May 2014


Tanguy LeSaoutActive management often emphasises alpha, but the beta element is crucial, and can be flexible. Pioneer Investments explained this to clients at its conference, where Funds Europe was the media partner. Virtually each passing week in the US brings another economic indicator illustrating a country in recovery. The rate of unemployment, the most critical indicator, is falling towards 6.5% (it was 6.7% in March). This is the threshold the Federal Reserve said it would consider increasing short-term interest rates. But despite the better employment situation, and even though nearly a year has passed since the Fed announced it could begin tapering its bond-buying programme – an announcement also indicative of recovery – investors still face uncertainties. CLEAR SIGNPOST
The central bank’s policy is so crucial to market behaviour that lacking a clear signpost for it – such as what will spur a rate move, or when tapering will begin – is a big problem for investors. The situation was made more muddy recently when the new Fed chairman, Janet Yellen, appeared to push the 6.5% unemployment threshold rate slightly aside, appearing to favour a broader set of indicators, while denying a change in policy. It was against this backdrop that Pioneer Investments, the investment management business of Italy’s UniCredit bank, hosted its investment conference for 120 clients from 20 countries in Boston, US, in April. Funds Europe was the media partner. The theme of the conference was Evolution – Progress Accelerated. Delegates heard that to be in risky assets over the past year was the right decision with small-caps returning more than large-caps, and high yield bonds beating investment grade bonds. Indeed, The Renaissance of Risk was Pioneer’s conference theme last year. Yet one delegate questioned why the resurgence of importance for risk assets over the past year had not triggered a large-scale shift out of bonds and into the equities market. Tanguy Le Saout (pictured), head of European fixed income at Pioneer, said there were various explanations, such as the challenging decision-making process that many investors have to go through to make such large bets, and also their propensity to “find a good excuse” to stay in fixed income. “It will take another leg of a bear market for people to move their money,” Le Saout concluded, referring to the bearish period for bonds following the tapering announcement by then-Fed chairman Ben Bernanke in June last year. Kenneth J Taubes, head of investment management US at Pioneer, added that the demographic effect of an ageing population also kept the demand for fixed income high. BETA DIVERSIFICATION
Holding risk assets paid off last year, said Giordano Lombardo, deputy CEO and group CIO at Pioneer Investments. But with equity markets at all-time highs and credit spreads at historical lows, it is important to ask whether the appetite for risk is still appropriate. Pioneer, he says, was long on risk assets until last year, but Lombardo now says building more balanced and diversified portfolios would be a better strategic choice. A key to doing this is managing the beta component of a return while also giving portfolio managers the ability to generate extra returns, or alpha, on top of that, he said. Hugh Prendergast, head of strategic product & marketing, Western Europe and International, at Pioneer, told the conference that his firm has developed the capability of separating beta and alpha returns in a measure to drive new solutions. This alpha-beta separation takes place in different ways across the asset classes. The first step for the fixed income portfolio is to replicate a benchmark for the beta, and then let fund managers focus all their effort on the generation of alpha. Alpha may come from multiple sources, such as relative value, foreign exchange, or mortgages, said Prendergast. By not adding in any benchmark replication for beta, portfolios can be built purely out of the alpha component with little or no correlation to the underlying fixed income market. However returns from alpha alone tend to be modest. To further increase returns, an additional beta can be added that may not be from a traditional fixed income set, such as equity volatility, or convertibles which are more negatively correlated with fixed income. Doing this, Prendergast says, could move the return on a low correlation alternative fixed income portfolio from 2-3% to 5-7% per annum, but adds to the volatility of the returns. In equity income strategies, volatility can also be used as an alpha to increase income for clients. This is achieved using call options on selected names. A call option gives the holder the right to buy something at a specific price, though upside may need to be sacrificed. But Pioneer’s experience shows that this technique can turn a basic 4% dividend income into as much as 16.3%, while still capturing capital appreciation. The crucial lesson in using call writing to enhance income is that it cannot be an exercised in a systematic way on the whole portfolio. Instead call writing decisions must be made selectively on a stock specific basis, said Prendergast. Assets under management in Pioneer’s first target income product European Equity Target Income, launched in late 2011, have recently exceeded €1 billion, as the concept proves popular with investors who are yield hungry. The firm has subsequently launched products using the target income enhancement approach in global equity, multi asset and real assets so that it can address rising investor demand for income from non-traditional sources. EQUITIES PLAIN AND SIMPLE
For investors who like their equities served more simply, Pioneer’s head of equity Europe says European corporate earnings will support equities this year despite a lacklustre period last year. Diego Franzin said three reasons to be positive for earnings were higher growth, central bank support, and improving levels of operating leverage at corporates. Improving operating leverage in a business generally means sales are contributing more and more to profitability rather than to paying fixed costs. “For every unit in the growth of sales [operating leverage] is double in Europe compared to the US,” Franzin said. But to have sustainable growth Franzin said companies needed to start focusing on capital expenditure, and indicators suggested they were. The best way to play European equities recently has been to hold stocks exposed to domestic demand rather than to the emerging markets. However, some domestically exposed stocks have become more expensive than stocks exposed to the emerging markets, he said, and so stocks with emerging market exposure should not be ruled out. On a similar note, the conference also heard from Taubes that emerging markets could recover this year. “When the US is doing better, and [so are other markets, such as the UK] how is it that exporters from EM [emerging markets] will do worse? I think some of the large EM exporters are going to do well.” He also said that after experiencing the worst weather in the US for years in 2013, “we are going to see some payback”. The view was supported by Vincent Reinhart, former director of the division of monetary affairs of the Federal Open Market Committee and now chief US economist with Morgan Stanley, who spoke at the conference. He said, with the weather effect abating and with solid non-farm payroll data, the US would see an “uncoiling spring of pent up demand” among many consumers in the country. Overall the conference sought to answer two broad questions: Is it still worth being long on risky assets? And how can investors meet the challenges ahead in light of issues such as tapering, the absence of quantitative easing by the European Central Bank, and the growth outlook? The broad answer to these questions calls for dynamic diversification. ©2014 funds europe

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