Building a diversified global portfolio

Global investing roundtable, 6 September 2010,

Roundtable participants:

• Jonathan Armitage, Global Fund Manager and Head of US Equities, Schroders Investment Management
• Martin Connaghan, Investment Manager, Aberdeen Asset Management
• Nicolas de Skowronski, Head Investment Advisory, Bank Julius Baer
• Bjoern Jesch, Head of Portfolio Management, Deutsche Bank PWM
• Ash Misra, Head of Investment Strategy & Research, Lloyds TSB Private Banking
• Michael O’Sullivan, Head of UK Research and Global Portfolio Analysis, Credit Suisse Private Banking
• Cesar Perez, Chief Investment Strategist for EMEA, JP Morgan Private Bank
• Markus Taubert, Chief Investment Officer and Head of Private Banking, Berenberg Bank
• Elisa Trovato, Deputy Editor, Professional Wealth Management

Elisa Trovato: The aim of this discussion is to assess different approaches to constructing diversified global portfolios and examine how to translate economic views into investment strategies and products. What are the key steps to constructing a portfolio with a diversified global exposure?

Nicolas de Skowronski: In a pure discretionary portfolio we usually go with a traditional approach, strategic and tactical asset allocation with equities and/or fixed income direct investment. We will use investment funds where we do not have the necessary know how and active management can yield additional return. On a pure advisory basis, clients are less interested in a global, pure traditional asset allocation approach; they may want to invest with a bottom-up approach; we will do direct stock selection to play a very concentrated theme or select the right fund to go into broader themes.

On one side you have the cost aspect of active management; you need to select the right investment boutique. It is more expensive for the client, but you give access to a better diversification. To invest directly, you need to invest more in terms of research, to have your own diversified investments at less cost, but it might be difficult to demonstrate you can really add value in markets you don’t know. In the next five to 10 years, the way forward for private banks will be to charge for advice, and we do need to add value through services.

Bjoern Jesch: You need a proven investment process with a top-down approach. As we found out in 2008, having a correlation and volatility view into the future is crucial for portfolio optimisation. Our unconstrained portfolio, which is the source of our different strategies, is aimed at preserving wealth and generating inflation-linked returns. This is the profile private clients are looking for, more than in the past, when they were looking for benchmark strategies. The client expects us to put their money with the best manager in the world, whether it is ourselves or not. Clients also expect cost reduction and home-bias. Especially in segregated accounts, the portfolio must include German stocks and bonds, plus cheap beta in the form of ETFs. Otherwise, clients will not be satisfied, even if performance is OK.

In discretionary portfolio management, where we are able to use much more derivatives, futures and options, than previously, we are definitely able to underline risk management more than in the advisory space. In advisory, when you offer single stocks or ETFs, the margin will decrease heavily, so we have to think about active advisory mandates, where we can charge for the added value of risk management.

Ash Misra: Pre-crisis, there was a strongly emerging view that there could be fairly homogenous regional trends, which you can profit from; the need to desegregate regional trends into country and sector-specific ones was not such a huge imperative. The one thing this crisis has thrown up is that different countries, different themes, different sectors would react differently to the exact same set of macroeconomic exogenous inputs.

We do not take big bets in any one direction. The portfolios are constructed in a way that not only diversifies clients’ portfolio risk, but also allows them to grab alpha from different developments in sub-sectoral, sub-regional trends. We have three primary building blocks in structuring portfolios: an income fund, a growth fund and there is a yield-kicker/yield-enhancer fund. The first thing we do is assess client risk appetite and categorise them across one of 10 different risk categories.

Declining levels of cross asset class correlation is actually a great opportunity as well. We have a golden opportunity to genuinely start generating genuine alpha.

At the asset allocation level, style investing is not that relevant. Every once in a while something comes up and hits us in the face as a very obvious style call. However, by and large what we do is present our clients with a very robust, asset allocation-level portfolio construction process. Between half to two-thirds of returns come from the big asset allocation calls. If you deconstruct that further, on a country/sector theme, the second level calls drive probably another quarter of returns. Before you even get to stock picking you have covered about 80-90 per cent of theoretical portfolio returns across cycles.

Jonathan Armitage, Schroders

Michael O’Sullivan: I would dispute the fact that styles do not matter in a long-term. We are increasingly aware of the style bias of fund managers, beyond whether they are good at adding alpha. We decide upon asset allocation structures on a country and regional level, on which styles we want to work with and that in large part informs the selection of individual investments.

Some are conviction fund managers in the area of valuation or early momentum or may have an emerging market bias, even if they do not overtly advertise it. Growth funds, value funds and EM-focussed funds will perform differently in varying market conditions. So there is an underlying factor bias and you have to be very very clear and aware of that.

One thing we base our strategic recommendations on is the business cycle. Last year we were long in cyclicals over defensives, but tactically we are cutting that as, given the cycle and the credit crisis, clients are more conservative in their risk profile. The appetite for cyclicals, even though the rationale and the performance is there, is quite low. The notion of high-yielding alternatives to government bonds is an attractive idea.

The onset of quantitative easing may provide investors with an exit point for safer assets. I would worry that from a haven point of view we are repeating some of the mistakes of the previous bubble. I do not think the fixed-income and gold markets are going to implode but I do think there is a growing positioning risk. That is an issue because a lot of the investors who have invested heavily in fixed-income and gold are sticky in their investment horizons and their ability to trade in or out of assets.

Markus Taubert: We expect volatility to stay high in capital markets over the next couple of years and it will be crucial to be active and flexible within your investment process and portfolio management. Volatility is often perceived to be negative, but it can be exploited positively in many different ways. However, it is crucial to keep in mind your investors’ long-term needs as we seek to build up a long-term relationship with a client. There is no need for having an active approach because it is modern or it is trendy; you have to have a transparent strategic asset allocation and lots of active parts within that structure.

Nicolas de Skowronski: When correlation goes to one, diversification is of no use. Clients will no longer accept double-digit negative performance because a bank was ust following a benchmark with a low tracking error strategy. You do need the flexibility to be closer to a hedge-fund type investment. We also face, post crisis, clients that not longer accept illiquidity or ask a premium for it. In this new environment we need to be able to generate asymmetric returns. Julius Baer launched a new, asymmetric PM offering, which aims at generating not a full participation to positive markets, while having a partial hedge of negative markets.

Cesar Perez: In order to run global portfolios, you need global footprint. Despite the high correlation of all asset classes, the market is segmented and you can get different performance if you have the tools to add value in all asset classes. For example, in Asian equity, if you were long India and short China you made 30 per cent return difference. If you were short Irish bonds and long German bonds the difference in performance is significant. If you do not have the tools, then go for a good global fund manager.

Due to the current macro uncertainty, macro is having a big overlay over stock picking. In fact the only call you had to make this year to get the right country in Europe was look at the sovereign crisis. We are going into a world where developed markets have low single-digit equity returns. We need to be more active, and try to get that extra mile from your money.

Once you choose a theme, you need to choose the right vehicle. Everybody is turning positive on China, but if you just buy the China index, it is full of banks, which are probably not very profitable because they are quasi-governmental organisations, and full of regulated industries, which does not give exposure to the correct thematic investment, which is Asian or emerging market consumer growth. You need to find a manager that will gain access to that.

Clients are demanding more clarity, transparency and higher conviction. Rather than benchmarks, they prefer absolute returns.

Due diligence is key for selecting managers at each different time of the economic cycle. What matters now is macro factors so you need to choose fund managers that look top-down and bottom-up. One of the biggest difficulties is that fund managers today are just stock-pickers, bottom-up, and do not care much about top-down factors.

Martin Connaghan: When you are constructing a global portfolio of typically between 40 to 60 stocks you do have to take some macro points into consideration. We produce our own research, we have an unrestrained model and we stay within pretty wide risk parameters. So we try to avoid getting into thematic views on the world.

We do not really care where a company is listed. For us it is about focussing on what the companies do, and where they do it and not where a benchmark classifies a certain stock or what sector it may be within. We would rather focus on the underlying fundamentals of the business and the management.

The majority of growth from corporates in the US is all coming from overseas. As a global manager we do not have to invest in the US to gain access to that growth; it can be Indian, Chinese or Latin American growth; we can invest anywhere, directly. We all know valuations can also get ridiculous in developing markets, and it is a well-known theme that is at play.

Jonathan Armitage: The question is where earnings growth is going to come from, partly because businesses are becoming more and more global and the growth that they seek is becoming more and more global as well.

Cesar Perez: It is not the case for domestic businesses. How do you approach local companies in Portugal, Ireland or Greece or in any country that could have those potential sovereign risks?

Jonathan Armitage: I do not think any of us take stock decisions in a complete vacuum. There is an element of understanding the economic circumstances that any stock is exposed to, whether or not it is something that is quite domestic, like a bank, or it is an emerging market company, which might be exposed to different forces whether it is currency or more localised ones. One of the great things about being a global equity investor is that your canvas is huge, we would look at those type of companies for a number of different reasons at any one point. Like Martin, we run very concentrated portfolios, which are unconstrained. You can construct a very concentrated portfolio but actually the volatility of that portfolio is not that different from the underlying index.

Elisa Trovato: How can a portfolio maximise the opportunities of the global universe of 15,000 stocks by only investing in a selection of 40 or 50 stocks? How do you pick the best stocks?

Jonathan Armitage: You need to work for an organisation, which has got the breadth that can give you that global coverage. We focus on the best ideas which come out of our local team, which gives us a pretty strong filter. Also, we have a market cap filter, so we tend to look at stocks greater than $2bn which are less volatile. Then because we have a growth bias, we focus on balance sheet and cash-flow strength and management quality.

As well as quality and valuation, the growth opportunities of a business are all important. I think some of the softer qualities of the ESG-type angle are becoming more important because that increasingly has a focus on the multiples that investors are prepared to pay. These change over time, and you can have companies that score quite poorly on those soft factors but because you could see improvement there, then investors over time may afford a higher multiple to that.

Markus Taubert: We do not have people on the ground in Asia or in emerging markets but we do invest in these markets. Our asset allocation call is definitely pro emerging markets and I assume that a lot of us within this group see emerging markets as one key to a global, broadly-diversified, portfolio. We don’t need in-depth expertise in any local region to pick the right stocks. As asset allocation becomes crucial in these days and presumably for the next future, identifying the right themes and timing becomes highest priority. You can make use of a variety of investments – actively managed mutual funds, ETF or others.

Elisa Trovato; Does concentrating your portfolio introduce a new layer of risk?

Martin Connaghan: The reason that we have the high conviction process is that we produce our own research and we believe that that is the best way to leverage off that research – that is why we need the local presences. We cannot invest in anyone unless we have met with management. We are always more likely to have a bigger weight in the stocks we are more familiar with and feel more comfortable with, rather than diversifying the portfolio for the sake of it. We invest in 40-60 stocks, and we have been at the lower end of that for some time.

The research we produce is very much forward-looking with regards to the bottom-up. The main thing for us at the point of initial investment is to protect the downside. If we are seeing positive fundamentals from the bottom up, we do believe that that will drive positive share price performance in the long-term, but it is much more important to be right in the longer-term than be early. We are quite contrarian so we do tend to be buying into weakness anyway. We do not mind some short-term weakness with regards to purchasing of stocks, because it does give us an opportunity to build those meaningful positions, which really drive the performance, when the turnaround does come through.

Elisa Trovato: How do you blend together different styles and strategies in a global allocation?

Markus Taubert: If you divide investors into growth and value investors I would definitely say ours are value investors on the long-run. Value investors want value momentum to be strong and overall we want to earn the value premium. Our investors, especially after the experience made in the financial crisis, look more for asymmetric return profiles: participating in positive market moves whilst reducing risk exposure in falling markets. It is about the willingness to give up some upward-performance by cutting the downside risk to a certain degree or financing the client’s downside protection, respectively. We have been very successful with this approach.

Elisa Trovato: What investment themes do you favour and how do you translate them into investment solutions or asset allocations?

Ash Misra: One of the asset classes in which we are currently overweight is the high-yield bond market. This year the volume of issuance in global high-yield bonds has actually broken the pre-crisis peak on two occasions. That is telling us that risk appetite is back and there is this mad scramble for yield, but it is also telling us that funding is, by and large, very easily available for the M&A theme. We are also seeing a pickup in M&A and corporate activity and buybacks and distribution of surplus cash. At some stage that supply will start to cause indigestion so at some stage we will start taking money off the table in that.

I am probably the only one here who is cautious on emerging markets. On a country level, I am very worried about China: overinvestment, negative real interest rates, excessive credit build up, particularly from regional government debt. In the worst-case scenario something very ugly could happen there in the next 12 months.

Bjoern Jesch: For the first time ever at Deutsche Bank we are overweight in emerging markets over developed markets. Our biggest call is our underweight in sovereigns as I see high-risk there in terms of increasing yields. Safe-havens, especially German bonds with a very low yield, are quite risky for the time being. The third big theme is the FX component in terms of emerging markets and commodity currencies such as the Canadian and New Zealand dollars and Brazilian real.

Michael O’Sullivan: Are people worried about the speed and the extent to which these themes become consensus, and they tend to be contrarian or at least to try to hedge?

Nicolas de Skowronski: We have a macroeconomic scenario, which is moderate growth, low inflation. We are assigning 20 per cent probability to an inflationary environment and 20 per cent to a deflationary one, which gives us a 60 per cent probability that the market could be more-or-less normal. We then select the right investment according to these scenarios.

The major risk in the current market is to face an extreme event and then, very quickly, end up in a difficult investment environment. Today our favoured themes are Germany, high-yield, non directional fixed-income exposure and cyclical equities.

Michael O’Sullivan: But there is a consensus already.

Cesar Perez: I disagree, there is no consensus. For example, recently we added Chinese equities. Last month, out of 25 emerging markets managers, 10 of them were still underweighted and now it is five. I agree there are some structural calls that you need to take, on emerging markets the question I would have is: ‘In which scenario do emerging markets not decouple?’ and the answer is probably in a double-dip, if the US would fall in to a double-dip, all bets are off and in that case they will fall substantially, but that is not our scenario today.

Bjoern Jesch: We see a 60 per cent market normalisation outlook. We are a little bit more aware of the deflationary scenario with a 30 per cent estimate and only 10 per cent of inflation. German clients always fear inflation, because they had it twice, but it is more deflation they should be worried about. I am not bullish on sovereign. If I knew I was 100 per cent right, I would not have any sovereign in my portfolio but I do, because I have a risk to the deflation scenario and a double lag in terms of double-dip recession; it is not the main scenario but it is likely to come. We have to move from this stimulated phase to the self-driving economy. A gold investment is a good deflation hedge, although it is not always a good inflation hedge. Private clients are really demanding gold, physically, in small coins.