The domestic market has historically rewarded Belgian investors. Kris Vanderstede at Fortis examines how investors and asset managers will cope with the choices ahead
In this contributio n, we discuss how the introduction of the euro is likely to influence the typical Belgian institutional investor and asset manager. We start with a brief recap of some distinctive features of the Belgian market.
The Belgian market
The general aspects of the euro are treated elsewhere in this issue, and we need not to dwell upon them again. The Belgian situation nevertheless presents some particular characteristics.
First, Belgian assets have historically offered an excellent risk/return ratio to Belgian investors. Studies consistently find that, in the past, the optimal portfolio would have been heavily tilted towards Belgian assets.
Secondly, the Belgian capital market has suffered a significant crowding-out effect due to the borrowing needs of the Belgian State. In the bond market, this has given rise to a market dominated by government bonds. Furthermore, the Belgian equity market is quite small relative to GDP.
Thirdly, and mainly as a result of the two preceding points, portfolios of Belgian institutional investors typically have a very strong domestic bias, with a high proportion of fixed income investments.
The euro and the bond portfolio
Managing a bond portfolio has always boiled down to taking decisions on four
levels: duration, curve positioning, bond selection and currency.
Of these four dimensions, duration and curve positioning should be familiar to any Belgian investor and asset manager. A bond manager who has managed a Belgian bond portfolio may, with some justification, claim that his skills in picking the right duration and curve position carry over into the post-EMU environment. Since the currency dimension disappears - at least for a euro-mandate - it would seem that his position is not threatened.
However, this overlooks the question of bond picking. The Belgian bond has basically been a Belgian government bond market. As a result, the bond manager has typically worked under a mandate that offered limited scope to show his capabilities regarding bond picking. Likewise, of course, the typical investor has had little exposure to this kind of decision.
At this juncture, it seems useful to make a distinction between sovereign risk and non-sovereign risk. As far as sovereign risk is concerned, the bond manager may claim that he is not entering wholly uncharted terrain. The Belgian yield spread has largely been determined by considerations relating to the real or perceived Belgian credit risk. Moreover, spreads between EMU-governments will probably be fairly low and quite stable.
As regards non-sovereign risk, there is a lot of work to be done concerning definition of appropriate benchmarks, management style, reporting, risk guidelines etc. The typical Belgian investor will probably make a first foray into the higher end of the credit spectrum, in order to gain some experience, test managers and, hopefully, enhance returns. This sort of mandate could also include some more sophisticated products, such as mortgage-backed or asset-backed bonds.
The euro and the equity portfolio
In the world of equities, the main issues are how the allocation on the macro level will happen, and what method of stock picking one will use.
The consensus seems to be that sectors will replace countries as the key reference point for asset allocation. The Belgian equity market, however, is dominated by a very limited number of really liquid stocks. Traditionally, this has led to a management style that relies heavily on stock picking, with relatively little regard for sector allocation. The introduction of sectors in the management process therefore represents quite a challenge.
In reality, the problems to be faced are highly unlikely to be unique to Belgian investors and managers. They are issues like the definition of sectors, constituting historical series, an understanding of what drives sector performance, etc.
Belgian asset managers undoubtedly have quite some experience regarding stock picking on the Belgian market. But this experience will be challenged when investors switch to a euro mandate, where the number of stocks is a few hundred instead of a few dozen! Managers can respond by demonstrating that they have sufficient resources to analyse this larger universe, or by a using a more quantitative style, or by a combination of the two.
While the Belgian financial sector has a lot of homework to do, then, the same is no less true for their European counterparts.
Impact on the financial markets
Studies have found that, if institutional investors adopt a euro benchmark, the Belgian bond market will suffer a net outflow. This is not surprising given the characteristics of the Belgian financial market described above. Nevertheless, we do not expect this process will cause excessive turbulence. If the spread were to widen substantially, it can easily be observed and is then likely to increase demand for Belgian bonds.
We think institutional investors will change their bond benchmark quite fast to a euro-based index, but also that the consequences for Belgian long term rates should be small. On a positive side, the market for non-sovereign paper will get an additional boost, with some of the larger Belgian industrials finally coming to the market on a regular basis.
As far as equities are concerned, things are less straightforward. The Belgian stock market is relatively small and at times suffers from a lack of liquidity. Any wholesale move out of or into Belgian equities could therefore have a substantial market impact.
A number of recent events may have increased the incentive to reduce the holdings of Belgian stocks. The Belgian market has had a very good performance this year, making this an opportune time to sell some Belgian positions and start building up a European portfolio. The recent wave of mergers - which has probably not yet petered out - has severely reduced the number of really liquid names in the market.
All this should not be a problem if enough foreign investors can be found to take up the slack. But here, of course, it is not yet clear how soon the typical European investor will look at the European markets in a truly global style, nor at what market level he is likely to start considering buying Belgian stocks ; nor, indeed, what indicators will guide him in this decision.
In the final analysis, all this refers to the question of how demand and supply in each national market will evolve once EMU is upon us. While most institutional investors seem to agree in principle that they should diversify into euro equities, there is no consensus as to the speed of this process, nor is it clear for how long Belgian equities will retain a 'special' place in the benchmark.
A commerical answer
At this moment, every asset manager is or should be repositioning his product line to address the new situation. In this section, we will outline the steps taken by Fortis Investments Belgium.
On the bond side, we decided to offer two products to our institutional clients. Both products follow the same strategy as far as duration and curve positioning are concerned. As for bond selection, the first fund is restricted to bonds that are guaranteed by an OECD sovereign. This fund addresses itself to the investor who wishes to switch to a euro benchmark, without losing the security of sovereign guarantee. The second fund can also invest in non-sovereign bonds. Since we sense that most investors will tend to adopt a rather cautious attitude, the lower limit has been set at A or equivalent.
On the equity side, an important effort is being devoted to re-engineering the investment process. With the help of a university research team, Fortis has tested a number of quantitative models to assist in sector allocation and stock picking. Furthermore, the analysis of stocks will be reorganized on a European basis. A fund has been launched that uses the results of this work. Since many clients still have a currency matching restriction, the fund is restricted to stocks quoted in euro member states. The benchmark is also a large cap index, since we feel most clients will prefer well-known names when it comes to taking their first steps into the euro market.
Kris Vanderstede is chief investment officer at Fortis Investments Belgium in Brussels