France: Adapting to difficult times

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Flexibility to move in and out of assets is important for investors navigating choppy economic waters. Gail Moss reports

Against a backdrop of continuing uncertainty, risk and flexibility are the buzz-words among French institutional investors.

“While the concept of the great rotation has attracted much comment, the situation is more complex than that,” says Erwan Boscher, head of European pension solutions at AXA Investment Managers. “Our defined benefit clients have established risk limits, so they cannot switch overnight from one asset class to another. However, we have discussed with them about making asset allocation more dynamic, or extending the leeway to allocate on durations, for instance, from plus or minus one year, to two years.”

Another candidate for change, says Boscher, is the risk hedge ratio; typically, this might have been set at 75% of liabilities, but could now be widened to a range between 50% and 100%.

At the same time, Boscher says clients are reallocating from defined asset classes – particularly credit – to more global investments, to diversify away from the euro-zone risk.

“We’ve been working with clients to replace duration matching overlays, partly using swaptions,” says Boscher. “That means they can control downside risk and also comply with internal risk limits. At the same time, they can try to bet on recovery in terms of rising interest rates.”

“Clients are implementing more flexible asset allocation policies and want to manage tail risk,” agrees Frédéric Debaere, head of Mercer Investments, France, noting that exchange-traded investments are becoming popular as a fast way to do this. “Two or three years ago at the start of the crisis, the issue for investors was inflation. Now they are more concerned by the prospect of a prolonged recession, with low growth and austerity policies over a very long time period.”

Perhaps the biggest worry for these investors is the systemic risk of a euro-zone break-up. But most appear to believe that the action taken by European central banks has stabilised the situation, at least for the moment.

This has influenced the approach towards peripheral bonds, for example, those issued by Spain and Italy.

“France and Germany cannot afford to let Spain go under,” says Philippe Mimran, CIO, La Française des Placements. “We think the European Central Bank’s programme of outright monetary transactions (OMT) is a very powerful tool, and the markets have agreed. So, although the fundamentals for Spain are not good, there are the funds in Europe to prevent catastrophe.”

Mimran says Spanish bonds are slightly undervalued, but that investors who believe the OMT will be successful effectively enjoy a put option on them.

“At the end of March, yields on two-year Spanish bonds were 2.3%, compared with zero for German bonds with the same maturity,” he says. “If yields go up, the ECB will buy them, and the carry is very good.”

Though French investors are still finding ways to exploit government bonds, there has been a significant shift towards credit over the past few years because of the financial crisis, says David Bouchoucha, head of institutional sales – southern Europe at BNP Paribas Investment Partners.

“There has been concern about spreads on these bonds, which have tightened a lot,” he says. “So the logic is new diversification products from debt, particularly private debt. At the end of last year, we saw this trend intensify: we raised €700m with large insurers, €250m for one dedicated fund on French loans and a €450m club deal with four clients on a global loan.”

He says that one of the big attractions is that these debts are floating-rate instruments, so they offer protection against inflation.

“It was the biggest clients who moved first,” he says. “Now we also see smaller clients entering the asset class.”

Boscher agrees that sovereign debt and investment grade credit, particularly for euro-zone countries, have generally become less appealing in yield terms.

“Last year there were interesting opportunities both for carry, and for spreads to narrow, but now spreads have narrowed, you’re just left with carry,” he says. “However, many players still need material investments in euro-denominated sovereign debt, especially well-rated debt, because of capital constraints which require longer duration assets to generate returns.”

Boscher adds that there is still interest in opportunistic investing within the euro sovereign pool, for instance, in short-dated peripherals such as Spain and Italy.

Wherever possible, however, clients across the board are seeking global diversification in fixed income, particularly in emerging market debt. Meanwhile, although the great rotation may have been overstated, at least from a French perspective, there has still been a discernible move back to equities.

“A year ago, clients didn’t want to listen,” says Bouchoucha. “But since the beginning of this year we’ve had a lot of conversations about active equity. That doesn’t mean there have been heavy inflows into them. But clients are considering investing again.”

One reason for the renewed interest is share dividends. According to Bouchoucha, the average allocation to equities is only around 10%, with even the most aggressive investors allocating 40-50%.

One factor inhibiting investment is Solvency II, despite the delays in its implementation. Another has been market volatility.

“We are telling clients to look for well performing equities, grabbing excess return through active management,” says Bouchoucha. “We think there are some European equities which are more attractively valued than US or emerging market equities.”

Alternatively, he says, clients could use asymmetric instruments with low volatility, such as global convertible bonds.

BNP Paribas’ advice is based on research by Robert Haugen, its late consultant, who found a correlation between low volatility and better yield, helping the company develop a product to make use of this.

Bouchoucha also says clients are becoming more selective about the regions in which they invest in equities. “A year ago, clients were looking for exposure to global beta,” he says. “Now that times are more difficult, they want single-country or single-regional exposure. We are active in countries such as Russia, Indonesia and India.”

Mimran says: “Even if the economic situation in Europe is complex and the political situation worse, we believe that growth globally is OK. The US economy seems to be growing, and we also have good indications in Asia. Having said that, we are still relatively bullish on Europe long term.”

Alternative investments are not a particularly hot topic at present. According to Debaere, hedge funds are out of favour, partly because of their perceived inability to deliver return and portfolio protection if tail risk events occur. “There is also the issue of transparency – large French investors have implemented responsible investment policies, so they need to monitor their investments,” he says. “With hedge funds, it can be difficult to find what the underlying investments are.”

Mimran, however, sees some value. “Returns from hedge funds have been very poor for the past five years, but they have been very good over the past six to nine months. This should continue because nearly all the sub-sectors are doing well. So we believe there is some value there, and that this improved level of return should continue.”

Boscher  explains: “Hedge funds have been less popular with French pension funds in recent years because of the Alternative Investment Fund Managers Directive, and also because of scares. They are now back featuring in our discussions, but with much more control. Clients are looking not at funds of hedge funds, but more sophisticated funds with concentrated portfolios. This means they can select sub-asset classes, and also have a full look-through of investments.”

Among other alternatives, he says clients are still investing in property because of the illiquidity premium on offer.

“From a long-term point of view, it’s an asset we’re looking at, because a diversified property portfolio makes a contribution to the real asset pool to protect against inflation,” he says.

Mimran says there is a more basic reason behind this: “People prefer to own real estate in, say, Paris, than keep their money in a bank. They are afraid to hold cash in Europe.”

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