The International Investment Spanish Forum took place last month. Here is a summary of the issues discussed and the problems facing both Spanish and international investors in today's markets
The International Investment Spanish Forum 2005 saw 120 of the top fund distributors and buyers in the country gather together to meet with the senior investment professionals from some of the world's top fund management companies.
The day was packed with seminars and private meeting, but the main conference area housed the highest profile speakers and presentations, a mixture of economists, fund managers and guest speakers, all of whom examined various issues facing Spanish, and more broadly, international investors and advisers today.
From Uncertainty to Clarity: Hedge Funds and the Spanish Market
Angel Martinez Aldama, director general of Inverco (The Spanish association of collective investments and pension funds)
Aldama started his presentation with an overview of the general trends in asset allocation in institutional money over the past decade or so. There has been a fairly volatile attitude to equities - unsurprisingly, given the market crash in 2001, and equity investments have only now started to recover. In 1992, 17% of international investments were in equity funds. This figure peaked in 2001 when it hit 45% of the total market and has barely come down since then - Equity funds accounted for 43% of mutual fund assets in 2004, according to the IIFA. Over the same period, bond funds have come down from 32% to 21% and money market funds from 40% to 22%
Spanish investors have followed the same basic pattern, except that they have been on average far more wary of equities, equity funds accounting for less than 1% of assets under management in 1995, rising to today's figure of 3.6%. But the other big trends are just the same - money market funds have come down from dominating the industry - taking 57% of assets in 1995 - to occupying a relatively small 26% today.
Aldama then went on to outline the wide-ranging changes in investment regulations and laws that have been passed or are in the process of being passed that will have substantial effects on the investment industry. He explained that implementation of Ucits in Spain, which is due to be implemented in June or July 2005, will radically increase the ability of retail investors to buy alternative types of fund, including funds of funds, and some forms of hedge fund. There are also new draft laws specific to hedge funds under which institutional schemes will have a different set of limitations than retail ones. Institutional hedge funds will have the same investment limits as Ucits funds plus the ability to hold up to 10% in 'other' classes. The retail version, meanwhile, will be able to hold only up to 5% in a single hedge fund and will need monthly liquidity.
Value Investing and Risk Management
Kim Asger Olsen, managing director, head of investments, Nordea Investment Funds
Markowitz's theories on risk and their broad acceptance in the investment services industry have not done us any favours, according to Olsen. Markowitz defined risk as divergence from the market.
"If risk is something that you get as soon as you diverge from the market, what do you do if you are risk averse? You do the same thing that everybody else does."
Transparently that is not helpful in many markets, including the recent one, as it fails to ask the question: Is it wise to invest in any particular market in the first place?
Olsen went on to describe how this attitude has pushed fund management development recently. In 2000, there were three broad types of funds: a small number of cheap index trackers, a scattering of high-cost specialist, high alpha managers, and then the rest - a large number of managers who more or less tracked the market for a middling fee.
The trend in recent years has been for most fund managers to either reduce their risk by attaching themselves more closely to their benchmarks or to remain occupying the specialist high alpha niche, although generally with slightly lower charges than before. The former have become index-plus managers, and they take up the vast majority of the market.
The risk management role has slipped away from asset managers and moved to institutional asset allocators choosing investment teams, but the end products offered to investors has not markedly changed, according to Olsen.
Another strong trend has been the rise of ETFs from investors who suspect that fund managers cannot add value anyway, so they might as well go for a low-cost option; and structured products, on the back of demand from battered investors. Ironically, ETFs are very popular among structured product creators, who use them to create products with very opaque pricing structures, something that is highly appealing to investment managers who can thereby invisibly ramp up their charges.
"The industry is notoriously uneasy about transparent price structures and investors tend not to be as stupid as we believe them to be and they are constantly on our tails trying to find out what it is they are paying for," he said. "All of this has led to traditional fund management losing prestige in the market."
A Spectrum Approach to Active Risk Budgeting
Kurt Winkelmann, managing director and co-head, Global Investment Strategies
Winkelmann's presentation contrasted noticeably with Olsen's in that it concerned using funds with traditional risk structures based around tracking errors, asking how a portfolio using these could be most efficiently created.
He outlined the results of recent Goldman Sachs research that broke down a universe of 1,000 managers funds into three groups in increasing order of tracking error - passive funds, structured or enhanced index funds and active funds.
"What we discovered was that there can be an improvement by making an allocation - and sometimes a significant allocation - to enhanced index funds. What was interesting to us was what part of the portfolio should be decreased to be allocated to enhanced index management. It is counter-intuitive but it turns out that you shouldn't decrease allocation to the traditional active manager but rather through decreasing allocation to the passive part of the portfolio. You are actually making the index money work more efficiently."
How they came to this conclusion is when they looked at the median returns over the test period, it turned out that enhanced index managers (defined as those with a tracking error of between 50 and 300 bps) and the active managers (tracking error of 500-1,200 bps) they were about the same - around 55 bps above the index.
"You are getting about the same performance but with lower risk with the enhanced index portfolios."
As would be expected, the spread of returns between the top and bottom enhanced managers was significantly lower than the active managers.
Winkelmann continued: "We all know that manager's selection is an important part of the business but it turns out that for active managers it is absolutely critical. If you want to minimise your regret then you are pushed towards the enhanced index managers."
The same point comes across when it comes to information ratios (IRs), which are higher for the enhanced index strategies than active strategies along every part of the performance line, whether top quartile, median or bottom quartile.
Putting the results into an optimiser, it turns out that the maximum IR portfolio is not the one with the highest possible alpha, but with a tracking error of around 160-170bps. According to the Goldman's optimisation process, this requires putting more than half the assets with the enhanced index managers. These are based on the assumption that the investor is on average able to consistently select top-quartile managers. If the investor is expected only to choose the average performing manager, then the allocation to enhanced index goes substantially higher.
So, according to the research, the traditional barbell strategy of balancing a low-risk manager with a high-risk allocation should be shelved in favour of a more balanced allocation across the tracking error spectrum.
Managing Style from the Bottom Up
Christopher Nikolich, vice-president, senior portfolio manager for Core/Blend services at Alliance Capital Management.
The value and growth methodology is not as neat as many investors believe, according to Nikolich. The classic value stock - Sears in the US, for instance - has a low price/book (P/B) ratio and a low earnings per share (EPS), whereas the classic growth stock - for example, Walmart - is the opposite with high P/B and a high EPS.
However, this leaves the other two sections of the market: the 'stars' with high EPS plus high P/B and the 'dogs' with low EPS plus low P/B. And since style indices typically define value and growth by P/B - cheapness - that leaves growth indices at a disadvantage - they contain dogs but not stars. However, this is deceptive, claims Nikolich. In reality, most active growth managers cross over the cost line and are happy to choose stars, sharing that ground with value managers.
In the active field, it makes sense to hold a strategic mix of both styles. But then should investors make tactical, short-term shifts to capture style outperformance year by year? The rewards for getting it right are high, but doing so substantially increases an investor's volatility. If the investor makes the right style choice only half the time, then the portfolio will underperform a static allocation. However, assuming an average level of style predicting skill, there is still a way to maximise the benefits of style changes to your portfolio - ask the manager. If you use the levels of conviction the manager has to make style allocations, you will profit.
Nikolich summarised his philosophy.
"We truly believe that even though value indices outperform growth indices you should not have a strategic style tilt to value over growth," he said. "We also think that you should not tactically time shift between styles. But at the same time it does not mean that your client's overall portfolio has to be style neutral. The style weighting should be driven by the bottom-up conviction of either the value or the growth manager."
Absolute Return vs Benchmarking
Miles Geldard, chief investment officer, global multi-asset group, JP Morgan Fleming.
There has been an evolution in fund management, according to Geldard. In the 1970s and 1980s, most institutional clients would give managers complete freedom to invest. Their risk was inflation so the manager would have to achieve 'inflation plus'. There were no risk measures. Then came the equity bull market and balanced managers found they were too conservative and lagged the markets so the money went to more specialised mandates - a more beta plus type of strategy with information ratios as the measure. Just when everyone had become very focused on equities, there came the big collapse in the stock markets. That generated a surge of interest in hedge funds, when people looked for alpha and cash plus and the main measures were Sharpe ratios and Sortino ratios.
"Going forward we have total return," he said. "What people have said to us is that investors have an asymmetric approach to risk. That is, they are more upset when they lose money then they are happy when they make it. In a low nominal return environment, alpha is obviously more important than beta. Investors are less focused on benchmarks and with good reason."
The big decision in the past was bonds or equities, a choice that amounted to 90% of the portfolio returns. But it is no longer appropriate to regard your portfolio as a series of asset class choices.
"You have to have a view of what the world looks like in terms of whether you take risk or not, but do not segment your portfolio as one has in the past," said Geldard.
"If you subdivide the portfolio aggressively, you create a layer of biases. If for example, we are biased towards equities, we allocate to a global equity manager who is biased towards cyclicals. They, in turn, allocate to a Japanese manager, a US manager and so on, who are themselves biased towards cyclicals.
"To avoid this you need to be very active - in other words, you do not hold a security in the portfolio because it is big or part of an index but because you believe it has the best risk/ reward profile for you investors."
Use of Funds in Private Wealth Management
Alfredo Piacentini, director and founding partner of Banque Syz & Co; and president of Oyster Funds
Piacentini divided his talk into three sections: The use of funds in private banking; the problems of fund selection; the different options available to those keen on offering a fund range to their clients.
He pointed out that over the past few years, the popularity of funds and other collective investment vehicles has risen. Previously, it would be the norm that a private banker would create an asset allocation strategy for a client, then they would also purchase the requisite securities to make up that asset allocation directly.
It turns out that using funds can be preferable in many circumstances, as they allow the private client to keep diversification higher and to keep volatility lower.
However, there are big potential problems with this technique. There are 40,000 funds available throughout Europe, but only a tiny proportion of them can be regarded as excellent.
This is where Syz has had to develop their expertise. They have three main criteria for fund selection: consistency in results; volatilty, returns and Sharpe ratios; and the total expense ratio (TER).
Piancentini pointed out, however, that too much reliance on these leads to the dangerous habit of looking at the past - the equivalent of driving a car while looking only in the rear-view mirror. Hence the need for strong qualitative analysis to try and determine whether past performance will truly be replicable in the future.
Spain And the Eurozone - Managing Economic Convergence
David Vegara Figueras, secretary of state for economic affairs, ministry of economics and finance, The Government of Spain.
Figueras's speech focused on three areas: the world economy, Spain's economy and the government's economic policy.
The global economy in 2004 was very good, according to Vegara. Growth stood at around 5% - the highest rate of growth over the past three decades, international business expansion of around 10%. And although there was some inflationary pressures, these were relatively low despite the significant increase in oil prices.
Undoubtedly the US and China grew the most. Japan has not yet taken off. Europe's growth - at three points higher than the previous year, is still showing modest recovery.
Europe in general, according to the EU Commission, believes there will be low inflation, good financial conditions and improvement in company balance sheets.
After a sluggish Q1 2005, Vegara believes that growth levels will move back up to predicted trend. However, the EU will lag behind the US and there is a big debate
"I would like to point out that performing this type of analysis is hard to do," said Vegara. "In recent years, the productivity per hour remains the same as that of the US. Profitability per capita is less in the EU and that is due to lower employment rates. This has implications for policy makers."
There are two main schools of thought about this. One states that the problem with Europe is that Europeans focus more on leisure and less on work. The other school says that it is not the case of preferences, it has to do with marginal tax rates and these are much higher in Europe.
"I think that both are partially right," said Vegara. "Spain must do more to create jobs and also to increase productivity levels. And this takes me to the Lisbon strategy. This was launched in 2001 and the purpose was to help create a favourable setting for structural reforms while respecting the EU model of social cohesion."
Structural reforms are necessary to bring the single market up to par and to face the challenges of an aging continent. In 2004, the Lisbon strategy was redefined to make it more practical. The old Lisbon strategy had 184 objectives, while the new strategy is focusing on a much smaller number of objectives, which should be much more manageable. In any case, in these circumstances, the Spanish economy similarly continues to be healthy and a growth close to 2.9% in 2005.
However, there are severe challenges going forward. Up to now, Spain has been boosted by three big factors: the exchange rate, low interest rates and the contribution to public infrastructure expansion. These three will progressively disappear for various reasons and, according to Vegara, the response has to be to introduce productivity-increasing measures.
The economic policy is based on three pillars: budgetary stability, productivity expansion and making the regulatory environment friendlier to companies.
Creating Alpha in a low return environment
Mauro Ratto, chief investment officer for Europe, new Europe and Asia, Pioneer Investments
Investors can expect a low level of investment returns in the medium term, according to Ratto. This has pushed investors into asking where they can find new sources of performance for their investments. In his presentation, he suggested one primary way of improving returns by changing the mandate granted to fund managers as a way to allow them to break the trend: release the manager from their traditional benchmark constraints.
He then gave two examples of portfolios where active investment strategies could add value - an active equity portfolio and a fixed income portfolio.
Hot European Funds for 2005
Jacqueline Aldhous, head of offshore equity analysis, Forsyth Partners
In her presentation, Aldhous outlined five main investment themes that would dominate the portfolios of continental European fund managers in 2005. They were: a general optimism towards European equities; an increasing allocation toward large companies; a focus on M&A targets across all sizes of firm; an increasing investment in Central Europe and Turkey; and a general shift of style focus towards growth. Certain sectors will be harmed by both the general market environment and also some factors specific to the industry. Pharmacueticals, for instance, are feeling a lot of pressure from manufacturers of generic drugs, while regulatory environment is growing more difficult. Technology companies are in general suffering from over capacity and a lack of pricing power. Food producers are similarly feeling competitive pressures and are seeing the power of their brands weaken.
On the reverse side, Aldous favours several sectors, including European food retailers, support services, life insurance (on the back of demand for long-term savings) and commodities (because of demand from China and India).
Considering all these factors, she named three funds as having the potential to perform well in 2005. They were: J O Hambro Capital Management Continental European Fund, The New Star GIF European Growth Fund and the Cazenove Euro Equity (Ex-UK) Fund. She explained that the managers of all these funds had proven high-quality stock picking skills, a disciplined approach to valuation, and a blended style that could manage different market conditions.
The European Hedge Fund Industry - a Health Check
Martin Phipps, head of hedge funds, Gartmore Investment Management
The hedge fund industry has been through boom times. It has grown beyond all expectations, reaching an estimated $256bn in assets by 2004. Back in 1998 the amount was just $16bn so that makes a CAGR of 59% over that period. Similarly, the number of European hedge fund launches has grown consistently, with a 104 launches in 2000 growing every year to 253 launches in 2004. Importantly, the capital that new funds are raising at launch has not shrunk in response, but has similarly grown.
And so, despite the huge increase in supply, the concomitant surge in demand has meant that the high fees demanded by hedge fund managers was not under threat, according to Phipps. That is, at least not at the high quality end of the industry.
Meanwhile, the strategies being employed by hedge funds has grown. In 2000, the 50% of European hedge money was in long/short funds. That has now changed and there is a much broader split between the major strategy types such as arbitrage, global equity, long/short, fixed income and macro.
Phipps pointed out that lot of the substantial increases in European hedge funds assets had come institutions. However, there is a statistical link between the propensity to using outsourced investment consultants and the tendency for institutions to use hedge funds. And that link is an inverted one. The UK, for instance, in which 90% of institutions use consultants, has a 10% hedge fund penetration rate of just 10%. The Netherlands and Switzerland are next up the scale of hedge fund users, with a corresponding decline in the use of consultants. A few markets break the trend - Nordic institutions rarely use consultants at all but have a healthy but modest 35% penetration rate.
Whatever the details, it shows that persuading consultants of the merits of hedge funds was a key task. However, according to Phipps, overwhelming pressure is upwards. In a recent survey of institutional investors not using hedge funds, 48% said they were planning to invest in hedge funds in 2005, and the largest swathe of these were in the UK and Switzerland. So it seems that the hedge fund rush is not over yet.
Hindsight is a Wonderful Thing - Bond Investing in 2005
John Birdwood, head of European bonds, London, Baring Asset Management
Birdwood gave an overview of the fixed income markets by looking at the broad factors that influenced bonds over the past decades and showed how they were influencing markets today. He showed that the US current account deficit had reached an all-time low point, while current account imbalances there were huge, moving from a figure of -$117bn in 1996 to -$666bn in 2004. And all the while, Japan, Asia and Europe, taken as a whole had moved into surplus during that time.
Birdwood warned economists to be careful in wishing the US should turn that around. "The US consumer might be addicted to borrowing," said Birdwood.
"But a number of countries are addicted to American demand, and they might find the adjustment more uncomfortable than they anticipate."
He went on to look at currencies. The spot rate of the Singapore dollar, which he used as a proxy for Asian currencies was far below its value on a purchasing power parity basis - in other words: "It has never been cheaper."
Singapore, and other similar economies, were running at huge current account surpluses. "Clearly it, and other major currencies, need to embark on a long-term currency appreciation. This has not happened, largely because the Chinese peg is unchanged.
In many ways the world is in uncharted waters - this environment has not been seen before and therefore the tools used in the past to rectify imbalances will not necessarily work.
"And yet the markets are priced as though history will repeat itself," he said. "I think we should take note."
Making Money in Bonds in a Rising Interest Rate Market
Mark Watts, head of global fixed income, Morley Fund Management
Watts started his presentation by pointing out some of the large-scale changes in the market. Bonds have been on a 25-year bull market, he said, with both real and nominal yields dropping steadily since 1996. The primary reason for this is a drop in volatility across the economies. Take the US, for example. In 1929, the US CPI figures were 30% food and 20% services; By 2005 it had switched to 16% food and 28% services. The relative size of different industries reflect this: in 1921, the notoriously cyclical agriculture and industry accounted for 78% of US GDP, with services at 16%. By 2003, finance and services had moved up to 49% while agriculture and industry had declined to 28%. This means that volatility will stay relatively lower permanently.
The future for bonds will not necessary be rosy - the JPM Global Bond Index Euro Returns forecasts a -1.2% performance for 2005-2006. Returns will not be stellar, warns Watts. So what should a bond investor do? The answer is to look out for those fund managers who can add alpha and has a flexible and innovate mandate with a structure to match. Among the types of financial instruments that Watts said could add to alpha generation were futures and options; swaps and swaptions; FX OTC options; and total return swaps. Use of these would allow swifter sector allocation, various degrees of downside protection and possibly even lower execution costs.
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