New investment ideas - What’s out there?
The quest for yield is a recurring theme for many institutional investors, especially amid renewed concerns of slowing global economic growth and worries the debt crisis will spread through the entire euro zone.
Typically, pension funds, insurance companies, sovereign wealth funds and central banks aren’t too focussed on trying to ‘beat the market’. They’re focused on achieving a certain level of risk-adjusted returns on their assets and the first step is to accurately project their liability stream going forward, and then come up with a minimum required rate of returns on their assets to match this liability stream.
After that, institutional investors typically forecast long-term average returns for the various asset classes they are allowed to, or are considering investing in, and come up with a long-term strategic benchmark whose binding constraint is achieving a 100% funding ratio.
The issue of needing to “beat the market” only comes up if their long-term expected returns for the various asset classes can’t yield an asset allocation that will achieve the required rate of return on their asset base, says Olivier d’Assier, Managing Director for Asia Pacific at Axioma. Another is if the investors are under-funded as a result of a large market event, such as the global financial crisis. “In both of these cases, where passively managing 100% of the fund’s assets must be ruled out as an option, the question of how to generate higher than market average risk-adjusted returns comes up.”
“Today’s pension funds need a new set of rules to guide them through this new environment of constantly and rapidly changing volatility and correlation regimes.
Developed market government bonds used to be safe, income-generating securities that could be relied upon to provide an anchor for a diversified portfolio, according to Pictet Asset Management. But since the financial crisis in 2008, this is no longer the case: sovereign bond investing has become more complex and risky.
Given the current volatile market conditions, investors are increasingly looking at risk-adjusted returns on their assets to match their liabilities on an ongoing basis, according to Jon Taylor, Managing Director and Portfolio Manager for global and international bonds at Principal Global Investors. “Safe assets are government bonds and those are not taking off and the potential for capital loss are significant unless you’re really good at market timing.”
“It’s a whole new sort of framework, it’s not benchmark relative returns, it’s not absolute returns but risk-adjusted returns, how much returns am I getting paid for per unit of risk that I’m taking.”
Still, it isn’t just a matter of being more risk-averse, it is a matter of acknowledging sovereign credit risk exists where it used to be risk-free and the need to amend the way to invest in global bonds, Pictet Asset says in a March report. “We believe the time has come for government bond investors to adopt a new approach. By investing according to an issuer’s willingness and ability to meet its debt obligations, investors can create a better diversified government bond portfolio capable of delivering attractive and reliable streams of income.”
With the government bond markets lacking, investors are looking for alternatives. Taylor adds: “People are looking at equities, high-dividend equities, they’re looking at mid-range bonds, triple-B, double-B, where they’re not junk bonds in the pure sense but they’re not A-rated credits either. You’re getting a reasonable yield for the risk that you’re taking.”
The lower rung of the Investment grade credits are attractive, and emerging market debt is also “the flavour” of the month, Taylor says. “A lot of the emerging market economies have emerged, they are pretty solid economies.”
The issue for investors is that most of the benchmarks for emerging market debt cover a broad spectrum, encompassing countries such as solid economies like Malaysia and still emerging and developing ones like Venezuela, Taylor says. “So many of the benchmarks are becoming inappropriate because if you’re running emerging market debt, you have to have exposure to Argentina and Venezuela because of their outrageous yields, but if you don’t, you will have a structural disadvantage. But they are high risk.”
Thus, the industry needs to construct better indices. Since the 2008 financial crisis there has been a strong demand for alternate beta strategies, according to Alka Bannerjee, Vice President for Strategy and Global Equity Indices at S&P Indices. “Low volatility, equal weighting, fundamentally weighted strategies have been gaining momentum.”
Bannerjee adds S&P Indices recently launched the S&P GIVI (Global Intrinsic Value Indices), which provides a broad, transparent, rules-based index where the weighting is by intrinsic value and the volatility is lower than the comparable market cap weighted index. It’s an index that provides exposure to both low volatility and alternate weighting for better risk adjusted returns. “Clients are looking for ways to control volatility, define risk, and also gain enhanced beta. We launched the risk control series which allows clients to define the level of volatility they were comfortable with for an existing underlying index.”
“Alternative beta strategies have gained a lot of popularity and acceptance around the world in recent times and Asia is no exception. All the large and sophisticated institutional asset owners from Japan, Korea, Taiwan, Australia, Singapore, Hong Kong and China have adopted some alternate beta strategies. Retail clients in Asia will follow soon as more and more retail products are built around such strategies.”
Extensive research showed the industry has entered the era of ‘smart beta’ and that factor-based investing was going to be the best way for investors to deal with it, d’Assier says. Axioma, he says, has modified its portfolio construction tools to make it simple for clients to run these new strategies in-house and research their impact on their overall portfolios through back-testing and stress-testing. “Out with the old, in with the new.”
“If Asian institutional investors are going to succeed in the new environment, they need to continuously question the old methodologies and develop new ones, starting with the definition of the market.”
Such investors should also better tap their distinct advantages and they can afford to be less risk-averse when it comes to their investments, d’Assier says. A core advantage is that institutional investors in Asia are young. “This last-to-market position gives them unique point of view; one built on the ability to see the historical record of their peers in the West.”
“The bulk of their liabilities are not due for another 20-30 years, so they can afford to be less risk-averse when it comes to their investments and allocate more to asset classes with a higher risk premium.”
Still, the industry may need more benchmarks and differentiation before Asian investors can become less risk-averse, Taylor says. “There are some pension plans which are matured and they really need income and distribution and a meaningful allocation to high-quality, high yield as opposed the near-death companies.”
d’Assier says: “The search for excess returns continues, but instead of thinking simply in terms of beta and alpha, institutions are now thinking in terms of ‘smart’ beta as alpha and seeking to multiply that approach across a broader set of asset classes.”