loan defaults on credit cards and alternative lending services (similar to Afterpay etc.):

The early indicators from China aren’t pretty. Overdue credit-card debt swelled last month by about 50% from a year earlier, according to executives at two banks who asked not to be named discussing internal figures. Qudian Inc., a Beijing-based online lender, said its delinquency ratio jumped to 20% in February from 13% at the end of last year. China Merchants Bank Co., one of the country’s biggest providers of consumer credit, said this month that it “pressed the pause button” on its credit-card business after a “significant” increase in past-due loans.” Bloomberg, 27 March 2020

As the harsh economic realities of lockdowns become more apparent, policymakers are now struggling to find a pragmatic and moral balance between the economic cost of ongoing containment measures vs. the mortality risk to the most vulnerable, if lockdowns are eased.

Investors are reassessing the value of liquidity

Faced with such a rapid shift in economic and financial market conditions, liquidity has become a major pain point for businesses and investors alike. In 2008, people had time to react as the deterioration played out over a year. This time, most did not.

For businesses, the risk is that a temporary liquidity problem becomes a permanent solvency one (i.e. bankruptcy). This happens if they can’t secure financing sources to make up for reduced revenues / cashflow. Many of the large policy measures announced to date are aimed at addressing this very issue.

We can further explore this liquidity issue for investors from two perspectives.

  1. Compensation for illiquidity risk: Sacrificing liquidity in return for additional yield can be a legitimate source of returns if the compensation for illiquidity risk is attractive and investors have the right time horizon of capital.
  2. Suitability of illiquidity risk: While there is always a price for bearing liquidity risk, material liquidity risk may not be appropriate for certain portfolios at any price. For example, defensive portfolios where investors may need to redeem their investment at short notice, in order to access cash. This is particularly problematic in adverse environments like the current one.

Tying these liquidity considerations into investment / portfolio construction decisions going forward, we anticipate a widespread structural reassessment of liquidity risk in investor portfolios.

What comes next?

Phase 3 will be when markets start to price the long-term ramifications of what’s happening now. Which sectors, companies, themes will be the long-term winners/losers from the structural changes to come. Phase 3 will also need to resolve tensions around the enormous stimulus being unleashed.

Right now investors are entirely focused on the near term economic damage, with markets applauding every new stimulus program being announced. At some point, we will reach a tipping point where the consequences of all this policy stimulus will have to be weighed. What does it mean for govt. finances, for longer term inflation, for the stability of currencies?

Phase 2 is about being extremely selective in where to deploy capital. No doubt there is genuine value to be found. For example, in equities there are strong balance sheet companies that are well placed for strategic themes developing out of this crisis. In credit, there are selective parts of the deep high yield and distressed credit segments where high default rate expectations may already be priced in and yields on offer are in the mid-teens now.

But in other parts, there are value traps where economic scenarios that are even modestly worse than what’s currently priced would easily wipe out the small yield cushions on offer. In the worst case the assets that look cheap today could easily fall down a deep recessionary hole from here, ending with bankruptcy and permanent loss of capital.

The peril of less liquid investments is that if you’re wrong about your market call or the downside economic scenario turns out to be worse than expected, it will be very difficult to get your money out.

3. How are we positioning?

Due to the extreme volatility and market dislocations of the past weeks, our ‘relative value’ (RV) opportunity set is now extremely attractive across global interest rate markets.

While we still prioritise caution and conservatism in all aspects of our investment process, we now have enough confidence in improved core interest rate market liquidity that we have started exploiting new RV opportunities. As always, we do this while maintaining reliable portfolio liquidity and excluding all credit investments.

From our investors’ broader multi-asset portfolio perspective, this emerging RV opportunity set is particularly compelling right now for two reasons:

  1. Unlike a decision to increase equity/credit investments, profiting from this RV opportunity set is not contingent on an economic recovery. We don’t need equities or credit to recover, we don’t need economic data to improve, we don’t even need volatility to decline (volatility is good). All we need is normal market function and liquidity to return to core interest rate markets … and that’s now happening.
  2. While equities and credit have fallen a lot, they are still nowhere near historically cheap (i.e. vs GFC levels). At the other end of the spectrum, conventional government bonds are historically expensive (i.e. record low yields). By contrast, a number of RV pricing relationships (e.g. govt. bond vs. futures) are already at peak GFC levels.
  3. It can be expressed through core interest rate market securities (i.e. highly rated govt. bonds and related interest rate derivatives) that retained far better liquidity through the March turmoil than any other segment of fixed income markets.

There are few compelling liquid investment opportunities available right now that are not dependent on an economic recovery in order to profit. Extreme RV mispricing across core interest rate markets is one of them.