Balancing risk and reward

In this highly uncertain macro-economic environment, dominated by the eurozone debt crisis, the Holy Grail of wealth preservation and portfolio diversification has become particularly challenging to achieve.

Market volatility is expected to remain extremely high over coming months, correlation between asset classes’ returns is increasing and the concept of ‘safe haven’ investment has been called into question.

The priority is to protect investors’ portfolios from downside risk but also to try and take advantage of opportunities as they arise, often through a dynamic asset allocation process with no hesitation to scale down exposure to risky assets to a very low level. At UBP Private Banking, asset allocation to hedge funds has decreased to 10 per cent from the historical heights of 30 per cent, explains the bank’s chief investment officer Alan Mudie.

“We do believe that, by controlling risk-to-capital losses when markets are difficult, we preserve the possibility to move back into the markets and take large allocations when we see more opportunity,” he says.

By losing much less when the markets are tough, rather than making more money when markets are good, portfolios tend to outperform, says Mr Mudie. It is only human for risk aversion to rise as markets begin to fall and decrease as markets start to rise. “We tend to build portfolios in a way that avoids the discomfort clients can feel, when faced with sharply negative returns.”

This means also having to reduce exposure to illiquid strategies, although they have much higher potential returns. “The aversion to risk is currently very high,” says Mr Mudie. “Investors have brought down enormously their investment time horizons and are willing to lock-in a capital loss to have that liquidity offered by instruments such as very short term deposits.”

The converse is that there is a high degree of premium and pick-up in return potential for being willing to accept liquidity risk and to lock money in to strategies for a longer term horizon. These include hedge fund strategies, in particular those linked to securitised loans.

But taking liquidity risk is not the path Mr Mudie recommends. Portfolios at the Swiss private bank are pretty defensively positioned. The largest allocations, up to 25 per cent, depending on risk profile, are in non-financial short-dated high quality corporate bonds.

GOLD RUSH CONTINUES

Another major allocation is in gold, which for a balanced profile in an unconstrained portfolio is recommended to be 25 per cent. This is well above the typical 5 to 8 per cent allocation private banks recommend clients should have to this commodity, typically viewed as a hedge against inflation.

“We view gold as a core position, which we manage actively through the traded options market and, depending on the outlook and strategy, the writing of calls against our position. This provides a level of income which gold itself does not produce,” he says. Special accounts, forward contracts and, to a certain extent physically-backed gold ETFs, are the vehicles used to gain exposure to gold.

“Gold has a number of characteristics as a store of value, against the depreciation of currencies. It will ensure preservation of purchasing power and preservation of capital, given the very difficult outlook for the global economy and the systemic risk we see in financial markets.”

Demand for gold is outstripping supply and will drive the price of the commodity to reach new heights in dollar terms of over $2,000 (€1,560) per ounce this year, predicts Mr Mudie. This compares to the $1,650 as of mid January, having bounced back from a 10 per cent decline in December. Because of price volatility, investors who consider risk as being equivalent to volatility, will view it as a risky asset, he says. “But we think that risk for investors is the risk of capital loss and rather we try to take advantage of short-term volatility through option strategies.”

Lower quality or high yield bonds represent up to 8 per cent of assets in private portfolios at UBP. Looking at the implied default anticipation in today’s yield, the market is expecting on average around 10 per cent of the universe of high yield bonds to default on their payment of coupon and capital, each year for the next five years. Rating agencies such as Moody’s and S&P predict for 2012 around 2 to 2.5 per cent default in that market, he explains.

“With a pick of, depending on the currency, between 750 and 950 basis points over government bonds, there is a high degree of protection afforded by the high level of current income, and an overly pessimistic view as to the risk of default over the coming five years,” says Mr Mudie.

“Extremely high quality companies,” which have strong balance sheets and are also paying substantial dividends, are used as the “bedrock” of the allocation to equities, he says.

Focus on quality is also the main theme at Société Générale Private Banking. “Corporate bonds are our favoured asset class, with a preference for the US market, including the high yield segment,” explains Xavier Denis, chief economist at the French institution.

“The liquidity conditions and the growth environment look fundamentally better in the US than in Europe and investor demand is expected to remain sustainable over time,” he says, adding that Asia is also appealing, with energy and utilities firms of particular interest.

On the equity side, the preference is for firms with solid balance sheets or low leverage, large exposure to growth and low cyclicality. Since mid year 2011, the bank has reduced exposure to developed market equities, but some good quality companies headquartered in Europe still offer excellent opportunities, such as brands in the luxury goods sector, which are exposed to the growth potential of emerging markets, from which they source an increasing share of their turnover, explains Mr Denis.

ROLLERCOASTER RIDE

Continuing the trend started at the beginning of this decade, stockmarkets will be characterised by ups and downs. “We do not see any kind of secular rally in the coming years, or a repetition of what we have seen in the 80s or 90s,” he says. Corporate margins, which are high, are more likely to shrink, as fiscal retrenchment will impact after-tax earnings. Higher inflation is not good news for corporate profits, either.

“All these factors may drag down expected returns from equities on the longer term,” predicts Mr Denis. “In the short term, we may see a rebound of emerging market equities, supported by monetary and fiscal policies. In 2011, emerging market stocks have been disappointing, but in 2012 should be brighter.”

Diversification of currencies is also a big theme, says Mr Denis. Asian currencies have potential for appreciation against the US dollar or the euro, but any massive return of risk aversion will have a negative impact on emerging market currencies. “Euro-based investors should not invest massively in emerging market currencies, apart from Asian currencies, because they will bring a lot of volatility to portfolios. It is a good idea, instead, to look at neighbour currencies, such as the Swedish, Norwegian or Danish krona, or Swiss franc.”

The world currencies most likely to lose ground over the next five years are the US dollar and the euro, argues Jerome Booth, head of research at Ashmore. To reduce currency risk, he advises clients to move out of those currencies into emerging market currencies.

“One of the safest asset classes is cash in a diversified portfolio of currencies which are likely to appreciate, and which have huge central bank reserves. That’s emerging market local currency debt. It is a very large, $9,000bn (€7,000bn) market, and massively liquid. It is basically the T-bill from all these different countries, and you get great diversification.”

Considering the purchasing power, emerging currencies are not volatile: they have a natural appreciation pressure and represent the best insurance policy in the world, he says.

“Risk is different to volatility. The risk we most care about is large permanent capital loss, not volatility in the short term, which I see as an opportunity to buy more at a bit cheaper.”

Investing in a fund of 35 different emerging market countries brings much more diversification than any developed market product, as emerging market economies are very diverse, compared to the developed world which is much more similar to itself.

A DIFFERENT WORLD

Going back 15 years, the main reason why emerging market currencies moved as one was because they had one common factor. There was the possibility that if a country got cut off from external capital it would default and then a contagion effect to others would follow. But that condition does not apply anymore, because these countries are better managed and they are net creditors, says Mr Booth.

“The idea that emerging markets are a homogenous block doesn’t fit the reality. If the emerging markets come off a lot, it is almost certainly due to behaviour of investors, who are victims of fashion, and nothing to do with fundamentals.”

Investors should focus first on emerging currencies and debt, which are safer, but emerging market equities are expected to “massively outperform” developed world equity over the next three to five years. “In the next 12 months, there is probably going to be a big rally, as there is a huge amount of value,” he adds, explaining that 90 per cent of his own personal wealth is invested in emerging markets, as he wants to preserve his capital from any big tail risk coming from the West.

Beware safety in numbers

Extreme events such as the Lehman collapse or the European debt crisis have generated in people a very strong awareness of the potential downside in financial markets and have led investors to rush to so-called ‘safe havens’, such as the Swiss franc or gold.

The risk is that some safe havens may become too popular or too overbought, says Michael O’Sullivan, head of portfolio strategy and thematic research at Credit Suisse. “We are trying to emphasise positioning and valuation risks to clients, so for example we stressed caution when gold reached $1900/2000 per ounce, and sound the alarm on German bonds when their yield is being compressed down.”

The search is for new safe investments which Credit Suisse has identified in large international companies, based in the US or Europe, but not in emerging markets, which have very strong balance sheets and produce sustainable dividends. These stocks – which provide a slightly higher than corporate bond level of returns on the medium term – are increasingly drawing investors’ attention. They can be seen as one of the “emerging safe havens”, he says.

Talks about “what if” scenarios are also increasingly popular with high net worth investors. “We are trying to identify the tail risks, if we can possibly do so, by tailoring around the edges of a portfolio, and providing clients with the right instruments which can be possible hedges against extreme events.”

Key hedges are today options around the euro, against the break-up of the eurozone or ‘out of the money call’ options on oil, to protect the portfolio against political instability in the Middle East.

Short-term strategies which extract value from high levels of implied volatility are attractive, but investors having a longer-term view are increasingly paying attention to Credit Suisse research on investment megatrends, he says. This focuses on three distinct, yet interrelated, pillars: rapidly changing demographics, the need for sustainability and the increasing emergence of a multipolar world, which is manifesting itself in the expectation that emerging markets will be contributing three quarters of global growth by 2015.