By Darius McDermott, managing director of FundCalibre
Even the most hardened tech bro may be starting to get twitchy about valuations in artificial intelligence. A share sale at the start of October saw ChatGPT valued at $500bn, up from just $300bn in March, while the technology giants continue to pour billions into AI development – Microsoft, Alphabet, Amazon, and Meta alone intend to spend a combined $320bn on AI technologies and infrastructure in 2025.
This shouldn’t matter very much. The market has dealt with bubbles before. Dotcom companies saw a boom and bust in the early 2000s and the rest of the market just kept doing what it was doing. The problem is that AI is now a huge part of the market and a huge part of the US economy.
In an article for the Financial Times, Ruchir Sharma, the chair of Rockfeller International, points out the US economy is increasingly dependent on AI. The billions of dollars companies are investing in AI now account for around 40% of US GDP growth this year, while AI companies have accounted for 80% of the gains in US stocks so far in 2025. AI companies in the US have sucked productive capital from around the world.
This makes the current market environment more fragile. Markets have been buoyed by the prospect of a US rate cut, but their expectations for future rate cuts now look optimistic – and in conflict with still-buoyant growth data from the US economy.
Some form of portfolio insurance can help manage fears over valuations. The problem has been that some of the traditional approaches to portfolio insurance now look very expensive. Gold, for example, has now tipped over $4,000 an ounce. Equally, it is difficult to make a case for the traditional safe haven of US treasuries – they appear to be anticipating an unrealistic level of rate cuts at a time when inflation and growth in the US are picking up. Debt levels are still problematic, which is likely to weigh on longer-dated bonds.
Targeted absolute return sector deserves another look
The targeted absolute return sector might have been a go-to option for investors in search of uncorrelated and defensive returns, but it picked up a difficult reputation in recent years as some high-profile funds imploded. However, it deserves another look. There are some strong funds within it that may be able to fulfil a protective role in a portfolio.
The sector as a whole has been doing better. It has largely delivered on its billing. On average, funds in the sector have delivered a positive return in eight of the previous 10 calendar years. They suffered a negative year in 2022, but only dropped 0.37% on average – avoiding the double digit losses of equity and bond markets.
Nevertheless, the sector is diverse and needs careful navigating. Performance year-to-date shows there is over 25% difference between the top and bottom performing funds. In 2022, when investors needed them most, five funds in the 73-strong sector saw double digit losses.
See also: FundCalibre: The new landscape of corporate bonds
Short-dated bonds have tended to be a lower volatility option, with less interest rate sensitivity. The Artemis Short-Duration Strategic Bond fund, managed by Stephen Snowden, has seen steady returns in most market environments. It dropped 4.6% in 2022, but this was far less than the wider market.
It helps that Snowden is also cautious about the environment and is positioned accordingly.
He said: “Against a backdrop of more price-sensitive buyers and the almost bullet-proof nature of risk sentiment favouring equities, we feel something has to give. And while we still believe that lower policy rates will anchor bonds somewhat, longer-dated government yields should face continued upward pressure.
“On the credit side, we continue to encounter a corporate sector that is cautious, focused on deleveraging and navigating policy volatility. Robust balance sheets among both corporates and households continue to underpin the seemingly confounding strength of demand. In high yield, we continue to avoid those areas that will suffer if we are wrong and macro conditions deteriorate meaningfully, notably emerging market high yield and lower-rated CCC credit.”
Long/short equity funds
Another option is long/short equity funds. Results from this type of fund have been mixed. It takes a skilled fund manager to generate alpha from stocks that are rising and those that are falling and it does not suit everyone. Often, fund managers fall back on market momentum to make gains and do not defend capital as they should in down markets.
Stefan Gries, manager of the BlackRock European Absolute Alpha fund, has proved himself as a capable manager on both sides.
The fund was down just 2.7% in 2022, a year when the MSCI World was down 7.8% in sterling terms. His fund has a growth tilt to it, with high weightings in industrials and financials. He is underweight in materials and consumer discretionary companies.
Another risk with absolute return funds is the fund defends capital during weak markets, but captures little return when markets are buoyant.
The BlackRock fund has participated on the upside, with returns of 7.5%, and 6.7% in 2024 and 2023 respectively. This is also true for Janus Henderson Absolute Return, which has a similar profile. It was down just 0.72% in 2022, and rose 7.2% and 7.3% 2024 and 2023 respectively.
The absolute return sector appears to be a good source of portfolio protection at a time when other options are expensive. At a time when any wobble in the AI story could destabilise markets, investors might need it.
