July-August 2012

CIO ROUNDTABLE: Know where your money is

CIOs at our recent panel gave an insight into how the eurozone crisis is shaping their world. The safety of cash, financial “repression”, and changing perspectives about risk are challenges that some of Europe’s top asset managers face. Chaired by Nick Fitzpatrick. QFCA logoThe Qatar Financial Centre (QFC) Authority  is proud to present the latest Executive Panel in the series of discussions organised in partnership with Funds Europe and Funds Global. Each panel looks at the core issues affecting the industry and includes some of the leading chief executive officers, chief operating officers and chief investment officers from companies driving the industry forward and shaping change. Many topics discussed are core to the QFC Authority’s beliefs: efficiency, transparency and integrity. It is the QFC Authority’s goal to build a world-class financial services marketplace where all participants, both domestic and international, will benefit from the considerable local market potential which they can use not only as a springboard into other countries in the Gulf Cooperation Council, but also as a powerful regional base from which to tap into the broader growth markets of the Middle East, north and sub-Saharan Africa and the Indian sub-continent. By supporting these initiatives, we hope to gain valuable insight into the future development of the global fund management sector and help us to realise our aspirations to become a regional hub for asset management in the Mena region. Shashank Srivastava is acting chief executive officer at the QFC Authority CIO roundtable july 12 Jerome Booth, head of research, Ashmore Investment Management
Eric Brard, global head of fixed income, Amundi Asset Management
Neil Dwane, CIO Europe, Allianz Global Investors
Jeff Molitor, European CIO, Vanguard Investment Management
Anne Richards, CIO, Aberdeen Asset Management
Philip Saunders, global head of asset allocation, Investec Asset Management Funds Europe: With the Greek election out of the way, the beleaguered country has dropped slightly from the headlines. What is the next deep well of risk for asset managers and what are the investment themes it creates? Anne Richards, Aberdeen Asset Management: Our business has relatively little exposure to most of the eurozone periphery, but now that the Greek crisis is out of the way for the time being, what bothers us is the security of cash. It is important to understand where your cash is. We are concerned about seeing more capital controls affecting the free movement of cash. Right now, there is an interesting trade-off when managing residual cash for clients. It is between the rating of the deposit-taking entity, the yield on that deposit, and the diversification needed on that cash. We are very much in a world where there is no safe place to put cash; all you can do is choose what risks to take. Philip Saunders, Investec Asset Management: We run quite a lot of money for central banks with fairly strict credit limits. These days, to do this you have to operate in the emerging markets rather than rely on ‘Old World’ banks, whose credit quality has deteriorated. If the industry were to carry on ignoring the credit issue then the degree of risk that investors would be exposed to would be totally unacceptable. Neil Dwane, Allianz Global Investors: We are focused on custodians and what they do with our cash as well as with cash that is not under our control. Our worry is that they may leave it in banks that we would find unacceptable. Jerome Booth, Ashmore Investment Management: Related to the cash issue is the fact we are now in an environment of financial repression – which is defined as any policy that basically captures institutional savings to fund the government, and at lower cost than would otherwise be possible. The fast implementation of Basel III and Solvency II are actually forms of this. What’s worrying is this creates an artificially low yield on these instruments, discouraging investors, and this in turn creates a more homogenous investor base, which actually increases systemic risk. I believe we will see some real risks in Europe as regulators continue to force investors to buy domestic sovereign bonds. Go down that road and then you may well even get capital controls to bail in foreign investors eventually. Eric Brard, Amundi Asset Management: The crisis that began in 2007 means we have had to reassess how we look at portfolios. We are used to analysing markets through the window of asset classes and the assumption was always that risk characteristics associated with these asset classes were usually quite stable. Now we face asset classes with unstable risk features. What was very safe in the past is not safe any more; what was a risk asset in the past is probably safer today than it was then. Two examples: sovereign and corporate bonds.   It is interesting to look at portfolio construction not through allocations across asset classes, but allocations across risk factors. Our clients are now really thinking along these lines. Big institutions are thinking about the different pockets of risk in their portfolios, asking themselves about the safety of cash, about inflationary hedges, about obtaining the right spread rather than allocating more to fixed income or other assets. This is a fundamental change. Richards: Yes, I think there’s been a dramatic shift in that sense – even from labelling something as low or high risk. The most you can say about any situation is that there will be different risk drivers. Investors need to pick as many of the different risk drivers as possible and avoid doubling-up on them. But actually putting a numerical probability on any particular risk given that so many risks are politically-driven and politically-affected is incredibly difficult because we all know politics changes on a sixpence. Therefore, it’s a question of trying to build in different drivers and hope that in aggregate you have enough protection across the widest possible range of scenarios. Jeff Molitor, Vanguard Investment Managment: One of the biggest risks is that investors lose perspective. They get tied up in the day-to-day noise. Much in the press on any given day is simply noise, so the idea they have to jump around in terms of risk-on/risk-off is wrong. By the time somebody decides it is time to be risk-on, it’s probably time to be risk-off. This is not a sound way to manage assets. Investors need to keep a longer term perspective and focus on their fundamental beliefs in terms of return and risk. Often, the best advice is to sit tight rather than responding to each news or market blip. Booth: There is a problem of timeframe affecting perspective. It is incorrect to only use volatility as a proxy for risk. This shows an intellectual failure. Volatility works some of the time when markets are reasonably stable, but in the longer term other factors come to fore. The risk we really care about is often not volatility but large permanent loss. Richards: I would challenge that because I think – whether they agree or disagree – a significant proportion of the client base feels not intellectually but quite viscerally about this.
Year 2008 showed a lot of people that we need to think much more about capital preservation and avoiding loss, and less about short-
term fluctuations. But I do think in some respects that we’ve just not kept up with that. Within debt markets, it’s ludicrous that we see emerging market debt as high-risk and Western sovereign bonds as low-risk. The much more logical thing is to stick them all together and categorise bonds by investment grade and sub-investment grade. End the fiction that an emerging market bond should be in a different bucket to, say, Germany. Dwane: We look at the funding process slightly differently. There are the ‘safety’ clients who – at all costs – want their money back. But there are other people who have capital and are prepared to take risk. The question is whether we can define what risks – and whether the returns will be worth it. For many clients I meet, the return in the past five years has not been worth the risk. Molitor: But in the case of an institutional investor, the focus may be career risk rather than investment risk. In early 2009, an executive at a sovereign fund told me he was willing to forego the first 20% gain in a rally to avoid the risk of buying too early. Twenty per cent of this fund represented a mammoth number – a high price to preserve a job. Booth: A lot of it is career risk. Agency problems are rife in our industry and that’s what we are describing here. Dwane: It’s not just that. The CFO who faces issuing a profit warning if the pension fund deficit gets bigger, has the risk of low investment returns. Booth: But this comes down to parts of the regulatory structure we’ve got in parts of Europe – it is actually increasing risk. We have, however, some good news. A couple of years ago I had a conversation with a US pension fund and they said they understood my point, which was that GDP weighting meant the fund would eventually have to put 50% of its money into emerging markets. They also understood my point about agency problems, like herding. But they said: "Jerome, we still have to be in the herd!” The solution is you go to the edge of herd – work out what your peers are doing and go to the edge. We have to live within that reality, pushing that herd boundary year by year. Dwane: To go back to the question about what happens after Greece – which we think will stay in the euro – we feel the problem now lies with Spain. It is the major economy with a housing bubble and that creates banking issues, just as it did in the UK, Ireland and the US. Another problem that I’m always perplexed by is Italy:  we don’t see why it is a problem. A modest amount of austerity, which they are prepared to implement, may not stabilise the government debt percentage but, given corporate and private wealth there, that’s not an issue. It’s the only country I go to where, when I ask audiences if they would pay a wealth tax, they say yes. Saunders: I accept that a lot of that’s true but Italy has effectively suffered. It’s been in a depression for twelve years and can expect more of the same for the next decade. To be permanently without growth is not a recipe for stability and happiness. Dwane: But what is interesting is the north-south divide. Venice to Pisa in the north is as competitive as the Germans. Go south and it’s a desert. They admitted spending $2.5 billion building a solar plant in Sicily and then worked out water was needed to clean it, which they didn’t have. But my point was, I think everyone was surprised last year when the firebreak went from Portugal to Italy, but not Spain. I have to say that I think the firebreak this time will go to France and that’s when Europe will have it’s defining moment. I think Italy is played out and the non-consensual concern should be about France. The president is already making policies that are going the wrong way. Brard: To me, looking at the situation within the eurozone on a country-by-country basis, looking to see which country is next is probably a dead end from an investment perspective. We should go for specific stories as opposed to systemic stories. What I mean is that when it comes to finding investment solutions, we should not put signs on Italy or Spain, but instead we should put signs on vehicles, instruments and securities that are very close to the crisis. In Italian, French and Spanish debt, for example, you can still find names and investment ideas that are worth considering. There is still value within some of these markets. Rather than talk about very low interest rates, we should talk about very low, but better, returns. Rates are very low in the so-called safe haven markets. But if you look at the markets a different way, not through the country-weighted benchmark window, there are a lot of opportunities in these markets. We should also stick to diversification. Widening the scope of the investment universe, at a time when regulation and markets are tending to shrink investment opportunities, is probably one solution. Dwane: I agree with you, but there is an issue about timing now if the bush fire jumps into another market. In 2008/09, the market didn’t differentiate and everything in Europe went down. But this year Spain is down 25%, France is down 1% and Germany is up 5%. Now it’s Greece being toasted. I agree with you that there are opportunities and I’ve got analysts looking for the remnants of what’s quoted in Greece that might be interesting. But because a Greek company had called itself Hellenic-something-or-other, it’s just been sold out to the last. Richards: More than ever in the last 20 years, when you look at Europe, it is the knee-jerk political and regulatory responses that are adding to the level of uncertainty. Investing is not about looking at a company and figuring out how many units this bottling plant bottles any more; it’s about thinking what’s going to happen in Brussels or Berlin that will affect that company wherever it is listed. There are three things needed for a successful economy: people who can actually deliver what an economy needs to grow; risk capital, which can back that innovation; and government to regulate what cannot be regulated by the free market. If the political leadership, particularly in Europe but not exclusively so, could really focus on those three elements of the food chain and think what it can do to facilitate the people side of things so that they are mobile and they are trained and they are fit for purpose, the risk capital so that it’s there, not unbridled. Nonetheless, they are able to back business when it needs to be backed. What government needs to do is to keep populations and countries safe from broader externalities, but get out the way and allow them the freedom to get on and do stuff. If you could just strip it right back to those three things we would go a long way to begin to move forward out of the current situation. Funds Europe: As you have expanded your range of investment markets, how satisfied are investment professionals with the standards of initial public offerings and the reliability of investment data? Are chief investment officers able to get sufficient ratings data from the established ratings agencies? And, finally, how difficult is it to maintain the same standards throughout a geographically diverse organisation? Booth: Ratings agencies are not my first port of call. I think most active managers would go and do their own research. Concerning standards, we take the environment as it is; it’s not a binary thing: we don’t avoid investing because standards are poor or conditions tough.  You do do some of the hard things because they are hard and you get paid for doing the hard things.   Richards: Where I see additional complexity is in the administrative chain, the owning and managing exposure, particularly in some of the smaller markets where you might deal with custodians or sub-custodians. A currency conversion, for example, might have all sorts of rinky-dinks in terms of what taxes are levied on the way into the position and on the way out. These can change. There is an operational and administrative complexity the more that you go into some of these markets. Dwane: In terms of the equity side, since the credit crunch and the banking crisis we’ve spent more time meeting our credit analysts to understand how they look at balance sheets. Credit and equity around the world in Allianz have been getting closer together. Our credit analysts are, so far, getting a lot out of it because in equities, let’s say we have 5,000 company meetings a year around the world, while the credit analysts used to have about 100, mainly with banks. Now they are beginning to realise they can learn more about the industry, the competitors, the dynamics by attending the equity meetings so they can then stress test balance sheets. So what we have tried to do is make sure all our graduates, whether they go into equity research or credit research, now understand how the other side will look at it. We are not really relying on different information systems or the investment banks or rating agencies, but we are now matriculating some of that information more effectively through a global research sharing portal. Saunders: There is a big convergence theme in the industry. International firms run the risk of being highly compartmentalised and the tendency for this is only reinforced by specialisation. This can lead to tense pressure within organisational structures, which are siloed. Then, all of a sudden, when investments have been made, managers realise they haven’t seen the wood for the trees by having people in different areas and geographies speak to each other. Molitor: Working on a global basis means you have to establish consistency. Embedding the proper  culture is vital. It is also important  to create incentives and find ways for people in different places to collaborate. Funds Europe: In many restricted markets, such as the Middle East and certain parts of Asia, are we likely to see more infrastructure projects being used to satisfy investor appetite for geographical participation and return? Dwane: Infrastructure in emerging markets is the only asset class that can absorb several trillion dollars of investment in a non-inflationary way. Saunders: But governments seem to me to want to own that process. Will they share out to institutional investors? Booth: That is the problem. I suggested to a central bank recently they ought to do a trillion dollars of infrastructure investment. The immediate reaction was: “Oh, but we haven’t got the budget.” And I said: “No, you misunderstand me, I don’t mean government money, I mean that’s where you should be directing foreign private portfolio inflows.” We as an industry should lobby policy-makers in emerging markets and, in fact, in the G10 to help solve this problem of global aggregate demand by funding large emerging market infrastructure investment. It is the only thing that really can create enough global aggregate demand to help the West and to make a substantial difference to exporters in Europe and the United States, yet at the same time avoid inflation. Saunders: Institutional infrastructures in a number of places are not sufficiently developed. Booth: That’s right, but I’m a big believer in the demonstration effect. I welcome China’s efforts in this regard because they’re a big leader on this. Saunders: Even in a developed economy you can chuck money at infrastructure and achieve very little. The history books are beginning to come up with a revisionist view of the whole 1930s FDR initiatives [Starting in his “First 100 Days” in office, which began March 4, 1933, Franklin D Roosevelt launched major legislation and a profusion of executive
orders that gave form to the New Deal, a set of programs designed to produce relief, recovery, and reform]. Richards: China has done a lot in terms of being the first mover in quite a lot of African places. I think there is a tremendous hope story for growth. If we can get the investment in Africa right in terms of where the global aggregate demand is going to come from, there is potential for some really big percentage change numbers to start coming out of there. Booth: I strongly believe we need to link up defence, foreign, and aid policy from Europe and the United States so we have proper incentives for better governance in sub-Saharan Africa. More capital could be unleashed in Africa. If you establish clear property rights for a house-owner – secure and transferable – they can then borrow against it and start a business. That is, capital creation. It’s often legal institutional reform that’s required to kick-start growth, not a huge amount of capital. If there was more demonstrably good progress in things like that, and on the bigger governance issues such as election rigging, then I think there would be huge potential unleashed. There are a lot of good quality second generation post-Colonial leaderships in Africa now. But we also need bond markets in Africa and we need the IMF to stop assuming that all return on private investment is zero and, therefore, these countries shouldn’t have any debt. Companies in Africa could issue huge numbers of bonds to fund economic growth, but we first need sovereign debt benchmark bonds off which corporate debt issuance can price. We thus need aid financing to give way to sovereign bond financing to enable this entrepreneurship. Richards: And to acknowledge the degree of entrepreneurship and the degree of technological change and imaginative uses of technology that has already happened in some of the sub-Saharan countries as well. New business creation is really powerful in some of these places. Dwane: I agree, but I’m just saying that Africa’s infinitely more complex than Latin America is, so… Saunders: In Africa, the infrastructure’s worse than it was at the end of the Colonial period. What Africa needs are local success stories of countries doing it right. Turkey is an example of a country that got it horribly wrong but is now getting quite a lot of things right, I suspect. But there needs to be local success stories and then countries that are getting it wrong will be much more apparent. The problem, of course, is that the West thought that all developing countries had to do was copy us. These countries believed that for a bit, but now the scales have fallen from the eyes. ©2012 funds europe 

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