The annual International Investment European Forum held in Frankfurt saw key speakers voice their opinions over the current state of equity markets, the opportunities in fixed interest and the use of alternative investments
The International Investment European Forum 2003 was dominated by continuing worries over the state of the equity markets. This issue was tackled from all sides, with a substantial amount of time devoted to the opportunities and risks in the fixed interest markets; how investment strategy should deal with current volatility and how it is reflected in peoples' appetites for risk; and the use of alternative investments, especially hedge strategies, in a diversified portfolio.
The first speaker at the Frankfurt venue was Michael Mewes, head of fixed income for JP Morgan Fleming Asset Management in Frankfurt. He was there to answer the question 'will fixed income beat equities for a fourth year?'.
Looking at historical data, the answer would seem to be easy. On average during a market cycle, equities overall beat fixed income. Therefore, it should be time for equities to outperform once again.
'We have hit new record lows in yields in almost every government bond market in the world,' he said. 'Fixed income should give a return of 5.5% with a relatively predictable risk level. Equities should give you a higher return ' by about 4% but they have a risk that is about four times higher. That is in a normal year but we have not had normal years for quite a while.'
He pointed out that there has been a recovery of high yield bonds over the last six or seven months. But this asset class has long periods of underperformance and volatility tolerance would be needed.
'You have to wait for these recovery years, like in 1991,1992 and 1993,' he said. 'And these are probably such years in 2003 and 2004 again, which rewards you sticking to this asset class.'
Emerging market debt has a similar risk profile. There are not so many long droughts but there have been periods of negative performance in 1994 and 1998, with the Mexico crisis and the Russia/Asia crisis. Nonetheless, since inception of asset class in 1994, the average performance has been 9.5% ' more than Mewes expects of equities.
These can allow a portfolio to be constructed that reflects equity returns with much lower volatility. Continuing the fixed income theme, the head of retail and institutional fixed income for M&G Investments took a look exclusively at corporate bonds. Jim Leaviss compared the risk/ return characteristics of corporate bonds with equities and government bonds.
Leaviss said that corporate bonds have outperformed equities and at a much lower volatility level. As an example, he examined the Dow Jones STOXX 50 and the Merrill Lynch EMU Corporate Bond Index from January 1996 to March 2003. The bond index returned more and at a seventh of the standard deviation.
He pointed out that for older investors looking to retire, they are looking for regular income. Fixed income instruments are often best suited to matching those needs.
'Pension funds are moving more in the that direction and we think individuals should as well,' he said.
That owned firms will go bankrupt is slightly less of a worry for bond holders than stockholders as corporate bonds have claim on a folding company's assets before preference shares or common stock owners.
Even without the risk of bankruptcy, equity suffers from a lack of certainty. Equity holders who have been used to getting good dividend yields on investments are at the mercy of economic activity. Leaviss gave the example of two companies traditionally generous with their dividends ' Deutsche Telekom and France Telecom. Both have stopped these payments.
'So anyone investing in these companies in the hope of getting income have found that they are getting none,' said Leaviss.
Bondholders have a guaranteed return. Finally, bonds have fixed period with a guaranteed return of principle at the end ' equities have no such promise.
Next, Marc Doman of AIM Global took the stand to talk about cash. He pointed out that when comparing asset types, people tend to misjudge cash by thinking about its relatively low returns.
'When you look at equities, we focus on the return, the profits of investment and we focus less on the volatility of that particular stock,' he said. 'But if you go right to the other end ' to cash, what do most people look at? They look at the return and not on the most important part of cash ' the lack of volatility.'
Cash is certainly regarded as the safest asset class but investors must remember that there are always third parties involved, those who store the cash ' the banks. And these are not absolutely risk free.
'The major institutions are fundamentally declining in credit quality. If you look at 1995 16% of banks in the top 50 were AAA. By 2001, the earliest figures I could get, was 7% and it is even less now.' At the other end of the quality scale, 10% of them had an A+ rating. By 2001 that had risen to 30%.
Two other aspects of holding cash are liquidity, and yield. If you can you should try and maximise all three. Banks will provide two out of the three ' typically safety and liquidity but not yield. Doman's conclusion was to recommend the use of money market funds, as they can provide all three.
Then Ewen Cameron Watt, head of investment strategy for Merrill Lynch Investment Managers, took to the stand to pop a series of myths that hold common currency in the investment world. The first was an explanation of the way risk profiles are often misjudged by advisers.
'It is crucial to any investor to decide if they are operating in a bull market or a bear market because investor behaviour is very different under each circumstance,' he said. 'In a bull market, you are worrying about missing an opportunity whereas in a bear market you are worrying about not having enough money left at the end of the day to meet your obligations.
Cameron Watt was scathing about the way this mantra is repeated to encourage people to spread into new asset classes.
'At its crudest it is the practice of investing in an asset after it has performed,' he declared. 'Or to put it another way, it is hoping that if you scatter enough money across the water eventually it will all work.
'It is also a development of the greater fool theory. This holds that a greater fool than I is going to pay for the asset than I did in the first place.'
The efficient frontier:
Although Cameron Watt admits the efficient frontier theory is correct, he was critical of the way it is used.
'I cannot tell you how often I have seen people saying 'you must invest in this asset class because it helps reduce risk and increase your return,'' he said. 'All the efficient frontier does is tells you which asset classes have just done quite well.'
This was the theory that was used in 1989 to persuade people to buy Japanese equities. It was also in 1993 to buy emerging markets.
'It is a stupid idea,' he said. 'It tells what has just done well in the past ' it does not predict investment success in the future.'
A fourth area of danger was the tendency of all investors to extrapolate past behaviour. In a bull market, for a currency, bond or equity, people always assume that whatever performance a successful asset class has achieved, the investor assumes it will continue that way in the future.
'This is good news for all of us in the investment business because if it was as easy as this, none of us would be in a job,' he pointed out. 'But at some point the value of the asset starts to fall.'
At that point, there is a discrepancy between what the investor expected to earn and what actually happened. If it is very serious this shortfall eats into their savings.
'And guess what?' he said. 'People again start extrapolating forwards ' they believe things will go down forever.
'The successful investor recognises that actually the extrapolated line down is just as much an opportunity to buy as the extrapolated line down was an opportunity to sell.'
Bear market strategies was the topic of the next speech. James Tew, head of fund ratings Europe for Standard & Poor's, said that there are basically three equity investment tactics one can adopt to cope with a bear market like the current one.
Firstly, do nothing. Secondly, find funds that adapt to different market conditions. The third is to find an alternative place to put your money.
'Doing nothing is a perfectly valid strategy if you believe that equities giving the best long-term returns and you have no confidence in either you or your adviser in making the decision to correctly time the recovery.'
On the further assumption that the investor's portfolio is efficiently constructed and well balanced, a short-term no-action strategy has something to recommend it, according to Tew.
However, the decision to do nothing most often comes from a lack of decision and as such Tew was against it.
'The first thing to note is that equity managers rarely seek to provide positive returns in a down market,' Tew pointed out. 'The exceptions are very rare. The rare ones are those funds that actively use cash and bonds and equities to time the markets.' Tew mentioned two managers who do fall into this category. First, he cited Gordon Grender, who manages US money for GAM.
The key to his strategy is his willingness to raise high levels of liquidity, noting that at the moment he is more than 50% invested in cash and fixed income. 'Because however good his stock selection is, he will not be immune to the general movements of the US market.'
The other manager he mentioned was Rustom Jehangir of Malabar Capital, who held 32% liquidity at the end of June 2002. At the end of April 2003 it was down to 23%.
'This is a fund manager who uses his ability to switch between markets and global themes, lowering the risk of each stock and its market relative to absolute returns.'
He still performs well in up markets, according to Tew. 'But the fund is managed with an attitude of mind that says 'I want to protect the downside and conserve wealth,'' he continued.
Investec's head of fixed income, Paul Griffiths, was next to speak. He said that although Treasury yields had been consistently coming down over the past decade, in the truly long-term, 150-year view, they were coming back into their historical levels.
'Almost every year over the last eight or nine years, there have been lower and lower yields,' he said. 'So much so that finally we are back to what I would deem to be somewhere in the middle of a broad band of fair value ' between 2% and 6% is where yields historically trade, with the last 40 years or so being something of a distortion.'
However, despite this macroeconomic situation, he claimed that there were still returns to be made from fixed income, with bond yields retreating still further. He estimates the 10-year yields will come down as low as 2%.
These very low levels are possible because: 'We have seen overcapacity in the economy in terms of goods and services,' he explained. 'We have seen the globalisation of world markets. And we have also seen explicit policies from government and central banks designed to combat inflation.'
Government policy was arguably the cause of inflation problems in the 70s. In the last 15-20 years, government policy has been used to combat inflation, and now there is a genuine worry about deflation.
Weak US economic growth will be ongoing, as it will in Europe. And in the rest of the world, real interest rates are very low.
The improvement in the interest rate environment has lead to excitement this year in a possible equity market recovery. This would be a worry for bonds, except that Griffiths has not seen a recovery.
'On a three-year view, equities are still in a declining trend and in our view over the next 12 to 18 months of something like a further 20% fall,' he said.
Yoon-Chou Chong, head of Pan European Equities for Aberdeen Asset Management, warned against complacency and the assumption that trends would continue.
'There is always an eye of scepticism on anything that's gone out of whack,' he said. 'For example, people are saying, 'equities ' they are awful'. But that is exactly when they become interesting to us.' Even a situation like the yen/dollar exchange rate where there is'no chance of a recovery', according to Chong, needs to be regularly checked for signs of change.
The final three speakers talked about different aspects of the alternative investment world, what it means to investors in the current environment and how the various strategies, products and services could be used
Omar Kodmani, senior executive officer for Permal Investment Management, was the first speaker to talk about hedge funds directly. He asked which would be the winning hedge fund strategies for 2003 and beyond. He looked at how to use three major hedge fund strategies as building blocks for asset allocation, both within an alternative investment programme and in co-ordination with traditional long-only portfolios. These three broad strategies are: the equity hedge sector, the various bond-related strategies and macro strategies, which make bets on currencies among other things. Richard Harwood, CEO of Theta Enhanced Asset Management, then talked about the use of derivatives in portfolio management. Specifically he talked about how non-geared derivatives can be used to smooth and enhance the performance of a long-only equity portfolio.
For the fund Harwood runs, he employs a selection of various tools: 'We use call options to enhance the yield of a holding,' he explained. 'And put options to enter positions; we also use stock index options and stock index futures. Finally, we hedge our currency exposure.'
For example, he might write a call option (where the stock is held, to keep the risks down) to gain certainty of the option premium, taking the risk of losing out on a windfall gain. However, he believes there is no reason why fund managers should not be using these tools more often, but also why individual investors should not.
Finally Malcolm Arthur, business development manager for Appleton International, put forward the case for European Long/Short Funds while at the same time telling delegates what to look out for when choosing managers. Arthur argued that these are not merely bear market products, explaining how these managers added value to their portfolios both on the up and down side.
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