Banks applaud poor performance

Are portfolio managers satisfied that they have performed well despite having ignored so many higher yielding – albeit higher risk – asset classes? Adam Courtenay explains that it is clients’ investment agendas and a fear of losing money that keeps them from actually making money.

In private banking circles, the terms “performance” or “outperformance” can have many and varied meanings. In light of poor equity markets over the past three years, not losing money over the period is deemed by many to be a success. Making extra money for clients, by re-allocating assets to apparently higher risk asset categories, does not seem to figure in many private bankers’ calculations.

A snap-shot of portfolio managers’ views on the best performing asset classes and funds goes some way to understanding current thinking on client-manager relations. Simply not eroding assets is acceptable, they claim. While they concentrate on capital preservation, the best performing sectors and the best performing underlying funds have been largely bypassed or ignored.

Michael Maslinski, a consultant to European private banks, says portfolios are managed “to cover the largest number of possibilities”.

“For the vast majority of people, preserving value is more important than seeking the highest possible returns,” says Mr Maslinski.

Super conservative

Portfolio managers selecting external funds are, in most cases, unashamedly conservative. Most are highly dismissive about sectors such as Russian equities and emerging markets bonds, despite the fact that these have outperformed most other assets over three years, according to figures prepared for PWM by Standard & Poor’s.

These funds simply do not fit in with traditional portfolio construction. And according to the portfolio managers, they do not match client expectations. In most cases, the wealth managers have aped each other with high loadings of fixed income funds within portfolios – usually around 50 to 70 per cent in the past year), with most of these invested in highly rated sovereign and/or corporate debt.

There are other questions: have the private banks captured just the last year of the European bond boom (8.56 per cent) or the last three years (18.64 per cent)? And have the fixed income funds used been the most appropriate choices for their clients?

Many portfolio managers have simply missed the boat. European emerging market bonds have returned over 60 per cent over the last three years. Emerging market debt as a whole has an averaged annualised return over the past 10 years of 15 per cent, making it the world’s most successful asset class over a decade.

The sector has managed these returns through the 1994 Tequila crisis, the Asia and Russian crashes of 1997 and 1998 and the Argentine debt default scare of 2001. Many funds have benefited from these events, though few portfolio managers have noticed.

Russia has shown it is entitled to more than just “passing star” status, by topping sector tables not just over one year but over three. Yet many managers still consider these markets as no more than fashionable whims.

High performing

John Gatehouse, head of the managed account programme at UBS, says that while Russia and precious metals may have had high performing funds over three years, they are yesterday’s performers. Other sectors are now in the ascendancy, he says.

“The Merrill Lynch Gold fund may have been among the best performing last year, but it would have only been picked by global asset managers which had given an allocation to global metals in their portfolio.

“They had to have an allocation first, and be pertinent to the client’s particular needs,” he says.

Thus it appears that if the fund is not in the original asset allocation remit, or within client mandates, it would never be recommended in the first place.

Clients’ agendas

Of course, a private bank may have positive views on such markets as gold and precious metals or advocate greater exposure to higher yielding European bonds, but these often come up against clients’ own agendas, based on their particular tax, currency and risk profiles.

Lance Peltz, head of manager research at Merrill Lynch Private Bank, says higher yielding bond funds are a classic example where the bank’s own tactical views clashed with client mandates.

“We have been very positive on high yield bonds against corporate bonds, because of the declining risk premium in the economy. High yield has significantly outperformed credit grades over the last six months and we have found some good products,” reveals Mr Peltz.

“But then we hit against the reality of client mandates – they may have specific limitations such as no junk or only credit grade bond funds. Tactically it’s an area we have been positive on, but in the end it comes down to individual clients’ mandates and restrictions.”

UBS has its own set of investment criteria based on asset allocation restrictions. First, it finds the required allocations and then populates these regions with the best performing and most appropriate funds.

Areas seen as “higher risk”, such as emerging markets debt, are either tiny subsidiaries of allocation fields or rarely even considered. It is a big enough step to move out of higher rated bonds into equities, let alone into Russian equities and global emerging market debt, argues Mr Gatehouse.

“These are what we would term low credit risk bond funds – they’re verging on junk bond status – that’s not a big step away from equities in terms of risk,” he says.

Merrill’s Mr Peltz says that even if a client’s mandates allow exposure to emerging markets – and Russia within that – the best performing fund may not be the obvious choice. “A particular fund may pop up as a top performer over X number of years but we would not confuse that with a good fund – as we would compare that to a manager in its peer group in the same space.

“If we were bullish going forwards – if we liked that region – we would then compare the managers like for like and then try to choose the best fund to capture exposure where appropriate for that client.”

Guy Paterson, a portfolio manager at Unigestion, says the main focus of fund selection is on clients’ “volatility tolerance”. “However good you are at tactical issues such as picking managers, if you have the wrong asset allocation it will end in tears,” he says.

‘However good you are at tactical issues, if you have the wrong asset allocation it will end in tears’

Guy Paterson, Unigestion

“Buying a high performing Russian fund is a tactical decision – you have to step back and ask what is the key strategic decision – which is how much we allocate to the different asset classes. As a result of that process we tend to be focused on the principal asset classes as a whole rather than the subsidiary classes.

“The critical issue is how much should be exposed to equities in total rather than to, say, Thailand or Malaysia.”

Unlike other managers questioned, Eliza Pepper, head of global manager selection at Citigroup Private Bank in New York, freely admits to raising exposure to areas such as Russia and the riskier debt markets over the period in question. While Citigroup uses much the same criteria for selection as others – formulating asset allocation to regions or markets and then selecting the funds – the company appears to have made significant investments into the top performing areas such as higher yield and emerging market debt, as well as regions such as Russia. However, she would not be drawn on which funds she selected.

Emerging high

A neutral weighting in higher yielding debt in both developed and emerging markets would have been around 4 to 5 per cent, she says, but it reached an apex of 7.5 per cent around six months ago.

“Now we are at the point of cutting back on emerging markets debt – there were huge inflows of capital into the asset class and because of that a lot of compression of the yields. There was too much demand and prices ran up incredibly fast,” says Ms Pepper.

Like many others, UBS also had a strong element in fixed income, but is generally in “harvesting mode”. Areas such as European and Latin American sovereign debt have been good performers over the periods, but the focus has shifted to picking good valued European equities, as well as hedge funds focused on “event driven” strategies.

From Russia with profits – via telecoms and internet

‘Russia benefited from the weakness in the technology sector in the west’

Steffen Gruschka, DWS

As the best performing market over both one and three years according to Standard & Poor’s, Russia has gone some way to proving it has more sustainable investment potential than many other previous “star” markets.

Among the funds to have benefited is the Luxembourg-domiciled DWS Russia fund, run by Frankfurt-based Steffen Gruschka, which has registered a 40.6 per cent return over 12 months to the end of June.

The fund benefited primarily from the cheapness of telecom and Internet related stocks, as well as the utilities sector, previously decimated by the 1998 crash. “In the West, mobile phone penetration became saturated. This was not the case in Russia, where penetration was still very low in 2000,” says Mr Gruschka.

Much of the old equipment now redundant in the West was virtually given away for free at the time. The Russian market did not need the latest generations of technology to build networks.

“Russia benefited from the weakness in the technology sector in the west,” he says. DWS invested in two of the major local providers, MTS and Vimtelcom, as well as an Internet stock, Golden Telecom.

One major preoccupation has been limited liquidity of many domestic shares. In a falling market, some of the companies bought have less than E1m of shares sold exited quickly, or may never be exited at all.

The fund has invested in Transneft, a state regulated monopoly pipeline builder. Yet even at the current price of $400 (e357)– there are just $600m in shares trading – it stands on a P/E ratio of under three. “Transneft aims to double export capacity by building new pipelines. It is both cheap and a growth story,” says Mr Grushka.

Another is Norilsk Nickel, which has cornered the palladium market. Car makers relying on the more expensive platinum are warming to palladium as a substitute for their catalytic converters. Norilsk Nickel has recently bought a US company to boost distribution there.

Mr Gruschka puts the the market’s reputation for corruption and mismanagement into perspective: “These days, who can you trust?” he asks. “You also need to be cautious with American and Dutch companies and their accounting methods.”

Tables 1 and 2 show the best performing offshore sectors over one and three years to July 1, 2003. Only sectors with at least five funds over the time period are included. Sectors with similar investment objectives have been combined. Table 3 features the top five funds in each of the best performing sectors over 1 year. Figures (% change) are calculated bid-bid, with gross income re-invested in euros. Fund sizes are expressed in millions of euros and are the latest available to Standard & Poor’s at the time of calculation.

‘For the vast majority of people, preserving value

is more important than seeking the highest possible returns’
Michael Maslinski, private banking consultant