New found freedom with total returns

Today’s “hippo” market – unpredictable and dangerous, happy to wallow around, yet ready to charge off in any direction without warning – makes proper diversification of assets particularly important. It has led to the rise of the asset allocator. This new breed of distributor can take on the onerous tasks of tracking investment performance of various classes, regions and markets and allocating between them in both a strategic and tactical fashion.

Major distributors around Europe are increasingly offering a tactical asset allocation product to their clients – more often than not based around a total return philosophy. The distributors argue they are perfectly placed to take advantage of current markets and that they can manage risk, yet create returns better than the individual or his adviser. This is due to the depth of these banks’ research resources, their geographical reach and access to diverse asset classes and managers.

The types of assets distributors are looking at have extended from equities, bonds and cash to include a more catholic range of options. Many distributors are turning towards alternative sources of alpha, and in some cases beta, investing in hedge funds, private equity, commodities, property and products such as exchange traded funds (ETFs) collateralised debt obligations (CDOs), swaps, derivatives and the like.

Depth and scope

The availability of these types of products, especially ETFs, has transformed the depth and scope of propositions that distributors offering asset allocation services can bring to the party. They have added liquidity to a market, allowing fund managers to store excess cash, or follow short-term investment trends for a few months, or even weeks and days.

Freedom to trade ETFs as frequently as required, without penalty charges, and their linkage to many countries and sectors, means asset allocators can easily make bets in most markets that can reflect their tactical view of the world. Hence ETFs allow asset allocators to hedge against the main indices and offer exposure to elements of certain sectors without the manager having to make active stock selections. The fact that clients do not know when to get in and out of markets and sectors has seen many distributors offering a product to facilitate this.

“Traditional balanced funds – split as they are between equities, bonds and cash – have too little scope and cannot provide protection from risk, or enhancement of returns,” says Danne Potjer, head of asset allocation for ABN Amro Asset Management in Amsterdam. “We are now looking at a greater range of options.”

ABN Amro Asset Management manages a range of balanced funds with a tactical asset allocation overlay and the objective of providing total returns. The overlay is based upon choice of asset class, region and style.

The range of new investment choices includes commodities, indirect real estate (in the form of real esate investment trusts), high-yield bonds and allocations to as many asset classes that are uncorrelated to one another’s returns cycles as possible.

Regulation implications

With the adoption of Ucits III regulations, ABN Amro’s products will use futures to replicate an index and ETFs to get in and out of a large range of regions and sectors.

When Mr Potjer and his team look at indices and investment style, they will play a short-term game, sometimes tactically switching overnight. Although the group’s mutual funds will be the primary investment vehicle, the asset allocation team sources ideas from across ABN Amro’s business. “The good thing about tactical asset allocation is that you are never stuck in one area,” says Mr Potjer.

But the ABN Amro game has not yet expanded to embrace hedge funds. “We make our money out of exploiting betas – by their nature, hedge funds are uncorrelated to betas,” says Mr Potjer. “What we do have in common though is that we are looking to offer our clients total returns, come rain or shine, which is the same as hedge funds.”

Halfway house

It can indeed be argued that tactical asset allocation products are a halfway house between mainstream balanced managed funds, measured in terms of relative performance, and hedge funds. Although a tactical asset allocation product belongs to the traditional market, it has the total return philosophy of hedge funds.

But using the process of asset allocation as both business driver and product source in a top-down manner is by no means the sole mode of operation. Roberto Scippia, director of Banca Mediolanum in Milan explains a more basic, popular investment model. “Our basic building block is limiting risk when dealing with a client’s asset allocation”, says Mr Scippia, whose bank uses the same asset allocation strategy across its distribution outlets in Italy, Germany and Spain.

“When we decide a line of investment we will not change, even if the markets move. We find sticking with our convictions helps retain clients in all of our markets,” says Mr Scippia.

Increasingly, the asset allocation decision is becoming the centrepiece of the investment process at many cross-border European groups, and it is being viewed as much more than just the split between equities and bonds of five or 10 years ago.

A good example is Société Généralé Asset Management (SGAM) in Paris, which breaks down each of the asset class decisions into sub-sectors covering, for example, on the equity side, capitalisation on both a regional and a single country basis. SGAM also

considers equity investment styles such as growth, value, blend or momentum and tries to allocate assets into the stage of the business cycle they consider themselves in. The same investigations are made into fixed interest, where the relative merits of credit against non-credit are discussed, along with how to allocate between yield and duration.

“We have a centralised process, where we actively allocate between asset classes and then within those assets themselves,” explains Jean-François Hirschel, head of marketing for SGAM. “We hope to give global exposure to markets, but base this upon local knowledge from our regional offices. It is the duty of an asset manager to advise clients on their asset allocation and we do this on a strategic or tactical basis.”

Although groups such as SGAM and Mediolanum are reluctant to embrace the use of derivatives in the same way as ABN Ambro, there is increasing demand from the distribution market for both new tools to create alpha and to limit the systemic risk of portfolios and multi-asset products.

Using derivatives

Ucits III allows fund managers to use derivatives in number of ways, including mimicking an index or synthetically shorting stocks and markets. Derivatives can also be used to hedge against an index and limit the overall risk in a portfolio, creating a safety net to protect a fund’s capital should an index fall.

French house BNP Paribas Asset Management (BNP PAM), which already allocates 15 per cent of its tactical asset allocation products to alternative investments, plans to develop an asset allocation product based on derivative overlay and futures, says Christophe Belhomme, head of asset allocation portfolios for BNP PAM in Paris.

BNP PAM already uses ETFs to buy into themes such as energy, while using its Fauchier Partners subsidiary for alternative allocations and currency research from its Oam unit.

The data is aggregated for use within the firm’s flagship Parvest range of open-ended Luxembourg-based Sicav funds. “Parvest is a representation of our asset allocation decisions and once hedged for currency, is distributed from Hong Kong to Helsinki,” says Mr Belhomme.

But this one size fits all scenario has not been adopted by distributors across the board. Some, particularly the private banks dealing with higher net worth clients, take a more tailored approach to asset allocation. “Asset allocation should be like going into a tailor and being measured for a suit,” says Thomas Schmidt, head of private banking for Coutts & Co in Geneva. “Although we have one central structured process, it is amended to fit a discretionary client’s individual risk and return profile,”

Coutts profiles clients on a risk and return basis and has more than 150 asset allocation profiles for its clients. They are a cautious investor, and Mr Schmidt says that they are reluctant to play too many themes.

Despite this, Coutts’ private clients enjoy a 23 per cent allocation to hedge funds, through the bank’s fund of funds strategy, although there can be different views on the suitability of different assets, depending on the investor’s country of origin. “Swiss and European investors seem to be much more conservative regarding asset allocation than American or British clients,” reveals Mr Schmidt.

A preference for fixed interest assets in Europe can also work to the detriment of conservative investors, although the view on whether bonds are suitable for asset allocation in the current investment climate varies between investment houses. Mr Schmidt of Coutts believes: “It is increasingly difficult to create alpha from fixed interest if you have a broad benchmark, and in allocation strategies it is more about avoiding losses on fixed interest, and making money in equities.”

However, Mr Hirschel says that SGAM actively allocate in fixed interest: “You can add alpha from an active fixed interest strategy – and bonds, whether they are gilts, corporate or inflation-linked – are not just investment ballast.”