Looking to the future

At a time of global financial crisis and economic downturn, the temptation for investors to shorten drastically their investment horizons is strong; but a consistent and diversified portfolio, focussing on long-term investment themes, some of which have just recently emerged, can generate interesting returns. “Having to deal with the financial crisis in the short-term does not change the fact that certain themes, trends or developments which are of long-term nature are still valid,” says Maria Lamas, head of financial products and investment advisory at Credit Suisse’s private banking arm in Switzerland. “Investors are very ready to understand this and they are also ready to accept the fact that new investment opportunities are actually arising.” Changing demographics One of the major global trends is demographic developments, says Ms Lamas. “In the world, there are increasingly more people, more consumers who live longer too, because of technological and medical advances. They are fighting for fewer resources and that creates massive imbalances. This is one of the biggest challenges that humanity is facing, beyond the financial crisis, and that’s where the potential lies in terms of investment opportunities.” While the population of the developed world is getting older and shrinking, emerging market countries are producing a mass of new consumers, who are gaining relevance at the expense of US consumers. Investing in those companies which are adapting their business model to this new scenario, for example by tapping heavily into the markets of the new consumers, is a good bet, says Ms Lamas. Similarly, the negative effects of global warming are not going to decrease because we are living through a financial crisis, says Ms Lamas. There will still be scarcity of water, scarcity of agricultural produce and there is still the need to invest in alternative energy. Another long-term story which is generating positive returns, even in this adverse environment, is micro-finance. The performance of micro finance institutions which give credits, generally worth $10-$15 (E7.8-E11.7), to the poorest individuals in the world is generally uncorrelated with the financial markets. Typically, it is a woman who asks for a micro credit and she is not dependent on stock-markets, but just on the cow that will give her some milk, explains Ms Lamas. “These individuals have better repaying morals than the rest of the world and 98 or 99 per cent of those credits get repaid.” Another example is infrastructure because “half of the world needs to be built and half of the world needs to be renovated,” says Ms Lamas. All these investment ideas can form the underlying themes of a variety of asset classes. “Investors can buy a long only equity mutual fund or they can invest in a structured product with a full or partial capital protection, if they believe in the long term story but they want some assurance in terms of exposure, because they believe that markets could still move downwards,” she says. There are also hedge funds or funds of hedge funds that play with these themes quite nicely, adds Ms Lamas. But timing is another matter. “We would have to sit down with the clients and make a clear analysis of the investor’s portfolio; that’s exactly what we are doing right now,” she says. “We have full understanding for clients who think there is no need to rush, because they have already an exposure to those themes or think that it is too early. But there might be clients that have no exposure whatsoever to those long-term themes and there, maybe, it’s time to start investing in these themes, very slowly,” explains Ms Lamas. “Most of our clients still have a sensible asset allocation but with a much higher cash portion than usual. Most clients would tell you now ‘I would rather miss a few percents on the up than take some more on the down,’” she says. Growth stories are emerging across most industries, according to Burkhard Varnholt, chief investment officer at Bank Sarasin & Co in Basel, Switzerland. “Some unusual companies, which a year ago would have been disregarded, look suddenly very strong,” he says. “We live in an era of capital rationing. Any firm which is more financially autonomous and has a good business model, and which is possibly even net cash positive, is likely to emerge relatively stronger from this crisis and see valuations appreciate. “We do a lot of analysis in-house and all our investment processes are around such themes,” says Mr Varnholt, explaining that Sarasin’s portfolios have moved towards investing in those sorts of companies and funds such as the Sarasin global balanced flagship has benefited from it and assets are flowing in. “We always try and apply our sustainable investment approach,” he says. The comprehensive term sustainable in this moment of crisis definitely refers to “the financial stamina that a company needs to have to weather the storm; if it doesn’t have it, its business model is unlikely to be sustainable,” he says. “That’s why for example, in our sustainable bond funds we never invested in bonds issued by investment banks. With five or six per cent equity to debt ratio, the financial stamina can evaporate very quickly in an environment like this.” Looking ahead, Mr Varnholt says: “What we are seeing today is an extraordinary flight to cash, but people will ultimately be disappointed. Cash looks like the ultimate asset of choice to everyone at this point, but in a year’s time it is much more likely to be an asset class out of favour,” he says. All these government policies will have an inflationary impact and therefore erode the value of cash. People will want to invest more assets into real assets. “I think a very conservative selection of well-run individual stocks is likely to be a good hedge against what we are currently seeing as the perfect storm, particularly in the money and fixed income markets.” Continuing demand for commodities This crisis could prolong the secular bull market in commodities, according to Yves Bonzon, chief investment officer at Pictet &Cie Private Bank in Switzerland. When the growth of China, India, and other emerging markets giants started to accelerate at the beginning of this decade, bottlenecks and shortages across a wide range of commodities started to emerge driving the commodity bull market. But commodities would have not boomed the way they did, had the US Federal Reserve not started cutting interest rates in September last year, and they would have not consequently crashed so badly in the last 6 months due to the global recession, he says. “Investment in additional capacities would have continued or even accelerated. But because of this crash in commodity prices, capital expenditure, research and development will be significantly cut,” says Mr Bonzon. “But one day this credit crisis will be over, developed economies will go back to slightly positive growth and emerging economies are highly likely to continue on their strong growth path during the next decade. So the demand for commodities will be there. “This crisis could lead to a longer cycle and more extreme prices of industrial commodities in the world,” he says. Investments in producers of industrial commodities are a good long-term opportunity, he says, whereas direct investment in precious metals is to be favoured. Mr Bonzon recommends, tactically, an exposure to gold of around 5 per cent to private investors. “The world has entered a secular bear market in 2000; in addition to the credit crisis there are profound structural issues that are affecting the economy. This drives us to do quite a bit of tactical asset allocation on riskier assets, such as equities, shift the focus from equity to credit and, in general, not to stick dogmatically to a strategic asset allocation,” says Mr Bonzon. “Tactical asset allocation has a very high value added potential in this environment, while it has almost none in a secular bull market” he says. In addition to cash, “which is probably safe again as systemic risk has been substantially mitigated by government intervention,” investors’ portfolios should include medium-term government bonds, denominated in the currency of the investors’ own market. “We strongly believe that not only interest rates will be cut further, but they are going to stay low for much longer than the market expects,” says Mr Bonzon. Liquity remains key Credit exposure, ranging from corporate bonds, high yield bonds to all assets that are related to grade risk premium in the traditional space, is also recommended. Twenty to twenty five per cent of a portfolio’s assets, depending on the investor’s investment horizons and risk profile, should be invested in blue chip companies. “You can find prime quality companies nowadays, large-cap blue chips trading at book value with dividend yield in the 5-6 per cent. We do not expect huge capital appreciation potential over the next five years, but we do think they are going to be good investments. Liquidity is a key characteristic that will remain extremely valuable for investors.” Alternative investments, such as diversified multi-strategy hedge funds, should represent around twenty per cent of a portfolio’s assets. “There is such an amazing dislocation in financial markets, that for those good quality players that will survive this crisis, there will be many attractive opportunities in several areas to take advantage from,” he says. There is no doubt that the future looks rather bleak. Economic growth will be negative, corporate profits will fall 30 or 40 per cent, unemployment will rise and house prices will fall just about anywhere in the developed world, says Richard Urwin, head of asset allocation and economics at BlackRock. “There is a very strong consensus view that the world is going to be an extremely difficult place, but a lot of this bas news is already priced in,” he says. For example, in terms of the expected default rate, investment grade credit is arguably priced for depression rather than recession, says Mr Urwin. “Some very attractive opportunities potentially have emerged in the credit universe as a result of the substantial spread widening that we have seen over the past few weeks.” These evolving themes are evident in both developed and emerging markets, he says. “An increasingly prominent theme in BlackRock’s portfolios is to have exposure to companies which have strong franchises, which have strong balance sheets and companies which are best able to withstand the cyclical slowdown,” says Mr Urwin, echoing Mr Varnholt at Sarasin. A firm that has these characteristics is less exposed to the current constraints of the banking system and it has a stronger degree of pricing power and higher ability to maintain sales than those businesses that don’t have them. Even if market conditions will get tougher, it is a good time now for long-term investors to gain exposure to those types of stocks. “The fall in markets that we have had over the past months has pushed valuations to levels which, in the longer terms, have tended to provide more attractive buying opportunities than selling opportunities,” he says.

Adjusting return expectations for the longer term “In a boom market, like the one we have seen from 2003 to 2007, investors get used to very decent double digit returns, and they tend to get greedy,” says Sven-Erik Knoop, head of European third party sales at Deutsche Bank’s asset management arm DWS. “It is always healthy to bring back the risk-return expectations to a more moderate level. In times of pain, investors are much more open to change their behaviour, their expectations and their investment approach.” Consequently, he says, the investment focus will shift towards absolute return strategies. “And those players who have shown they can manage these types of products will benefit from this.” Indeed, market-neutral, alpha generation products are currently the focal point of the DWS distribution machine, explains Mr Knoop. The DWS Alpha family is made of four Luxembourg-domiciled funds. DWS also manages around $24bn (E19bn) in absolute return institutional mandates, of which $8bn is sourced from Europe and the remainder from America and Asia. “Absolute return [strategies] deliver the returns when markets are rational, and they aim for capital preservation during downturns”, says Philippe Holzwarth, product specialist for absolute and total return products at DWS. The DWS alpha opportunity fund, which targets libor +500 basis points, aims for an average yield of 8-9 per cent; this is what a conservative equity portfolio should deliver normally. “The DWS alpha opportunity fund has returned +3 per cent, compared to 30 or 40 per cent down in the equity market, this year,” says Mr Holzwarth. Diversifying a portfolio away from equities in an absolute return type of product helps stabilise the portfolio, he says. “Everybody is worried about what could happen in the next three to six months and investors are moving their money into time deposits. We talk to clients about the alpha opportunity fund; investors will see the difference versus time deposits, when the yield picks up. This is what makes this story the focus of our distribution network,” explains Mr Knoop. Richard Lockwood, head of UK business at Morgan Stanley Investment Management highlights the importance of portfolio diversification and shares a similar view on absolute return strategies. “We don’t know when this crisis is going to stabilise, there is clearly some uncertainty about timing. But the truth is that investors have to look at their long term portfolios and not just think about the here and now.” “A widely diversified asset mix would bring benefits to most portfolios. Strategies that are not correlated with equities and bonds should be well worth,” says Mr Lockwood. “I would argue that absolute return products are an important part of a long-term growth return seeking portfolio.” In the absolute return space, Morgan Stanley offers two daily dealing Luxembourg Ucits III funds, including a pure currency strategy, which is quantitative by nature, and it has recently launched a diversified alpha fund which, as does the currency strategy, uses a value at risk target. The firm offers many other alternative strategies, some of them, such as single strategy hedge funds, are less liquid. “Corporate bond strategies are also a fantastic opportunity, for someone who is prepared to invest for the long term,” says Mr Lockwood. The underlying assumptions are that the default rates on those corporate bonds are extremely high, beyond anything seen before. “One can be paid very well for holding those corporate bonds, so there are great value opportunities to invest within this asset class.” Another good investment opportunity is in secondary markets in private equity, he says. “Investors that hold private equity funds may have to raise liquidity; they will have to try and sell their interests; these can be picked up at very attractive prices.” In the equity space investors should look at classes that have got a track record in operating well in difficult markets, or at some of the more defensive active equity strategies. They should also consider which markets might recover, or those who might recover quicker than others. For example Japan is an interesting opportunity, says Mr Lockwood. Alex Brunton, member of the UK sales team at Morgan Stanley Investment Management notices an increased clients’ interest in defensive strategies, such as the Morgan Stanley American franchise strategy. This fund invests in 20-25 high quality equity stocks in the US markets, which have high quality earnings, high cash flow and intangible assets, such as strong brands and patents. These kinds of stocks will do well over the long term, and they will be very robust in difficult markets. The firm runs a similar defensive strategy in Japan, the Japan advantage strategy, which is also drawing clients’ attention, says Mr Brunton.