In part two, the panel talk about the shift from equities to fixed income, potential bubbles, absolute return funds and future challenges. Chaired by Nick Fitzpatrick (part 2)
William de Vijlder (CIO Strategy & Partners, BNP Paribas IP), Marino Valensise (CIO, Baring Asset Management)
Andreas Utermann (Global CIO, RCM), Richard Wilson (Head of Equities, F&C)
Peter Elam Håkansson (Head of Portfolio Management, East Capital)
Funds Europe: Could the wave of investment in emerging markets benefit the developed markets?
Wilson: Their contribution to the idea of a ‘new normal’ is not just a consequence of the credit crisis; their importance in this regard started some time ago, so this is not a new phenomenon. However, the fact that the emerging economies have resisted the economic downturn has led to significant capital market flows in the last few years – in terms of corporate investment, this has been around for a while. If you look at the equity risk premium on emerging markets relative to global markets, this has been on a constant decline for the best part of a decade and a half. The resilience and continued growth in emerging markets has unquestionably mitigated against the catastrophic financial meltdown of 2007 and 2008 being as severe as it could have been.
Is it a long-term trend? Yes, absolutely. Should you be strategically positioned for that? Yes, absolutely, whether directly or indirectly. Investment in emerging markets has already been of benefit to developed markets and economies and not just because they became the ‘get out of jail card’ in the aftermath of the credit crisis.
Emerging markets should certainly be part of a strategic allocation, on a long-term risk/reward basis. The challenge in the short term is that as capital flows in and out of these markets, even at the margin, it creates short-term challenges for those long-term holders, particularly in terms of volatility as they are still relatively illiquid and underdeveloped capital markets.
Funds Europe: Institutional investors have been gravitating much more towards fixed income than equities. Is this driven by regulation or by investment consultants with the aim of matching liabilities? Are equities valuations attractive now and to what extent has fixed income been oversold?
Wilson: There has been a strategic shift towards fixed income. The de-risking we saw by insurance companies in 2007 and 2008 has given over to capital concerns derived from regulatory frameworks such as Solvency II or Basel III – neither of which are particularly equity friendly. Regulation has also played its part in the pension fund hedging strategies that have been especially prevalent in recent years.
In terms of equities generally, valuations in my view look decidedly attractive. Balance sheets have become stronger and earnings are recovering. There are many corporates out there that have never been in ruder health, and that clearly suggests there is an opportunity to be had. Whenever I mention European equities, people look at me in horror as if these could ever be investable again, beaten up as they have been by poor economic growth, the sovereign debt crisis, contagion issues and the allure of more interesting opportunities in emerging markets. Maybe therein lies the opportunity to be contrarian, but certainly they are not the asset of choice at the moment.
Valensise: Continental Europe stocks are historically cheap, but the UK market is cheaper and is probably the most internationally oriented. This means the FTSE100 is quite a strong candidate for the multinational theme. Therefore, I think it is a good way to access emerging market themes in a diluted and low beta way.
In terms of the alpha, offering asset management and stock picking services in developed markets is a tougher proposition than offering them in emerging markets. Developed markets are quite efficient and unless you have something very special to offer or something which really makes you different, business is going to be tougher. The growth of ETFs [exchange-traded funds] will also add to the challenge.
Utermann: It’s been a perfect storm for European equities. Institutions have de-risked their portfolios and retail investors have been consistent sellers across Europe over the past ten years. A number of things have been behind this, including the fact that we haven’t generated enough alpha as an industry and that the products are too highly priced. Therefore, relative to ETFs, it doesn’t really measure up. European equities have been abandoned in favour of global equities or global emerging markets.
The little risk budget that investors have is going to be spent on something with perhaps a higher return expectation than Europe. It’s pretty negative but maybe, as Richard says, therein lies the opportunity.
The one area outside the alternatives space is income growth, which has been neglected in Europe. And the concept of total return with an equity beta and with dividend income streams, and maybe with some convertibles exposure to enhance the yield and the overall return of the fund, that’s something that will grow. Those are the new bonds. And they’re not in a bubble.
De Vijlder: There was one cloud in the storm that has been forgotten, which is that non-European investors were scared about Europe collapsing.
Håkansson: Emerging Europe has suffered a bit in the global emerging market context over the last few years, and it was really only during the autumn that we actually started to see outperformance of the R in the Brics [Brazil, Russia, Indian and China] acronym. Before that, everyone was putting their money elsewhere, and it was almost as though emerging Europe was influenced by western Europe. So it’s not only in the western part of Europe that Europe has had a bad name.
Funds Europe: Do you anticipate a bubble anywhere in the market in the next year or two? And what would the drivers behind it be?
Valensise: When real interest rates are close to zero, it is almost inevitable that we will see a bubble forming. People will take advantage of the cheap funding and invest in risky assets. One of the first experiences of the last few quarters has been commodities and gold. Gold does very well when real rates are negative and rates have been negative now for a while. If rates will stay down here for longer, then we may have a chance of seeing a real bubble in the commodities space.
De Vijlder: People tend to look for bubbles too early in the cycle and the first references about the next bubble were made in the first half of 2009 – people were mentioning emerging equities at the time. We can see specific, local bubbles, like certain types of property, for example, in Hong Kong. Government bonds are sometimes mentioned as a bubble but this all depends on your economic scenario; depending on the scenario they’re either cheap or in bubble territory.
Utermann: You can have asset classes that are conditionally very expensive, so gold is either very expensive or incredibly cheap. What is really getting trickier is if you have the bubble fuelled by debt. So what I would be looking at specifically is more on the macro perspective: does credit growth have some link with the asset in the country?
Valensise: With domestic Chinese equities, they’re only trading at 11 times P/E and the market has been de-rated aggressively. Today we are in a situation where the Chinese government wants to empower the domestic consumer. It is providing free housing to more people and has decided finally to sponsor citizens’ healthcare. On top of that, it is giving people wage increases. In some time, people will have more money to spend and invest. If they do not buy bonds because they’ve got an inflation problem, and cannot buy property because it is going to be more difficult to buy second and third homes, where will they put their money?
Households in China only hold 6% of their savings in equities, so there is an enormous potential to add to this. I don’t exclude the possibility that this could happen soon. There is only one extremely liquid market domestic savers will be able to access and that is the Chinese domestic market. I wouldn’t be surprised if we were to move closer to that situation.
Håkansson: I agree that we may see more bubbles – but I think they will be smaller in scale. Frontier markets are one area I would highlight. These are very dangerous when people are not content any longer with the returns they get from big emerging markets and they want to go into smaller ones as a result, and everyone enters at the same time. That’s when I get worried and I think we will see more of these flavour-of-the-month investments coming and going.
Funds Europe: Absolute return funds have been consistently attractive, but they have been criticised for a lack of transparency. How do you make absolute return funds more transparent?
Utermann: It’s incredibly important to have transparency around activities in these products, because a lot of these strategies that purport to have excellent returns for the same amount of risk, or lower risk, are not going to work out. So it’s obviously a very dangerous area, but enormously attractive.
The worrying thing for our industry is that Libor +5 cannot be achieved for a level of risk that does not correspond to that. But they say that the +5 is all skill.
De Vijlder: I think that at the point of purchase people understand they do take market risk. The issue is that you have to run a product with a medium-term time horizon to deliver alpha, but investors look at it as a short-term horizon product in which you cannot have underperformance too often. The performance objective forces the manager to take risk but the investor may focus too much on the link with Libor.
Valensise: The more restricted the strategy, the less you can do with it. Imagine an absolute return bond product that can only invest in European government bonds: compare and contrast it with a multi-asset absolute return product where you can
buy and sell different asset classes in different parts of the world. I’m a little sceptical when I see UK equities-only absolute return products. If I had to, I would choose a multi-asset broad universe approach.
Utermann: We’ve talked about regulatory change and what it means, and in some cases it means that risk is being shifted from the plan sponsor to the plan member. If you’re the plan member and you’re suddenly faced with this asset allocation decision, what do you do? You might move away from individual asset classes and try to make asset allocation decisions, and that’s where you end up with absolute return products.
Wilson: Transparency in understanding what the manager is trying to do is critically important. A product that says it will target 5% over Libor doesn’t tell me very much. There’s a risk that we almost define absolute return funds as an asset class in their own right and assume the aspiration to perform is taken as read. I don’t see it that way at all.
Håkansson: What is the maximum loss in a month? It’s nice to see this positive side of a Libor+ return, but what can you lose? This information needs to be disclosed properly.
Funds Europe: Since the early days of socially responsible investment, ESG [environmental, social and governance] factors in investment seem to have become more visible. How important are ESG factors in your investments?
Håkansson: More of our clients are asking a lot of questions about this, so it’s not only something that is important as an investor, it’s also something that is important when you’re communicating with your client base. We have always been conscious about these things. It is not only that you please your clients, but in the long term, companies who are complying with these things are actually more profitable.
Utermann: If you look at the whole space of sustainability or anything that people might group under that heading, it’s important to distinguish two concepts that are different from an investment perspective, and different to how clients view them.
One is essentially that you have restrictions that limit your investment universe – the other is using a best-in-class approach. For the latter, you don’t restrict your investments, but within each sector, whether it’s a
‘bad’ sector or a ‘good’ sector, you try to pick those companies that are most focused on ESG matters within their universe. Behind this is the assumption that you reward a company’s good behaviour and that other investors will, over time, direct their capital to that company.
If you’re a client, you may have reasons that go beyond the optimal investment outcome, and that’s where it becomes justifiable to have restricted universes.
Wilson: There is a sea change in the way clients are considering and questioning the way ESG factors are included in investment decision-making. It is fair to say that academic research is inconclusive in terms of the specific value creation attached to these factors, particularly in terms of screened funds. But these factors can be important drivers in an overall investment assessment, particularly at a company level. We’ve seen a whole series of events in the last year alone where investors may have been better off if they had considered these factors more closely. I believe that incorporating ESG factors into one’s investment judgment is the new norm.
Funds Europe: Would ESG factors impact investment in emerging markets, such as China for example?
Valensise: The governance rules are easier to apply to developed markets than to emerging markets.
Utermann: Regarding the best-in-class approach, if you move in a different direction you would say, ‘I don’t really care if that’s not very transparent. If I find a Chinese company in its sector that is slightly more transparent than the next Chinese company, I am happy.’
Wilson: That’s the difference between a purely screened fund and something that looks at the relative merits of each situation.
Utermann: It is entirely justifiable and, obviously in the nature of things, that the client is not only allowed but is expected to have views as to how that money should be invested. The risk and the danger that the asset management industry faces is that we engage in moral relativism, and that is not our fiduciary duty. Moral standards vary tremendously across cultures and within cultures over time.
Wilson: That mindset is changing quite fast from a client point of view, and it’s our responsibility to do that.
Funds Europe: What are the main challenges the fund management industry faces over the next two years? How do you see the industry developing?
Valensise: There will be less tolerance for poor or mediocre performance; medium alpha product will be less of a proposition. You have ETFs on one side and high alpha positions on the other; the middle-of-the-road product, particularly in developed markets, will be extremely difficult to redeem.
Utermann: Putting it a different way, we have to deliver value for money.
Håkansson: Regulators will be more active.
Wilson: Developing the right governance and advice framework in a rapidly changing investment environment. If you’re a board of trustees and you have 25 managers doing different things for you, actually understanding it and keeping on top of it is not a part-time job – it’s a full-time job for an investment professional, and that’s where the investment advice provided by a fund manager under a ‘fiduciary management’ model or by intermediaries in terms of ‘implemented consulting’ is going to be very important.
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