Global Real Return Fund Q&A

Suzanne Hutchins
Senior Portfolio Manager
Global Real Return Team

Aron Pataki
Real Return Portfolio Manager
Global Real Return Team

 

Managed by Newton, a BNY Mellon company, the Dreyfus Global Real Return Fund seeks positive absolute returns over a full market cycle—with a strong emphasis on low volatility and capital reservation. With the U.S. dollar version of the strategy recently marking its six-year anniversary, we asked managers Suzanne Hutchins and Aron Pataki about their views on markets, portfolio positioning and risk management.

What is your starting point for building a multi-asset portfolio?

Suzanne Hutchins:

We view the portfolio in two parts. First is our "return-seeking core" of individual securities, selected based on bottom-up research and consistent with Newton’s long-term themes. We then construct an "outer layer" of risk-stabilizing positions to insulate the core, with the aim of reducing volatility and preserving capital.

Aron Pataki:

What the team ultimately attempts to do is strike a balance between a core portfolio of traditional, alpha-generating assets and an insulating layer of largely uncorrelated assets, currencies and simple derivative strategies. (Alpha is a measure of the return on an investment due to active management.) We think of this outer layer like a car tire that surrounds the core and absorbs shocks when the road gets bumpy. Just as the type of tire can change to suit the terrain, we adjust the outer layer based on prevailing market conditions to hedge against a range of scenarios.

How do these two parts of the portfolio work in unison?

Suzanne Hutchins:

The return-seeking core will typically have lower turnover. It will change in size and characteristics based on the opportunities and risks in the investing environment. On the other hand, the outer layer will be more dynamic in the way downside risk is managed.

Within the core, we believe today’s challenging, risky landscape lends itself more to sustainable dividend-yielding equities, higher-quality global growth businesses, a few select corporate debt issues and convertible bonds—all judged to offer intrinsic value to their business worth. The core may also include, for example, infrastructure-related securities, such as solar and wind alternatives, which generally provide less correlated returns along with strong and stable income streams.

The outer layer may include government bonds, currencies, inflation protection instruments, derivatives and gold-related securities such as exchange-traded funds (ETFs) and mining equities. Currency forwards and options are deployed to mitigate currency risk, whereas "call" options have been used on U.S. Treasuries to gain "optionality" on the underlying bond.

What makes the Global Real Return Fund different than other multialternative strategies?

Suzanne Hutchins:

Our focus on fundamental, bottom-up security selection is very transparent and differs from strategies using fund of funds structures or quantitative models. We hold securities directly, meaning we "own" the profits and cash streams of the underlying businesses. From a cost standpoint, there are no hedge fund-style fees or fund of fund-type hidden charges. In fact, the Fund’s net expense ratios are rated "Low" by Morningstar across all share classes compared to peers in the Multialternative category.*

How could an advisor use the Fund with investors who are new to liquid alternatives?

Suzanne Hutchins:

With the long run-up in equities over the past few years, the Fund can serve as a buffer against some of the downside risks in core assets. It could be a "one-stop shop" for clients looking to combine traditional and alternative assets into a single investment. Or, clients could reallocate some assets from stock and bond holdings into the Fund as a way of complementing existing managers. Either way, our emphasis on low volatility and capital preservation should resonate with risk-conscious investors seeking the potential for relatively stable returns across all market environments.

And what about more experienced alternative investors? How can they use the Fund?

Suzanne Hutchins:

The liquid alternatives space is broad and diverse, spanning a range of risk/return profiles. We view the Fund as a "Goldilocks" strategy—more conservative than other offerings in the category, but not so much that it restricts our ability to capture upside potential. Our returns are likely to be largely uncorrelated to other alternative managers due to major differences in strategy implementation and portfolio structure. The Fund can complement more advanced, complex liquid alternatives as well as peers classified in Morningstar’s World Allocation category. When we are paired with those peers, our benchmark independence and absolute return orientation can help reduce some of the volatility inherent in strategies with more market exposure.

Let’s get into some specifics. How do you source ideas for the portfolio?

Suzanne Hutchins:

Newton’s global investment themes represent the first stage of idea generation and risk management. The portfolio is then built from the bottom up, using fundamental research into individual securities.

Themes provide us with a framework for focusing our ideas and informing our investment decisions. Views are formed on the relative attractiveness of asset classes and their various sub-classes. These views can be short term or long term, tactical or strategic. Most importantly, they give us perspective about change, which can make us less likely to be caught off guard.

Can you give an example of a theme?

Suzanne Hutchins:

One trend we identified some time ago is "financialization," which we define as the unintended but inevitable consequence of long-term over-reliance on financial assets as the main monetary tool. It incentivizes the use of credit, leverage and financial engineering over other, often more productive, strategies and has led us to avoid owning highly indebted businesses in general.

What do you look for when selecting securities?

Suzanne Hutchins:

We select securities that have been recommended by Newton’s equity and credit analysts and by a wider research group covering more alternative opportunities. We look for the types of characteristics needed to generate returns in the Fund’s "core" and to insulate risks in the outer, defensive layer of the portfolio. Examples might include "safe haven" qualities; income sustainability and growth; cash flow and balance sheet strength; inflation linkage and/or pricing power; and growth and insurance protection typically via relatively simple derivative contracts and strategies.

At a basic level, the individual securities considered for the portfolio should be transparent, liquid and priced daily, with counterparty risks minimized. Clearly understanding what we own and why we own it is a critical part of our core values in managing risk.

Do you follow that same approach for all three currency versions of the strategy?

Suzanne Hutchins:

Yes, the three base currency strategies – euro, sterling and U.S. dollar – are managed the same way by the same team. The only major difference is currency exposure and how we manage it to the base liabilities of our clients. With the U.S. dollar version, the performance aim of the strategy is to deliver cash (One Month USD LIBOR) plus 4% annualized over five years, before fees. However, a positive return is not guaranteed and a capital loss may occur.

What role do derivatives play in the Fund?

Aron Pataki:

We use derivatives primarily to manage risk rather than generate extra returns. Our derivative strategies aren’t complex or exotic and aren’t used to increase leverage in the portfolio. In order to minimize counterparty risk, we prefer exchange-traded products instead of over-the-counter contracts.

Risk and derivative policies vary slightly across the different denominations of the strategy, depending on the underlying base currency exposure. We can hedge 100% of the portfolio back to the base currency, but active currency positions are used to manage risk through both currency forwards and physical assets.

How do you view markets and what’s currently influencing your thinking?

Suzanne Hutchins:

In recent years, a number of signals have suggested to us that deflation and lack of growth were the prevailing risks. This view challenged the consensus opinion that "escape velocity" had been reached and the "great rotation" trade from bonds to equities was underway. Our assessment is in line with the team’s long-held views and lends credence to our cautious portfolio positioning, especially as equity markets make new highs and valuations become richer.

Markets have become much less liquid. There is "gap risk," with a lot of people "geared" into the market to spice up returns while rates are low. Banks are no longer on the other side of trades, investors are. Let’s hope they don’t all try to exit at once.

Aron Pataki:

We contend that hidden risks are real and rising. We’ve been living through the illusion of a perpetual money machine in which debt continues to finance spending and support unsustainable economic growth.

Deflation is likely to be a dominant feature due to factors such as overcapacity, weak consumer demand and misallocation of capital. This, in turn, is a side effect of artificially low interest rates and a consequence of technology’s impact on pricing power.

Ultra-low rates have pushed investors into riskier assets in the hopes of earning ever-higher returns. The ultimate impact of near-zero rates is very likely to be amplified by increased leverage in the system and the dangerous mismatch between risky assets and their holders. This will lead to volatility in unexpected places—for example, increased debt defaults if economic activity falters. In an environment distorted by central bank policy and investment banks warehousing less risk, liquidity could be a key question.

The authorities are likely to maintain very accommodative monetary policy, including more potential quantitative easing. However, investors will eventually lose confidence in policymakers and the effectiveness of QE-type intervention, which could trigger a substantial de-rating of risk assets.

How do you view markets and what’s currently influencing your thinking?

Suzanne Hutchins:

In recent years, a number of signals have suggested to us that deflation and lack of growth were the prevailing risks. This view challenged the consensus opinion that "escape velocity" had been reached and the "great rotation" trade from bonds to equities was underway. Our assessment is in line with the team’s long-held views and lends credence to our cautious portfolio positioning, especially as equity markets make new highs and valuations become richer.

Markets have become much less liquid. There is "gap risk," with a lot of people "geared" into the market to spice up returns while rates are low. Banks are no longer on the other side of trades, investors are. Let’s hope they don’t all try to exit at once.

Aron Pataki:

We contend that hidden risks are real and rising. We’ve been living through the illusion of a perpetual money machine in which debt continues to finance spending and support unsustainable economic growth.

Deflation is likely to be a dominant feature due to factors such as overcapacity, weak consumer demand and misallocation of capital. This, in turn, is a side effect of artificially low interest rates and a consequence of technology’s impact on pricing power.

Ultra-low rates have pushed investors into riskier assets in the hopes of earning ever-higher returns. The ultimate impact of near-zero rates is very likely to be amplified by increased leverage in the system and the dangerous mismatch between risky assets and their holders. This will lead to volatility in unexpected places—for example, increased debt defaults if economic activity falters. In an environment distorted by central bank policy and investment banks warehousing less risk, liquidity could be a key question.

The authorities are likely to maintain very accommodative monetary policy, including more potential quantitative easing. However, investors will eventually lose confidence in policymakers and the effectiveness of QE-type intervention, which could trigger a substantial de-rating of risk assets.

The authorities are likely to maintain very accommodative monetary policy, including more potential quantitative easing. However, investors will eventually lose confidence in policymakers and the effectiveness of QE-type intervention, which could trigger a substantial de-rating of risk assets.

So Newton believes markets are distorted?

Suzanne Hutchins:

Although policymaker responses to the financial crisis of 2008 may have worked in theory, economic activity is still very tepid in practice, even in the U.S. Among the unintended consequences of QE is the misallocation of capital, which can clearly be seen in the rising debt of emerging countries like Brazil, Turkey and China.

Today’s high level of uncertainty stands in stark contrast with the positive perceptions in place when our strategy debuted in 2004. A troublesome mix of deflation, slow growth and heavy debt now increases the potential for unwelcome surprises and underscores the need to balance return generation with capital preservation.

Our focus on minimizing volatility aims to generate decent risk-adjusted returns, with downside protection potential in place at a time when asset valuations are broadly stretched. Our flexible, unconstrained approach is well suited to meeting the demands of this challenging environment.

How is your team focusing on capital preservation?

Suzanne Hutchins:

Concerns over high valuations, profit outlooks and unconventional monetary policy continue to underpin our cautious positioning and emphasis on capital preservation. Uncertainty surrounding the immediate consequences of Brexit compounds these challenges, while the likelihood of policy intervention provides considerable scope for two-way market swings.

Within our portfolio, net equity exposure remains near the low end of our historic range. We continue to carefully select global securities that we believe are well positioned to withstand market turbulence. We also continue to like gold-related securities for their potential to not only preserve capital, but also generate returns.

Although we don’t currently view inflation as a significant risk, we recently implemented put options on U.S. long bond futures and similar positions on Euro-Bund futures. These moves should offer some protection to those safe haven assets if inflationary concerns intensify.

Investors should consider the investment objectives, risks, charges and expenses of a mutual fund carefully before investing. To obtain a prospectus, or a summary prospectus, if available, that contains this and other information about a Dreyfus fund, contact your financial advisor or visit dreyfus.com. Read the prospectus carefully before investing.

Newton’s comments are provided as a general market overview and should not be considered investment advice or predictive of any future market performance. These views are current as of the date of this communication and are subject to change rapidly as economic and market conditions dictate.

Diversification and asset allocation cannot ensure a profit or protect against loss of principal. There can be no guarantee that the fund’s investment approach will be successful or that any particular level of return will be achieved for the fund.

MAIN RISKS

Equity funds are generally subject to market, market sector, market liquidity, issuer and investment style risks, among other factors, to varying degrees. Bonds are generally subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest rate changes, and rate increases can cause price declines. Investing internationally involves special risks, including changes in currency exchange rates, political, economic and social instability, a lack of comprehensive company information, differing auditing and legal standards, and less market liquidity. These risks are generally greater with emerging market countries. The use of derivative instruments, such as options, futures, options on futures, forward contracts, swaps, options on swaps, and other credit derivatives, involves risks different from, or possibly greater than, the risks associated with investing directly in the underlying assets. A small investment in derivatives could have a potentially large impact on the fund’s performance.

The Dreyfus Corporation is the fund’s investment adviser. Newton is the fund’s sub-investment adviser. Each is a subsidiary of The Bank of New York Mellon Corporation. BNY Mellon Investment Management is one of the world’s leading investment management organizations and one of the top U.S. wealth managers, encompassing BNY Mellon’s affiliated investment management firms, wealth management services and global distribution companies.

"Newton" and/or the "Newton Investment Management" brand refers to the following group of affiliated companies: Newton Investment Management Limited, Newton Investment Management (North America) Limited (NIMNA Ltd) and Newton Investment Management (North America) LLC (NIMNA LLC). NIMNA LLC personnel are supervised persons of NIMNA Ltd and NIMNA LLC does not provide investment advice, all of which is conducted by NIMNA Ltd. NIMNA LLC and NIMNA Ltd are the only Newton companies to offer services in the U.S.

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