Rebalancing for the new world order

A timely review of the product offering, which is always important in meeting client needs and adapting to changing market conditions, is an indispensable exercise for both asset managers and distributors in a new world order generated by the financial crisis. It will undoubtedly emphasise the difference between the trail blazers and the laggards.

Last year, Pimco’s annual secular forum coined the expression “new normal” to address the post-crisis environment. Pimco argued the crisis had been so systemic and severe, and required such an unorthodox response, especially from governments, having shaken the very core society and the financial system, that it was unlikely the world would return to how it had been prior to 2007.

Mohamed El-Erian, Pimco’s CEO, stated last year that the world is “on a very bumpy journey to a fairly stable destination”. This year Mr El-Erian’s report Driving without a spare confirmed the world is on a journey, but the destination may not be as certain, having to negotiate through unfamiliar territory, and having already used its spare tyres.

Humankind is heading into a world that is re-regulated, de-levered, and growing less rapidly in the industrial countries “where concerns about the dark side of globalisation temper enthusiasm for its net benefits, and in which politics matter for markets and the economy,” according to Mr El-Erian.

In addition to offering investment solutions in those sectors which experienced extreme volatility or pricing anomalies through the crisis, such as investment grade credit, allowing investors to exploit the “bumpy journey part of the story,” the firm launched three main products to address the world’s uncertainties, including a multi-asset strategy, using fixed income, commodities and equities.

Different factors

The underlying principle of the strategy, which, since its launch last year, has gathered $1.3bn (€1.05bn) in Europe, mainly sourced from family offices, banks and distributors, aims to challenge the traditional way of thinking about asset allocation.

“You need to be forward looking, you need to look at the underlying risk factors that make up each of those asset classes, and be proactive about some of the extreme outcomes or tail risks,” explains Michael Thompson, head of European remarketing at Pimco. “You need to be prepared to spend a very small portion of the portfolio on hedging against potential tail risks, very early on, even if there is a very low likelihood that the risk might occur.”

Another product, launched early last year, the Global Advantage Strategy Bond Fund was designed to address one of the key features of the “new normal”: the increasingly larger amounts of debt issued by governments and investors’ growing discomfort in the cap weighted approach to index construction, where the largest issuers of debt have the largest allocation.

“The idea is to move from cap weighted to income weighted, based on a concern that government balance sheets are massively levered,” says Mr Thompson.

The fund, which may invest in a broad range of fixed-income instruments, includes the recently launched Pimco Global Advantage Bond Index as one of its benchmarks, now administered externally, which employs a weighting system based on gross domestic product and is designed to avoid allocating too heavily toward overpriced securities and heavily indebted issuers.

Also, the recognition that a large number of investors have lost faith in benchmarks and want to access the best ideas available on a relative value basis within fixed income led the firm to launch its first publicly available absolute return strategy in early 2008, which aims at delivering returns of about 300 to 400 basis points over Libor. Unlike all the other Pimco’s Ucits III Dublin-domiciled Global Investors Series of funds, which are relative return based strategies, the fund can invest in any sector of the bond market and is very flexible.

The crisis has made the role that exchange traded funds (ETFs) and alpha strategies play in clients’ portfolios even clearer, says Christophe Girondel, head of global fund distribution at Nordea Investment Funds. “There is a very strong polarisation today between beta and alpha, while before the financial crisis it was a more blurred environment. ETFs play beta and are more tactical plays, while alpha strategies are long term conviction investments,” he says.

On that basis, the Nordic bank continues to implement its multi-boutique strategy, launched four years ago, with the appointment of sub-advisers which can generate alpha in asset classes where in-house expertise is not sufficiently developed.

Over the past two to three years Nordea has been focusing on broadening its geographical areas coverage, launching US high yield equities managed by MacKay Shields and a number of funds in the emerging markets area, such as the Far Eastern equities managed by Tokio Marine, LatAm equities managed by Itaù Asset Management and African equities managed by Standard Bank’s Stanlib in South Africa.

Patrick Wierinckx, KBC

“We don’t think we can generate alpha on African or LatAm equities sitting in Copenhagen,” says Mr Girondel. “All the managers we have selected have local teams, they can be seen as boutiques as to the levels of assets they manage, but they are part of large organisations, which gives us comfort in terms of support and compliance.”

Moreover, local companies can provide that exclusivity of distribution in Europe that the firm seeks.

Emerging markets

Growing client interest in emerging markets played an important role in the bank’s decision to launch these new products, but the strategic review of the company’s own competency is important too, says Mr Girondel. Indeed an emerging consumer fund, a thematic product managed internally, was launched at the end of 2008 when there was no demand, in the belief that domestic consumption would drive emerging markets growth in the long-term.

Being able to cover distributors’ needs in all the different areas, and to innovate, is perhaps even more relevant after the financial crisis, as distributors focus on their in-house products even more and private banks increasingly move towards a more guided approach, notes Mr Girondel.

However, broadening the product range cannot be done at all costs, just to pander to clients short-term needs. “We very much take into account client demand, but we want to see if the demand is sustainable in the long-term too,” he says. There is no point in launching me-too products, as banks will prefer the existing products, unless their performance is bad, he adds.

Perceptions of third parties

During the crisis, third-party products suffered more than in-house products, confirms Laurent Auchlin, head of external fund selection at Lombard Odier. Clients generally perceive higher risk in third-party products and question whether they will have the same transparency and access to managers as in-house products.

However, since the beginning of 2009, third-party funds have doubled their assets under management net of market effect, he says. The number of third-party funds available to clients remains 70 in the long only space, sourced from 60 managers, and 20 in fund of hedge funds sourced from 15 different investment managers. Inflows remain quite heavily focused in just a few products, with 80 per cent of new money going to 20 per cent of the funds. This is not linked to fund performance but to client preference and knowledge of specific funds, says Mr Auchlin.

Stock-pickers are favoured and in the long-only space the preference goes today to more concentrated equity portfolios, as opposed to diversified funds. “Concentrated portfolios show our clients that we are convinced of such managers and on the other hand, clients are comfortable with such products, because they indicate that the managers have a high degree of conviction in what they say and in what they put into the portfolios,” he says.

There is less demand for low tracking error types of portfolios, replaced by cheaper ETFs or passive products, says Mr Auchlin, while quantitative investing has been banned for the moment. “We no longer offer quant investments, because clients associate the quant approach to black-box investing.” Customers are now demanding full transparency and want to see their portfolio hold, but this approach may be back on the agenda in the future, he believes.

Demand for higher liquidity and transparency has also driven fund changes in the fund of hedge fund space, and greater attention is now paid on making sure there is no mismatch between the liquidity that the fund of hedge fund promises and the liquidity the underlying funds can deliver, says Mr Auchlin.

In Germany, Sal. Oppenheim plans to leverage on the hedge fund expertise of its new owner Deutsche Bank, to offer to its clients a more robust product platform in the alternative space. This is the only investment area where Sal. Oppenheim, which will retain its full decision making power on selection of hedge funds too, is looking to establish close relationship with its larger owner, says Dr Wolfgang Leoni, chief investment officer at Sal. Oppenheim. “On the investment side we are independent and we will be independent in the future,” he says, explaining that this is also Deutsche Bank’s goal.

Integrated platforms

The two banks employ different investment approaches and have different target clients. Sal. Oppenheim manages money on a discretionary basis mainly for ultra and very ultra high net worth clients and makes its integrated asset management platform for private and institutional clients, launched three years ago, its key strength.

“We realised that our high net worth clients and our institutional clients have similar needs and requirements, and therefore it makes sense to have one integrated portfolio management for both types of clients. This is a clear differentiation to what Deutsche Bank does,” he says.

Also, Sal Oppenheim rejects the preferred architecture approach, of which Deutsche was one of the pioneers, and starts its fund selection process from the whole universe of funds available in the Morningstar database. A bigger emphasis is today placed on tactical asset allocation.

“During the financial crisis, it was important to actively manage portfolios to preserve clients’ wealth, and reduce allocation to risky assets,” says Dr Leoni. “Today, given the high uncertainty about the eurozone, and high market volatility, you have to be a little bit more short-term oriented, and we increasingly use ETFs, especially in the equity space. We think it is absolutely necessary to be well diversified, reduce the home bias that many investors have and become more international than in the past.”

Based on the conviction that emerging markets will play a key role in the near future and in the long-term, at the beginning of 2008 the German private bank introduced emerging markets equity and fixed income in its strategic asset allocation, while before these asset classes were just used in an opportunistic fashion.

Rupert Robinson, CEO at Schroders Private Bank, highlights the greater importance of using risk budget in portfolio management, by analysing the risk for each different underlying investments, and having a better qualitative and quantitative approach for assessing total portfolio risk.

Mr Robinson is quite sceptical on the need to add new asset classes to meet client needs. “I am a great believer that there are only so many ways in which you can carve up a cake. I think we work in an industry that is constantly wanting to change to adapt to a particular crisis, by offering clients something that’s new, which is a bit of a variance on a theme, offering them something that frankly sounds good in its name. But in reality the proof [of the pudding] is always in the eating, and the taste is not always so good.”

An example is absolute return strategies which promise positive returns and capital preservation in any market condition. “That’s nirvana, there are very few successful absolute return managers,” he says.

A lack of talent

At Schroders, where portfolios are built along the lines of multi-asset class and multimanagers, the level of turnover of managers is low, says Mr Robinson. “The number of managers that we use is relatively limited. It is not so much deliberate but reflective of the fact that the industry is saturated with mediocrity. We make active use of the talent within Schroders, but our fiduciary role to our clients is really to only invest with those managers in-house who really have a demonstrable track record process and performance record, and then we complement those with other managers.”

Beyond the top 20 holdings by size, assets in funds fall away dramatically, as they are with managers or funds that are mainly legacy holdings. “We have stable portfolios of investments that we really like, that we have the due diligence on, that we have held historically where we know the managers and we know the style of investments that they are going to hold at any point in time,” adds Mr Robinson.

Increased demand for transparency, liquidity and capital preservation are driving the review process of the product offering at KBC Private Banking in Belgium, which has E20bn in assets under management, predominantly in advisory mandates. All the structured funds the in-house asset management proposes are now screened rigorously. “All the products that contain too many ifs and whens are put off the list now,” says Patrick Wierinckx, business development manager.

Increased transparency has also translated in increased frequency of reporting and the elimination of all those positions in funds that can create issues. “We have a very dominant position of in-house manager, KBC AM, so our interests are very much aligned,” he says.

ETFs on the rise

An instrument that the bank is looking to introduce more actively in clients portfolios are ETFs, which address needs for transparency and liquidity. “We are looking to come up with a portfolio construction where the beta risk of ETFs can be compensated by the alpha generating instruments of the portfolio,” he says, explaining that hedge funds and private equity are back under the scope.

The major innovations have been introduced in the absolute return space. The bank recently launched a fund of funds containing funds of the bank’s long-term preferred partners, BlackRock, JP Morgan and UBS. KBC manages the constant proportion portfolio insurance (CPPI) layer on it, which guarantees the net asset value of the product will not fall below a certain percentage on a yearly basis. The application of a different floor to the core and satellite parts of the portfolio enables the manager to be more aggressive on the satellite ideas.

“We had to have very strict Service Levels Agreement with our third-party providers to be sure that they provide us with the accurate positions of their funds on a daily basis. To be able to do that, you have to limit yourself to a very select group of partners, who are willing to disclose their positions to what is in effect a competing manager,” says Mr Wierinckx.

The funds that are sourced from the three partners and land in the bank’s recommended list are between 25 to 30. While the bank’s model portfolios allocate 25 of total assets to third party funds, in practice the actual assets managed by the preferred managers are much less than that, although they are growing from an historical low percentage, he says.

“The only reason why there is a dominant percentage of in-house products in clients’ portfolios is that our customers prefer capital protection products, which, together with CPPI products, are KBC AM’s areas of expertise.”