Identifying stable returns

As the worst of the storm appears to have passed, wealth managers are carefully positioning themselves to benefit from investors’ increased interest to listening to advice on investment solutions and portfolio construction.

“While 18 months ago investors were not concerned about holding a lot of cash giving negligible returns, today they realise this is not acceptable,” says Nick Tucker, market leader for the UK and Ireland at Merrill Lynch Global Wealth Management. “I wouldn’t say people have huge optimism but they realise the world is not going to end. They appreciate they have too much cash in their portfolio, they want to do something about it, but they are nervous and are looking for leadership.”

Conversations with clients are much deeper, as they are rightly asking more questions about investments and the risk involved, he says, emphasising that across the whole industry a firm needs to provide its advisers with a significant growth of tools and upgrade the quality of advisers aggressively, as the technical competence of practitioners has to be a lot higher. While the major lesson learned from the downturn at the beginning of the century was diversification, what the recent crisis taught everyone was that liquidity and transparency matter, says Mr Tucker.

“We are spending all our time with clients on how to construct portfolios, to understand what they are trying to achieve, what their time horizons are and what money means to them. But we are looking at products that can be as transparent and liquid as possible.”

An example would be in the hedge fund arena, where Ucits III structures have drawn wealthy investors’ attention away from offshore hedge funds which can potentially have lock up periods for up to 12 months. “These Ucits III hedge funds may be giving up some returns or reducing some of the flexibility that offshore hedge funds are allowed, but clients are prepared to accept that, because they want to be sure of that liquidity,” adds Mr Tucker. In particular, the old style aggressive investors have significantly lowered their expectations and are prepared to accept lower returns for greater consistency and liquidity, he says, adding that high leverage is also off the table for those types of clients.

Enhancing stability

Some clear trends are emerging in the Nordic countries, where the traditionally equity-focused investors are moving towards a multi-asset type of portfolio to a greater extent, explains Hans Peterson, head of investment strategy at SEB Wealth Management. “Clients are less inclined to take risks and we are using all the possible sources of return available to enhance stability in a portfolio and generate growth even in tricky markets.” To build a multi-asset portfolio where alpha sources are not correlated, it is important to focus on what drives the performance of each investment and not so much on historical correlation or historical returns, he says.

Over the next 12 to 24 months, portfolio returns will be mainly driven by sectors sensitive to the business cycle, these may be generated by equities, private equity and to some extent commodities, he believes. “In equity investing we use a bar bell strategy, as we acknowledge that while developed economies in the world are moving at a much slower pace, some emerging markets are showing rapid growth rates,” says Mr Peterson.

“Therefore, on one side we focus quite a lot on slightly defensive stocks such as pharmaceutical or biotech, which offer stable growth with high dividends, and on the other hand on sectors that are exposed to increased demand for industrial production and infrastructure investments, in many cases linked to the growth in emerging markets. On average, we have an exposure to emerging markets which is at least double that of the MSCI world index, although that depends on the portfolio strategy,” he explains.

The way clients’ portfolios are constructed take into account that the economic cycle is still very fragile, as there is the fear of a double dip scenario in which economies might tumble again, if central banks increase interest rates too strongly or too quickly, believes Markus Taubert, head of private banking at Berenberg Bank, Germany’s oldest private bank. “The majority of our clients have a strong exposure to bonds, but that is a difficult class to get earnings and we recommend shorter duration in the three to four year range,” he says, explaining that expected tightening of monetary policy from central banks is going to lead to a slight to moderate increase in interest rates. Corporate bonds are not as attractive as a year ago but it is worth adding some defensive selected companies, he says.

Planning for inflation

The looming inflation risk needs also to be taken into account. “The year 2011 will bring high inflation and CPI [consumer price index] numbers for the industrialised countries, and we tend to hedge our clients portfolios against inflation fears through inflation-linked bonds.” Mr Taubert says that for the past 15 months they have been strong investors in precious metals, gold but also silver. “We believe that investor demand for precious metals is not over yet,” he adds, explaining that as gold has historically proved to be a good hedge against inflation, it will have its role in clients’ portfolios once inflation picks up.

“One thing for sure is that volatility will come back,” says Mr Taubert. That brings opportunities too if money is managed opportunistically. “Our main focus is to be a very active manager, and change asset allocation very intensively; we strongly believe that private investors can make money out of this way of managing money. In general we are very diversified across the portfolio, not only across the asset classes, but also within each asset class,” says Mr Taubert, echoing his colleagues.

Also advocating the importance of an investment philosophy relying on simplicity and transparency is Dr Christian Raubach, co-head asset management division at Zurich-based Wegelin & Co. Privatebankiers. “What is back in fashion is the good, old, boring balanced mandate of bonds and stocks, which we manage adding a tactical overlay.”

The Swiss bank has always been very conservative with regards to portfolios construction, he explains, bucking that trend which has seen portfolios of investors become increasingly full of opaque products, such as triple barrier reverse convertibles or structures products.

The bank’s active indexing global equity investment strategy, which was launched eight years ago for institutional customers, has also met the interest of the bank’s high net worth individual clients. In contrast to traditional single stock picking, this investment strategy selects individual country and global sector indices and dynamically weights them, based on their relative attractiveness and outperformance potential. This has the additional benefit of being an actively managed investment that uses a highly diversified portfolio - indirectly holding 500-800 stocks via the indices - which is more commonly associated with passive investing, explains Dr Raubach.

Many years ago, Wegelin also launched a balanced product designed for private clients, which follows the same investment concept of using highly diversified passive index products. Various types of index products are used, with exchange traded funds (ETFs) becoming increasingly more attractive as building blocks, due to their flexibility and ever expanding asset class coverage. “For private investors ETFs have become the new world of indices. If I launched this product now I would call it active ETF rotation,” he says.

Now with the growth in popularity of passive instruments, there is a clear trend for private banks to offer this kind of value added products, where wealth managers provide allocation amongst the different ETFs or offer an ETF selection programme. Credit Swisse for example has created an entire product range using this philosophy.

Wegelin embraced the passive way of investing a long time ago and it was also able to adjust the value added it provide to clients earlier than other competitors. But for other banks, which are not ready to face this drop in revenue coming from private investors increasingly asking for ETFs, it may be very tough, predicts Dr Raubach.

Stress testing

At London-based multi-family office Stonehage, wealthy clients’ portfolios are also built on the ground of a “back to basics philosophy”, which privileges transparency, liquidity and asset protection, and involves a lot of stress testing, explains Ronnie Armist, head of the advisory unit at the firm.

A typical model portfolio has a rather cautious asset allocation, where fixed income represents around 30 per cent, states Mr Armist. Exposure to equities, which ranges between 25 to 30 per cent, is gained mainly through direct investments in very liquid, blue chip stocks, which tend to give good dividend yield and also offer good exposure to emerging markets, from which more and more of them source a large percentage of their revenue. Alternative investments, primarily in risk-averse single manager hedge funds, which are selected in-house, account for around 25 per cent of portfolios. “If, say, 10 to 15 per cent of the portfolio is generating “cash like” returns of about 1 per cent, asset classes like equities and alternatives and to a lesser degree fixed income, have to do well in order to generate overall portfolio returns of high single digits this year, which would be a very decent return,” he says.

In the debtor-in-possession financing space, investors can benefit from expected annual returns of 10-12 per cent, by investing in the lenders who are prepared to give credit to companies that are going to file for Chapter 11 bankruptcy. Returns on investment for these lenders, who enjoy strong protection from the US Government, shot up to the high teens during the credit crisis but now these returns are around 10-12 per cent.

In the fixed income space, emerging debt in local currency is very attractive, believes Jean-Marie Mercadal, head of multimanagement and deputy CEO at French firm Ofi Asset Management. “Local currencies are undervalued, so in addition to the yield, the investor will benefit from currency appreciation. This is true in particular for the RMB in China, Real in Brazil and Rupee in India,” he says.

Equity returns will be driven by corporate earnings, which are expected to increase by 20-25 per cent, and markets will be volatile but will return between 15 and 20 per cent this year, he predicts. “In the short-term we are cautious on emerging markets, but China, Taiwan, maybe Brazil will be good bargains within the next four to eight weeks,” he believes. In major markets, the focus is on growth, large caps stocks in “old fashion” sectors such as utilities, healthcare and retail sales, as the cyclical sectors are a bit overstretched in the short-term.

“This year, most of the performance will come from stock picking, whereas last year, which was the year of recovery, came mainly from sector picking,” adds Mr Mercadal.

While Ofi invests directly in European companies, it also has a substantial multi-manager range. “The aim today is to choose real stock-pickers, we select managers who don’t follow the benchmark but focus on the growth potential of each individual equity in the portfolio.” Recent appointments of US-based managers reflect this, he says.

In the alternative area, where Mr Mercadal welcomes the new developments in the Ucits III space, long-short is the strategy that will deliver good returns this year, because of this emphasis on stock-picking, he says.

The French firm has increased the usage of exchange traded funds over the past couple of years to gain short-term, tactical exposure in the long only equity space, in satellite areas such as mining or some emerging markets. “We are expecting volatile markets going forward, so probably we will use ETFs more,” he says, explaining that he is also exploring the possibility of using hedge funds ETFs.