Policy change brings caution. And none are more prudent than those in the investments industry. Funds Europe met with a group of leading asset managers to find out what impact these regulations will have on their clients, and in the coporate world. Chaired by Nick Fitzpatrick
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: The regulatory environment has never been more crowded. What impact is regulation having on asset owners and can fund managers offer the right strategic advice?
Marino Valensise, Barings: Changes in regulation do affect the choices of asset owners and institutional investors. Going back five to ten years, the one change that had quite a dramatic impact on the way people invest is the development of pensions regulation in the UK. The changes in policy have led to a migration away from equities into fixed income instruments and an implicit encouragement from the authorities to have better liability matching.
In terms of most recent changes, I notice how – in a few jurisdictions – regulation is now applied in a stricter way; it takes more time to register funds in certain jurisdictions and the level of scrutiny has gone up.
William de Vijlder, BNP Paribas IP: I think there is a strategic shift towards less risky assets, which means there are hardly any long-term investors left. Everybody has become far more short-term focused. It’s almost like the bulk of investors have a kind of CPPI [constant proportion portfolio insurance] strategy. If you’re a pension fund you will cut your risk if you’re afraid of going through your minimum funding requirement. And then, when you’re a private investor, you will also reduce your risk because you are risk averse. The basic idea of markets is that you can count on mean reversion – good times follow bad times – and that is really changing. That has a profound impact on how markets behave.
Andreas Utermann, RCM: I’d like to pick up on the point about time horizons because it seems to me quite pertinent to this question – and I’d like to raise the point that the regulators are perhaps focusing on the wrong type of risk.
We’re talking principally about volatility risk and about downside protection to mitigate that risk. But if we looked at it differently – namely the risk of not hitting the target term in particular – you would have very different outcomes. For society as a whole, that is a far bigger risk: that you underfund and under-compensate saving by looking at it too short-term and looking at volatility risk rather than target-term risk.
In my opinion, you cannot hit returns over a 20- or 30-year time period with a risk mitigation strategy that works on a short time horizon.
Peter Elam Håkansson, East Capital: There are differences applied in capital requirements needed for different countries. There is a lower risk level for OECD countries versus non-OECD countries and if you’re looking for long-term performance you need to have an exposure to emerging markets, that is, non-OECD countries. By actually introducing this you run the risk that people will be underweighting some of the best performing assets.
Richard Wilson, F&C: The dichotomy that you have with the current regulatory environment is that regulators are looking at very long-term theoretical models, such as a one-in-200-year event – the so called 99.5% confidence limit – and then trying to mitigate against the possibility of catastrophic loss. However, more often than not they end up putting in short-term measures and frameworks for risk mitigation; so what you have is a massive duration mismatch between the regulation and the objectives. This means they are potentially penalising a number of the asset classes that should look attractive and are ultimately consistent with the long-term objectives investors are trying to achieve.
Funds Europe: Does the point about moving to a short-term investment horizon resonate with everyone?
Valensise: When the authorities make a pension fund sponsor, that is, a corporate responsible for the pension deficit on a yearly basis, the finance director has a strong interest in the performance of the pension fund in the short term, otherwise the sponsor itself may be in trouble.
A deep deficit may have consequences for the sponsoring company so, in order to minimise the risk, the finance director is going to lobby with the pension trustees and offer additional contribution, but only if they are invested in liability-matched assets, that is, bonds. This is what has been happening. Since 1999, institutional investors in this country have been taking money out of the domestic equity market, and this is witnessed by negative institutional flows for at least the past ten years, as the regulator decided to change its stance.
Funds Europe: Are equity flows from sovereign wealth funds, which are not hindered by the same regulation, compensating for this in any way?
Håkansson: I’m not so sure they’re compensating for this but they are very much needed because they represent a different type of time horizon. As they are less regulated they can benefit from these long-term trends in different ways and stand to have a big advantage in their investments.
Valensise: In the US, the average exposure that retirement schemes have to emerging equities is 1% on average. This data comes from an InterSec study released about six months ago; this is a small 1% exposure to that part of the world that has got the highest economic growth. This will change.
Håkansson: Exactly, and in reality if you look at the world economy even 13%, which is the weight in the MSCI World index, is not enough. The importance of emerging markets in the global economy is higher than this. So the indices are underweight to start with – and if people are underweight on the indices, then that is a double underweight.
Wilson: Taking the total market capitalisation of emerging markets as a percentage of the entire global universe as a proxy for investors’ total exposure is somewhat simplistic in terms of how much economic exposure to emerging markets people have in their funds. The UK market is a very good example of this; more than three-quarters of corporate exposure is outside the UK, with a very considerable amount of this exposure to emerging markets – either directly or indirectly via intermediates such as commodities.
Håkansson: If there were a situation where emerging market assets actually went up in price, there would always be a demand and supply situation. You would probably see more privatisations and IPOs providing supply of equities if valuations went up. There will always be counter elements, meaning the markets will not just shoot up too much, I hope.
Funds Europe: To what extent are investors hindered from investing in emerging markets? Is there a connection between regulation and the lack of investment there?
Utermann: We need to be very careful about what we mean by emerging markets and by investment and time horizon. You can be invested in emerging markets directly or indirectly. You can buy Volkswagen today, for example, and it will have enormous exposure to China.
There is no doubt that strategically, for demographic and microeconomic reasons, you want to have a significant exposure.
Arguably, if emerging market bonds have a premium over OECD bonds, you can ask yourself which ones you want to hold long and which ones you want to short. Perhaps you will want to be short OECD and long emerging market bonds without necessarily being overweight in emerging market bonds because that seems to be a clear kind of value trade in the bond markets.
The second asset class that’s very interesting is currencies: I think everybody agrees that emerging market currency needs to appreciate. But then the question becomes, is the appreciation going to happen in nominal terms, or is it going to happen in real terms?
Valensise: In the last six months, we have seen that when people decide to invest more in Asean [Association of Southeast Asian Nations] – like Indonesia and the Philippines – the markets go out of control as the extra flows move these relatively small markets. These markets began to move faster in Q3/Q4 last year just because a few investors decided to put in a couple of additional hundred million dollars. We learnt that prices will be positively impacted once the ‘big boys’ in the US all of a sudden decide to get into emerging markets. We think pension funds will keep on adding to the asset class, but on a gradual process.
Håkansson: There is a question around the fact that some people – those with a considerable home bias – look at the emerging markets more as a possible opportunity. These are really the guys who go in reluctantly when there’s momentum and get out quickly.
The consequence of that behaviour is that you have an asset class which is high in beta because of this. This may impact the longer-horizon investors who have to report to somebody and who think the volatility is disturbing. They need to be confident about the long-term risk premium.
Funds Europe: Are we seeing a market recovery and what should investors be doing to make the most of it?
Utermann: In some markets, namely the emerging markets, there is no such thing as a recovery. They just grew through the crisis, so we are talking about OECD economies primarily here.
What does it actually mean in terms of our investment approach?
We need to be very cognisant of the fact there might be other bubbles. We are also moving into a world in which it’s clear that debt deflation is not going to happen, and where we are going to move towards more inflation. The central banks have already been talking about deflating the global economy. The very near miss of going into a real collapse of the global financial system encouraged most central banks to review their inflation targets and to review their policy objectives. I’m not necessarily saying it’s going to end up at hyper-inflation, but certainly we’re going to be in a more inflationary environment.
Håkansson: It is also very interesting talking about recovery only now, since 2010 was perhaps one of the strongest years for the world economy I have ever seen. If you add it all together I think it was 4.6% to 4.7% in the end, which is an amazing figure. It was very much the effect of emerging markets continuing to just grow.
We are seeing a recovery now, especially in the US, which is feeding through into our economy, which is in itself going to give another year of very strong performance. The risk at the moment is very much what’s happening with the oil price and on the rise of natural resources, very much coupled with the tension in the Middle East. That’s what could derail these very nice growth figures.
Valensise: Industrial production is going up, real rates are low, capital expenditure is picking up and conditions for an M&A fever are in place because the cost of borrowing is low. You can buy equities for decent multiples – and would be inclined to do so as the private sector is in a decent state, and improving.
On the other hand, the public deficit is an issue and there are many structural problems still unresolved. One way to get rid of the stock of nominal debt is a period of some, but not excessive, inflation. It would be a very positive thing for the developed world because it is the only way in which the stock debt could be reduced in real terms. And, in such a mildly inflationary environment, equities should do very well.
Wilson: From an asset allocation point of view, one of the main concerns is extreme prices at either end of the spectrum; either deflation or high and rising inflation. If you are a plan sponsor, how do you actually plan your allocation accordingly? In this environment, a diversified approach to investments will typically yield optimal returns. Avoid government debt for all but hedging purposes, own commodities due to real demand shock and loose policy, trade developed equities and own emerging markets on a secular basis. Within that context equities are a pretty good place to be.
Utermann: Let me just address the point about the risk of the oil price. I do think it’s a significant risk if the oil price were indeed to stay very high; it would probably throw a big spanner into the global growth works. You would have to bet that the oil price is going to come down sharply because the rulers of a lot of oil-producing countries have less-than-free societies. They are currently under pressure and what they need to do is feed their people.
And how are they going to do that? By getting cash very quickly through the door. As soon as the political tension reduces, the oil price falls from current levels.
Valensise: Every time there has been a revolution or social unrest, these countries began ‘pumping’ oil again as soon as things settled down. It’s the only source of revenue for those populations. It’s very disturbing for the market in the short-term, but I think we will ride out these few months.
De Vijlder: Recovery is often very artificial and we just have to be aware of how artificial everything is when you have central bank balance sheets being boosted, as in the case of the Fed [Federal Reserve] and the ECB [European Central Bank]. On top of that there is the issue of currency management and pegs, for example, like China, which is to an extent artificial in the sense that it leads to the build-up of huge external reserves.
An important question is how much patience the markets have. We seem to be in a situation where markets don’t have enough patience, they want the answers to their questions, like how to tackle budget deficits in the Eurozone, today and not tomorrow, and that’s an important issue when we are considering how this will play out in the coming years.
Håkansson: A lot of the manufacturing capacity in Asia is pretty much used up at the moment, whereas at the same time there is an interest for the United States to keep inflation high to take down the debtors. This raises the question of what the position of the Europeans will be. Will they actually allow slightly higher inflation than has been the case historically? This is a good background for equities.
©2011 funds europe