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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 steps do you take to evaluate investment merits?

A: We run a model one or more times a day. Our approach across every asset class and market that we cover is to derive an expected return for each.

With equities, for example, for each market that we cover we take positions primarily at the country level, rather than the individual security level. For global stocks, we look at each market we cover, and break it down into individual stocks.

As the primary investment for the U.S. we look at all 500 of the S&P’s stocks, starting with the consensus earnings expectation, and adjust them based on factors we’ve developed in-house: earnings quality, earnings management, trend and revision, and the impact of actual or anticipated economic growth on that particular market. We create an expected return for each stock, and weight them according to the S&P500 Index.

We perform the same process for indexes of every country that we cover; the DAX Index in Germany, the TOPIX Index in Japan, and the FTSE 100 Index in the U.K. The aggregate of those expected returns gives us our global stock return. We are also selective in gauging which markets we think are more or less attractive.

For example, we have been tilting more towards international markets during the past 18 months. We particularly correlate with Germany, but also Japan, and pared back our U.S. exposure. At the beginning of 2014 we had nearly 40% U.S. exposure, today it’s more like 20%.

We can also take short positions when a given market looks unattractive; our largest short in the equities today is the U.K. To complement that, we look at expected returns across all asset classes. Our expected return on bonds is similar to yield maturity. We compare expected returns for stocks to those of corporate bonds, taking into account the credit risks premium.

Government bond level positions tend to be a bit more tactical because of where yields are today. We tend to prefer U.S. Treasuries and U.K. Gilts. The biggest short in the portfolio has been the German Bund.

For commodities, our expected return is based on our expectation of surprise inflation, our forecast of inflation relative to consensus. We hold real assets in the portfolio because in the case of surprise inflations, they maintain some capital preservation. When there’s an adjustment in inflation expectation, although equities are a great long-term inflation hedge, it’s not usually the case short term.

The final area is currency. Over the long term, currency adds risk to the portfolio without adding return. So, we fully hedge all of our exposures back to the U.S. dollar, making adjustments to our positioning. Essentially, they’re active currency positions, not driven by our currency model.

Our currency model looks at relative macro-dynamics: pay acceleration/deceleration, relative interest rates, current account balances, purchasing power parity. For the last three or four quarters we’ve often been outright long the dollar, mainly through shorting the British pound and the euro.

As we calculate all of the expected returns, we generate our expectations for risk correlation within the asset classes and markets.

Q: How do you construct your portfolio?

A: The first step is to align all of those aspects to build a robust diversified portfolio. We apply a few risk management filters, starting with the risk concentration screen. Throughout the optimization process, we avoid concentrating undue risk in any one or two positions.

The second step is a liquidity screen. We score every market that we cover based on its liquidity, holding smaller positions in markets that are less liquid.

For example, the U.S. Treasury market is typically more liquid than Canadian government bonds, so even with comparable anticipated returns, our Canadian position would be slightly smaller.

The strength of our more model-driven approach shines, as we analyze close to 2,000 individual securities on a daily basis.

Q: How do you manage downside risk?

A: Drawdown control and reducing downside risk is important to us. There are four pillars of downside risk management within the strategy that help us do that.

The first is explicit volatility management. We have an internal expected risk range of 7% to 10%, based on long-term expectations. We also view the shorter-term risk forecast. When we see expected risk moving above the upper end of that 7‒10 threshold, we start scaling out risk.

Maintaining wiggle room enables us to allow for normal market volatility if we’re running at an expected risk of 10%. We manage volatility explicitly because if you see rising volatility, you typically see falling markets. Markets tend to go up the stairs and down the elevator, so proactively managing the shorter-term volatility within the portfolio is an effective downside risk management tool.

The second pillar is the macro environment. We’ve developed a signal in-house designed to alert us when the global economy is trending downward significantly. This isn’t about any short-term differential in economic performance; it’s about identifying when we’ll have a negative investment environment, which is often a volatile, unrewarding time to hold riskier assets. It relies on economic data, primarily concurrent and forward-looking, and signals when it’s time to scale out risk.

In most crisis periods, we’ll first work to reduce risk through volatility management and then potentially more through macro-environment signals.

The third pillar is options. Rather than buy the same level of protection, we focus on how to cost-effectively hedge against portfolio risks. If you’re worried about a global down trend, it won’t matter very much whether you place a put on the S&P, the TOPIX, or the DAX. But the pricing of those instruments can be quite different.

We use options in conjunction with the fourth pillar, stress testing the portfolio, looking at elements outside the model. These are primarily geopolitical events, but economically driven events can wield sudden impact on the market too, having significant impact on the portfolio. A good example was the Swiss National Bank removing the cap on the Swiss franc in January.

What we care about when stress-testing the portfolios is what is coming that might significantly impact the portfolio, and the potential resulting drawdowns. If the drawdown is greater than we’re comfortable with, and it appears likely, we’ll reduce risk within the portfolio, possibly by combining purchasing some options with selling some equity exposure, or increasing our defensive asset exposure.

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