As an investor, if you haven’t had the benefit of building up your reserves in the boom years of the 80s and 90s, to provide a cushion for the down cycle, you will probably be looking at a serious shortfall in your fund, and questioning your investment approach as a consequence. The last 12 years have given us three major equity market shocks. As a result, the return on equities over the period makes a mockery of the assumption that buy and hold for the long term is the best approach. It is said that equities are the sum of humanity working to create value. If we no longer believe that, then what’s the alternative? A year ago, everyone was talking about how the sovereign wealth funds were going to save the world. They too have suffered a rude awakening, and having committed billions to global equity markets, it will take a long time for them to recover their minimum return targets. The post-Lehman world has called into question many trusted assumptions about investing. We are questioning the fundamental concepts of asset allocation and the efficient portfolio. There is an argument that diversification has not offered the protection it was meant to. There’s a lot of interest now in fat-tail insurance. We doubt the efficacy of the supervision given to the management of funds. And while much of this is the natural reflex reaction to the shock of what has hit us in the last six months, it’s important to take stock and assess whether your portfolio is properly constructed.
The question has been raised about whether strategic asset allocation is a flawed process. Pension plan funding ratios for S&P 500 companies, that were significantly overfunded in the late 1990s, are facing huge deficits to the tune of approximately of $400 billion. In 2008, the aggregate funded status for the largest US pension plans dropped to a 75% funded status. To make up for the shortfall, some institutions are discussing with their investment board whether their long term strategic target has lost its relevance, at least in the short term, and that a new target return should be set.
No one has yet disproved Brinson, Singer and Beebower’s contention that asset allocation is the principal determinant of long term fund performance. What is perhaps needed is a more dynamic approach to asset allocation, based on a greater understanding of how to optimise an asset mix for a given policy target, and with the knowledge that the unthinkable can happen.
Vincent Trouillard-Perrot, chief executive of BNP Paribas Investment Partners in Hong Kong, is aware that many of his clients are reconsidering their positions. He says it is too early to tell what change will come of this: “All clients are being guarded about their intention. They all say they are reviewing their asset allocation and their risk envelope and improving the quality of their external managers. The next step is that we expect to see a significant uptick in the number of RFPs. However a lot of RFP decisions are being delayed currently, so that’s a good indication of the uncertainty.”
Consultancy firm Cambridge Associates doesn’t think you should use an extreme event as a basis for changing a strategic asset allocation. According to the firm’s US managing director Celia Dallas, they have been having discussion internally about the whether the new investing environment, and the need to drive higher returns with a different asset mix, changes the nature of what is deemed strategic and what is tactical. But CA’s managing director in Singapore, Peter Roney says, “It’s tempting to think that the asset allocation of the past is no longer relevant. We think that is probably not true. I don’t think, as a cautious investor, your asset allocation would result in something dramatically different from what you have done before. You need the same basic components; something to provide the growth, a way of diversifying your risk, and to take account of inflation and deflation, because over time you are likely to see both. Asia’s stage and development makes it important to have this debate about asset allocation.”
Vincent de Martel and Kevin Kneafsey of Barclays Global Investors, in their recent paper on the subject, concluded that “portfolios invested predominantly in equities with the goal of providing future growth are overly exposed to risks in an economic cycle that can affect all equity markets”. In other words, in a global recessionary environment, all markets are highly correlated, so the good will suffer with the bad. That’s not exactly a revelation, but their point is that that properly diversified portfolios can at least minimize the downside risk: “Diversified portfolios provide a greater risk-adjusted return potential over time than equities, because they are exposed to different risk premia. Investors should attempt to create more efficient portfolios with a genuine long term view.”
Andrew Dyson, BlackRock’s Head of International Institutional business thinks the arguments for diversification will remain intact: “Recent months showed the limits of diversification in the face of exceptional market volatility. But the principle remains intact since genuinely diversified schemes will have withstood the onslaught better. Common sense and investment theory suggest that diversifying risk and return is prudent. The challenge is to understand the underlying risk/return drivers of each asset class and their relationship with each other - as did not happen in the alternatives area in recent months, where schemes discovered some of their alternatives were in effect repackaged traditional assets with high gearing. Schemes are likely to seek expert input in terms of timing, risk management but also strategy/manager selection and generally we anticipate an increased interest in holistic alternative solutions. Diversification will remain a critical feature in cash management.”
Benjamin Graham once said “the essence of investment management is the management of risks, not the management of returns”. Elsewhere in this edition of IPA, we analyse the wisdom of relying on a single risk metric, be it standard deviation, tracking error or VaR. But diversification, across asset classes, sources of return and types of risk, remains a key element of the process.
Burkhard Varnholt, Chief Investment Officer at Bank Sarasin, speaking in Hong Kong, described the current crisis as creating ‘once-in-a-generation’ opportunities for investors, encouraging them to be both open-minded and contrarian. “Two simple words summarise the single most important driver for investment performance in 2009: asset allocation. We are witnessing a unique global policy experiment. It is natural that this will create once-in-a-generation opportunities. But it takes courage, staying power for the longer term, and experience for investors to benefit. Rapid and decisive asset allocation - even if it is painful - is necessary to protect and build investors’ wealth in this environment.” To hedge against the possibility of policy and economic failures, Sarasin recommends investing a 10% portfolio allocation in gold, which may also serve as hedge against the next wave of reflation and the potential devaluation of the US Dollar. Among his other recommendations for 2009 are China A-shares and Asian currencies, with the exception of the Hong Kong Dollar.
Peter Roney of Cambridge Associates in Singaporesays that investors are still getting over theirshellshock. “There is a growing realisation that we are in an entirely different situation. The important change that needs to occur is for investors to overcome their risk aversion. Our advice is to cautiously continue to invest, particularly in areas that look relatively cheap. That is not to say things won’t get cheaper. There are real economic problems out there, and they will take time to work out. But this is not a market issue.
Watson Wyatt expects the price moves of ‘risky assets’, notably equities, to continue to mirror the economic picture, as they have done recently and that falling demand will increase pressure on corporate profits resulting in a wave of ratings downgrades and corporate credit defaults. The firm is advising investors to weigh their beliefs about long-term investment against their ability to adapt their thinking as circumstances change. Robert Brown, chairman of the global investment committee at Watson Wyatt says, “In general, the aggregate risk/reward trade-off still does not look favourable and staying at the lower level of risk ranges is advisable for most investors. The current economic problems are structural in nature and will take time to sort out; so long-time horizons will be needed to benefit from these dislocations.”
While the financial markets crisis has led many institutional investors to withhold or withdraw investment in equities, the mood amongst investors in Australia follows the line suggested by the consultants, to develop a cautious approach to investing in growth assets. According to Tony Cole, partner at Mercer, “the main challenge is to figure out where the risks lie and whether you can do anything about them. People are finding it hard to see the things being done by central banks and by governments will be sufficient to lift us out of the problems. We are seeing a titanic struggle between the believers and the unbelievers.
“Our view is that growth assets have been oversold, and we are suggesting that gradually, people bring their exposure to equities and to selected property and maybe infrastructure assets back up to their benchmark allocations. We are suggesting they fund that by reducing their government bond holdings and cash holdings, so that they move back to benchmark in growth assets.” However, he acknowledges that clients are still highly cautious.
Graham Miller, Head of Investment Consulting at Watson Wyatt Australia says every active manager will tell its clients and prospects that it has unique insights and skills that allow it to outperform the pack. But according to Miller, the truth is that only a small minority actually add value. The current financial markets crisis has raised questions as to whether many alpha strategies have simply been expensive beta strategies in disguise. In particular, people are having second thoughts about hedge funds. Cole agrees: “Hedge funds will continue to exist and our clients will continue to use them. But they are going to be much more discriminating and they are going to want to put managers together themselves rather than using funds of hedge funds.”
The risk aversion that is evident in investor behaviour is driven by the desire of most pension scheme managers to have increased oversight on their managers and consultants. BlackRock’s Dyson expects this process to evolve, with pension funds taking greater advantage of their position as long-term providers of capital. “In the liquidity-constrained world of 2009. We expect that pension schemes will be looking to exploit their advantage of being able to offer long-term liquidity. We believe this will be most obvious in some of the more opportunistic solutions whose typical closed end, fixed term structure will enable pension funds to capitalise on market pricing anomalies - notably in distressed debt opportunities and new private equity offerings.”
He sees investors making greater use of actively managed credit across the spectrum.”Extreme risk aversion post-Lehman Brothers has led to credit spreads reaching historically high levels. Schemes will take advantage of this in corporate bonds, capital securities - where appropriate - and, longer term, high yield. We expect that there will be a diversification away from government bonds, which long term, are expensive, into credit to take advantage of their equity-like return potential. Given the increase in default risk, we anticipate that schemes will turn to active fixed income managers that have a good track record in anticipating those defaults.”
Todd Kennedy, Head of Active Equities for Asia at State Street Global Advisers says that in up markets, performance is a key driver of manager selection, but in challenging times there is more to consider: “We believe that a good investment plan now is one that can safeguard and help manage the different risk factors: volatility, liquidity, downside risk, funding risk and asset allocation risk.”
Using a quantitative investment approach, SSgA is able to offer clients a mix of long only, long/short and 130/30 strategies, depending on risk appetites. Kennedy adds, “The quant approach gives us the advantage that we can rank all stocks within an investment universe, as long as we can get the data to calculate our model factors. This means that virtually all stocks in the investment universe have a forecast future return. We are not only looking for the winners to invest in, but we are also identifying the losers to either avoid, or better yet, to position against. Over at another quant specialist, Axa Rosenberg, chief executive Anthony Fasso believes investors will need to monitor closely how the intensified business environment will impact their asset manager’s ability to deliver: “A key theme in this environment is the continuity of service being provided to investing clients. Clients should be saying to their trustee banks and asset managers, OK, you’ve delivered reasonable performance, but show us your own balance sheet. We need to know how secure your business is. With so many firms in distress, it is relevant to ask, will they be around, or will the principals be distracted by trying to keep the business afloat?”
Investment objectives have also changed, from outperforming established published benchmarks to ensuring that pending liabilities can be met. Kennedy says, “Investors are establishing more risk-averse goals, which include protecting capital, looking for investment vehicles that provide liquidity, working with proven investment managers that have endured different market cycles, and investing in outcome-oriented solutions designed to address a specific need.”
He sees increasing interest in benchmark insurance strategies, ie. outperformance against cash. “Investors are not so interested in using equity benchmarks. A minimum variance portfolio we run for Australian superannuation funds outperformed the ASX by 6% last year.”
Firms such as SSgA and Credit Agricole Asset Management have been actively promoting the minimum variance portfolio idea to Asian clients. A minimium variance portfolio differs substantially from the traditional market portfolio, which is often represented by an index. The MV portfolio is constructed to have the lowest volatility possible, so with reference to the efficient frontier, the minimum variance would be the point at the far left of the frontier curve. So, its risk return features are substantially different than the index. Market capitalisation is usually used to construct an index, whereas volatility of stocks and co-variance are used to construct minimum variance portfolio.
The main drivers of this so-called ‘assymetrical’ approach, are the volatility and covariance of the market constituents. Stéphane Mauppin, Head of Product Specialists, Equities & Global Balanced, at Credit Agricole Asset Management in Paris, says, “Once this is performed, the portfolio manager uses fundamental analysis to reduce/constrain style risk (ie gearing, momentum, valuation) and remove selected undesired specific company risk. An example would be a corporate with a high risk of bankruptcy which nevertheless would score highly on low volatility parameter.”
The goal is to have a higher participation rate in bull phases than in bear phases. Since CAAM launched the assymetrical fund in Dec 2007, it has participated in 47% of the rise in monthly positive returns of the equity market, and only 17% of the down months. Mauppin says, “the 47% - 17% difference is exactly what we are looking for. Bear in mind that we are not predicting a given participation rate beforehand. We are checking it from an ex-post standpoint.”
The tracking error is substantial. Mauppin explains how this impacts the fund: “Intuitively the TE is around 20%, which is more or less the volatility of the equity market. Now the TE is not stable, because the market volatility is not either. Obviously they move in tandem. We pay no attention to it, as the basic idea of this process is asymmetry leading to a higher Sharpe Ratio than the market itself.”
The fund has a final beta exposure ranging between 0 and 0.3. To reach this, CAAM hedges with futures some beta exposure. Specifically, the raw minimum variance optimisation gives on average a beta of 0.7, so they need simple derivatives to correct it. This is fully allowed under, UCITS 3 the European cross border fund passport.
Trouillard-Perrot at BNP Paribas sees a high level of interest in theirglobal TIPS (treasury inflation-protected securities) product. “The entry point is cheap for these long duration kind of products. What we don’t see is much interest in, outside of Japan, is alternatives. Maybe 3,000 of the 10,000 hedge funds have dropped out and there is a loss of trust in the fund of hedge funds, which was supposed to be the best way to invest. Perhaps we will see multi-managers coming into the loop, offering more flexibility in terms of managers and asset classes - a faster and more flexible approach.”
One of the ideas that Sinopia is advising investors to look at is developed market inflation-linked bonds (ILBs). Chief executive officer Alfred Yip explains their thinking: “Strategically, it makes sense to invest into ILBs to diversify your portfolio to improve the risk/reward characteristics. For clients who have been investing in nominal government bonds, given today’s yield level, probably the risk for yield is to the upside rather than further downside, particularly if you see through the next 9-12 months, diversifying into global ILBs will be a defensive move under the circumstances.
“Tactically, we feel that ILBs are currently undervalued, as the break-even inflation rate implied in the ILB markets ise forecasting an extreme low inflationary or continuous deflationary scenario for the next 5-10 years. Given the stimulus measures central banks and governments have taken in recent weeks, and the requirement to finance these going forward, the current breakeven rates are too low and represent good opportunities to investors looking for inflation protection.”
The asset managers are aware of the need to be seen as part of the solution, not the problem.Peter Kerger, Head of DB Advisors Asia Pacific, based in Singapore says it is important for investor to exercise goodjudgment if they are considering transitioning their portfolios. “The primary problem is to overcome the idea that the financial community is part of the problem. We need to be part of the solution and to help them create an active plan, using our global network to get good pricing.”
Trouillard-Perrot says, ”One thing is certain, you need to be close to your customers to help them through this environment. They are receiving us warmly, but it is an uneasy time, especially if you don’t have a strong conviction about the markets.”
Robert Brown, chairman of the global investment committee at Watson Wyatt adds: “While admitting considerable uncertainty about the economic and market outlook, understanding the dynamics currently driving the major economies is critical for the positioning of long-term investors. We think the fall in growth will not be quickly fixed as it is the outcome of structural debt problems accumulated during the past decade.” Or even longer; it has been said that the market is unwinding 20 to 30 years of excess.
Russ Kosterich, Global head of active equity strategy at Barclays Global Investors sees a steady improvement in market conditions: “As risk aversion has moderated, implied volatility for US large caps remains well below the panic levels reached last fall. While volatility remains elevated - implied volatility is still more than twice its long term average - the last few months have witnessed some moderation in investors’ risk aversion. Future improvements in sentiment are likely to be predicated on three factors (1) credit conditions (2) consumer sentiment and (3) expectations for further economic activity. A further reduction in volatility and a corresponding increase in risk appetite, is likely to be of particular significance to emerging market equities, high yield bonds and, to a lesser extent, commodities.”
Above all, investors do need to take a step back and assess whether a short term change in their asset allocation is appropriate. The risk in the market is much reduced, so it’s important to consider the implications of becoming more conservative. Cambridge’s Celia Dallas says, “as long as you have the financial strength to take the risk of investing in equity assets, you need to do so.” The biggest risk of all, she says, is making decisions based on regret.