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Smoother Dynamic Total Return
Dreyfus' Dynamic Total Return Fund
Interview with: Sinead Colton, Vassilis Dagioglu

Author: Ticker Magazine
Last Update: Aug 27, 8:34 AM ET
Traditionally investors have been encouraged to diversify portfolio between stocks and bonds with 60/40 allocation. Dreyfus’ Dynamic Total Return Fund takes that process further and can diversify across many asset classes to generate equity like returns. With the strong overlay of risk management tools, the fund seeks to limit downside and remains focused on delivering superior outcome to benchmarks.

“The fund is a go-anywhere, managed volatility strategy that invests across a variety of asset classes from stocks, bonds, cash, currency, and commodities.”
Q: What is the background of the fund?

A: We employ a dynamic total return strategy and our aim internally at Mellon Capital is to deliver equity-like returns within an expected risk range between 7% and 10%. The fund is a go-anywhere, managed volatility strategy that invests across a variety of asset classes from stocks, bonds, cash, currency, and commodities.

Downside risk management is how we target delivering a smoother equity-like return profile with significantly less volatility.

In 2006, this fund was not managed pursuant to the dynamic total return strategy. It was set up with a 60% equity and 40% fixed-income benchmark, and we took extra risk around that. Two years later, the fund was down 34%, two-thirds of that was driven by the decline in the benchmark, and the remaining third was from our exit positions, which were down about 9%.

That prompted discussion with investors on what they desired from a strategy and revealed that their focus was on outcome, not a benchmark-centered approach.

Since 2009 our approach and the fund’s strategy have evolved and we are benchmark-agnostic, and we have become more macro-oriented, to capture returns in the most efficient and effective way. For example, we introduced an options program in 2014.

The bottom line is that the strategy today is much outcome-oriented, with our focus on delivering smoother equity-like returns within that expected risk range of 7% to 10%.

Q: How do you differ from your peers?

A: Our strategy fits within the alternative liquid universe that spans from the lower risk/return categories.

We differ in how we run our strategy. First of all, we focus on total rather than absolute return. That’s an important distinction, because absolute return strategy aims at avoiding a negative return during any given period. We, on the other hand, may have some negative returns because we aim to deliver a more attractive growth-oriented return.

Our goal is to provide a significant cushion when equity markets fold sharply, and so we take a directional macro-strategy approach because we have a number of risk management tools embedded in the strategy to reduce exposure caused by market environment changes.

Our flexibility to take that directional exposure, as well as the pure long-short, more market-neutral approaches, is one of the reasons why we’ve developed such strong returns over a 3‒5-year basis.

Our correlation approach is also a little different in that our correlation with traditional assets varies. Over the last five years, it’s been close to 0.6, because over that period we tended to find directional exposure attractive.

Many alternative strategies aim to offer diversification by providing positive returns both in up and down markets. The challenge has been that many of these strategies have underperformed over the last few years while equity markets have posted solid performance.

The challenge with that is that many have delivered disappointing returns over this period. Our approach is more nuanced, as we’re comfortable with a higher correlation. Directional exposure looks attractive, with the goal being to have a lower correlation in more risk-averse market conditions.

A good illustration of the type of reduced drawdowns that we seek to deliver is the first-half of October 2014, when markets were down. Global equities were between 8% and 10% in those first two weeks, and DTR was down just over 2%. Then as markets recovered during the second-half of the month, we participated and ended the month up at 1.7%.

Q: How do you measure expected risk?

A: We look at the standard deviation of the total position in terms of our expected risk, which we keep between 7% and 10%. If we have more directional exposure, we’ll move toward the higher end; with less directional and more market-neutral exposure, we tend toward the lower end. We also ensure that drawdowns don’t exceed the threshold we’re comfortable with.

Q: What are the core beliefs that drive your investment philosophy?

A: We believe:
– Long-run fundamental valuation and relative risk within and across global financial markets drive asset pricing
– Changes in investor sentiment, structural factors, and the behavior of local investors, central banks, and non-profit maximizing market participants may create exploitable investment opportunities across global capital markets
– Systematic valuation, risk management, and implementation processes are critical to extracting alpha
– A strategy that is responsive to and resilient in uncertain environments may help mitigate downside risk while preserving the upside potential.

Macro-economic awareness needs to complement valuation, because while valuation-oriented approaches deliver very attractive returns over time, there are periods where the macro environments overwhelm.

A huge case in point was 2008, as was 2011, where we had concerns regarding Greece, Spain, and Italy. The valuations may remain robust, but there are other driving forces that impact markets significantly that can be overlooked.

Our approach is model-driven, but it is not a black box. All the data that we bring into our process on a daily basis is fundamentally driven, whether it’s earnings, yield, or current account balance for currency. For example, in Q1 of this year, we pared our U.S. equity exposure back somewhat because of negative earnings revisions.

We’ve managed asset allocation strategies using these types of processes for over 25 years, and find them to be effective in delivering robust repeatable performance over time. But models can’t account for everything, such as geopolitical risk, so, in such cases, we utilize an element of portfolio manager discretion.

One such example of being outside the model was the negotiations and possible exit of Greece from the euro zone in the last few weeks. So, we assessed how we might expect that particular scenario to unfold, and whether it would be prudent to reduce risk in the portfolio in order to navigate the volatility that might result. We reduced our equity exposure to help manage that uncertainty.

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Sources: Data collected by 123jump.com and Ticker.com from company press releases, filings and corporate websites. Market data: BATS Exchange. Inc