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Liquidity Risk: What Bond Managers Aren’t Getting Right

Remember the story of the blind men and the elephant? One man grabs the tail; another, the trunk; another, a tusk—yet nobody knows what the animal looks like. Liquidity risk is like that elephant. It’s easy to misunderstand—and mismanage.

It’s not that investors are unaware of the risk. Bond managers are paying more attention to liquidity, and some of what they’re doing and recommending to their clients is good. But as we’ve pointed out, there are many reasons why liquidity has seeped out of the bond market—and several trends that could make the situation worse.

Managers who don’t understand all the moving parts or who take a piecemeal approach to managing the liquidity risk in their clients’ portfolios are playing a potentially dangerous game.

So what do we mean about not seeing the big picture? Here are just a few examples.

Focus on Traders, Not Trading

Some asset managers see the decline in bond market liquidity, first and foremost, as a regulatory issue. In other words, they attribute it to new rules that require banks to hold more capital and limit their ability to trade for their own profit.

No doubt, these changes have reduced market liquidity, though they’re not the only force at work. Even so, many asset managers say they can cope by deepening their pool of potential trading partners. This means using smaller brokers to complement the stable of more traditional liquidity providers, such as banks and primary dealers.

There’s nothing wrong with that approach—but it doesn’t go far enough. In our view, the best thing firms can do when it comes to sourcing liquidity is bolster their own trading ranks.

With banks playing a smaller role in the bond-trading business, it’s more important than ever to have skilled traders with the expertise to find liquidity when it’s scarce and take advantage of the opportunities it can offer. In the past, traders at buy-side firms tended to simply execute orders. That approach won’t work anymore.

Over time, more electronic, “all-to-all” trading platforms that can match large orders among a bigger pool of buyers and sellers may help address these issues. But in-house trading expertise is critical.

Cash: Opportunity Cost or Opportunity?

Asset managers recognize the wisdom of keeping cash on hand in a low-liquidity environment. But too many view it simply as a way to meet redemptions should large numbers of investors suddenly want their money back.

Being able to meet redemption is important, of course. But focusing only on this overlooks another benefit that cash confers: the ability to act quickly to take advantage of liquidity-driven dislocations. When liquidity dried up during the “taper tantrum” in 2013, investors who avoided crowded trades and kept some cash on hand were able to swoop in and buy assets at attractive prices. Think of it as compensation for providing liquidity when so many others needed it.

Of course, with interest rates as low as they are, there’s an opportunity cost associated with cash. But there’s a way to partly offset that performance drag: use relatively more liquid derivatives to get exposure to “synthetic” securities.

Look Beyond Volatility

Having endured the extreme volatility of the global financial crisis, it’s no surprise that many have embraced “risk-aware” strategies. These use volatility-managed or value-at-risk (VaR) techniques in an attempt to provide downside protection.

We can see why this approach may seem attractive at first blush. But the number of investors using these strategies has exploded in recent years. That means a lot of people are doing the same thing at the same time. Asset managers who see these strategies as a panacea may not realize that they can make a liquidity crunch worse.

Why? Because when volatility rises, managers who use VaR-based strategies generally have to sell assets to bring their portfolios’ risk back in line. That can be bad for individual returns (you’re selling when prices are falling) and for broader market liquidity (you’re selling when everyone else is, too).

It’s always useful to keep an eye on volatility when managing risk. But a better approach, in our view, is one that allows investors to buy assets when they cheapen and sell them when they get expensive. This can only be done by lengthening one’s investment time horizon.

During times of high volatility and low liquidity, this may mean sitting tight, turning a blind eye to price declines and waiting for the storm to end. But in the long run, we think this approach is more likely to lead to better investment returns.

Seeing the Big Picture

Navigating today’s bond market requires a thorough understanding of liquidity dynamics—both the risks and the potential opportunities. We think managers who are just feeling around in the dark—like one of the proverbial blind men examining the elephant—may struggle to keep their clients’ portfolios afloat.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Opinion column by Douglas J. Peebles, Chief Investment Officer and Head—AllianceBernstein Fixed Income, and Ashish Shah, Head – Global Credit.

Reflections on Market Volatility

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Reflexiones sobre la volatilidad del mercado — Photo: Paramita. Reflections on Market Volatility

To say it has been a difficult quarter for investors would be an understatement, with markets and investor confidence experiencing the most significant weakness for many years. We have all read and heard about the challenges facing China, and the implications for the global economy, but the issues are broader than just how China and the developed world copes with the former’s inevitable slowdown. As I write, the MSCI World index (total return) is down 8.3% in Q3 in US dollar terms, although given the sharp falls in some sectors, it sometimes feels worse than that.

Depending on one’s starting point, we are now some seven or eight years on from the start of the Global Financial Crisis (GFC). For what it’s worth, my reference point is the HSBC profit warning in February 2007 when it cut its profit forecasts due to the escalating bad loan experience in the then recently acquired US subprime lending division. Even if the crisis didn’t really start with a vengeance until 2008, history would suggest we are closer to the start of the next downturn than we are to the end of the last one.

The problem is that even with ultra-loose monetary policy with zero per cent interest rates and abundant liquidity from (effectively) global quantitative easing (QE), developed world economic growth is modest at best. On our forecasts, global growth is going to be only 3.5% in 2016, and will be much weaker than that in much of the developed world. In the US, the strongest developed market, growth forecasts continue to come under pressure, acting as a restriction on the authorities’ ability to start normalising interest rates. In Europe, growth could pick up but only to 1.5% next year, despite massive monetary stimulus, a much weaker euro, and a big fall in energy prices. Even in Japan, where QE is now running at over 14% of GDP per annum, growth and inflation are very hard to come by, with growth set to be no better than 1.5% next year.

This is why China matters so much; it has been such a significant driver of marginal growth. With credit-fuelled investment spending inevitably slowing down, or even potentially coming to a halt, the effects this has on the global economy and financial system are significant. For commodity prices, we have already seen the collapse in the oil price and in industrial metals more broadly as consumption has been curtailed. With new areas of supply for oil, and unwillingness by OPEC to cut production, the oil price has fallen to levels previously difficult to imagine. Although this is effectively a much-needed tax cut for Western consumers, so far they appear to be saving rather than spending their gains.

For the oil producers, the effects are potentially catastrophic, putting their budgets under enormous pressure and placing a spotlight on expensive (and now unaffordable) social welfare programmes. This in turn has placed downside pressure on many of the emerging market currencies, and many economies are being forced to implement pro-cyclical interest rate policies to protect their currencies from collapse. All of this is negative for global growth, and places the financial system under some pressure. How this will unfold is difficult to predict, but what we do know is that global economic growth forecasts will continue to be downgraded.

Why developed market growth is so weak, despite the numerous monetary stimuli, is difficult to explain. Maybe it is the invisible force of deleveraging as we grapple with the debt overhang built up during the ‘noughties’. Maybe it is unfavourable demographics or a lack of productivity improvements. Whatever the reason, a weaker China is bad news, because at the margin, its growth has been so important. One has to worry that, if global growth comes under real pressure, there is not much left that the authorities can do to stimulate the economy; interest rates are already at zero, QE has had a limited impact, and budget deficits restrict the ability of governments to spend their way out of trouble. Our central case is that China will slow to perhaps 5% GDP growth per year. This would mean we wouldn’t need to wait to find out what China does next on the policy front, as further major stimulus would probably not be required. Whatever the outcome, it seems clear that rates are going to stay lower for longer, and the end point for interest rates once they do start to rise will be much lower than in past cycles.

Before one gets too depressed, there is some good news resulting from this. After years of losing market share to passive providers, active managers are fighting back. This year in Europe and the UK, the average active manager is some 3-5% ahead of the index, and our own funds have mostly done better than that. Reflecting our cautious stance and investment style, we have been very underweight the large energy and resource stocks, and have observed as bystanders as the share prices of many once-mighty companies have collapsed under the weight of downgrade after downgrade. For those that are also badly financed, it could get worse from here, and one should expect some bankruptcies to follow. This has already been reflected in credit spreads, where high yield spreads have risen to nearly 600bps over gilts from a low of 300bps in 2014. In our opinion, robust stock selection, risk management and portfolio construction are going to be critical as the backdrop continues to deteriorate.

Thankfully, these are all areas where we believe we excel. Although we are now arguably in the most challenging macro and market backdrop since the onset of the GFC, we believe strongly that we are well placed to continue to deliver for our clients. We have been pleased with our performance versus our peers, and areas of weakness are few and far between. It is however a time for focus and vigilance, and we will be keeping that in mind at all times when managing portfolios.

Mark Burgess is CIO EMEA and Global Head of Equities at Columbia Threadneedle Investments.

Europe’s Listed Real Estate Revolution

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To be sure, we could have said almost the same thing in 2012 or 2009 (aside from the “securities” part). However, for investors who can’t hold “bricks and mortar” in a portfolio, or who prefer the liquidity of listed exposure, that suggestion would have been essentially useless. Today, after major advances in Europe’s listed real estate market, things are very different. For the first time, having a genuinely global listed real estate portfolio—as opposed to a U.S. and/or U.K. one with a “global” label on it—is a realistic prospect.

Let’s be clear: We continue to believe there are compelling opportunities in the North American REIT market, which has a dividend yield of 4.1% (as of August 31, 2015). In our view, select areas in Asia look attractive, too. And within Europe, currently we would also caution against being underweight the U.K., where real estate fundamentals remain strong, and where we are seeing a number of quality companies (with mixed-use assets in iconic locations and demonstrated management strategies) that we believe are attractive for listed real estate portfolios throughout an economic cycle.

Nonetheless, we believe the U.K. real estate cycle as a whole should moderate in mid-2016, with the listed market’s prices anticipating this trend some months before, despite continued rental growth. In contrast, Continental European valuations have a lot of catching up to do and, in contrast to the U.S. and the U.K., seem unlikely at this stage to see any headwinds from imminent monetary policy tightening. While the FTSE EPRA/NAREIT U.K. Index provided a dividend yield of just 2.6% at the end of August, the Developed Europe ex-U.K. Index yielded 3.4%.

What makes this especially noteworthy, however, is the nature of the opportunity in this cycle compared with previous ones.

A World Transformed

One reason I joined Neuberger Berman as a manager of European listed real estate was that I was so excited about the growth I was seeing in those markets.

At my previous shop, I worked alongside colleagues investing in bricks and mortar, and in 2012 it was an exquisite frustration to hear them rhapsodize about the low valuations in Dublin and Madrid offices—where we on the listed side had no companies to invest in.

Of course, there was plenty to do in the U.K., and Unibail Rodamco in France is one of the largest pan-European real estate investors. But apart from that, Europe as a whole was a bit of a non-starter.

That world is almost unrecognizable now. The value opportunity in Continental European bricks and mortar three or four years ago led to demand for more listed opportunities, which in turn spurred a wave of IPOs.

Since 2013, there have been 45 European real estate company IPOs, worth a total of more than €13 billion. Twenty-eight of those, representing an IPO value of €10 billion, were Continental European listings. Of the 16 €300 million-plus IPOs over that time, seven were seen in Spain and Ireland, including Merlin Properties, which now owns more than 900 commercial real estate assets on the Iberian peninsula, worth €3.4 billion.

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The effect of these listings can be seen by looking at the EMEA ex-U.K. constituents from the FTSE EPRA/NAREIT Developed Index. As of the end of August, they account for 11% of that index and their market capitalization has doubled since the beginning of 2012, from €69.3 billion to €141.5 billion. Moreover, the regional composition of this group has changed markedly: France, which had been 45%, is just 23%; Germany has gone from 10% to 22%; the Netherlands has gone from 9% to 19%; Spain is up from less than 1% to 4%; and Ireland, which was not part of the Developed Index at all until March this year, represents 0.7% and almost €1 billion of market cap.

We don’t anticipate that 2016 will be a value opportunity like 2009 or 2012. Most of the low-hanging fruit had already been picked before this wave of new IPOs. Nonetheless, Ireland and Spain are still very interesting to us, and the cycle for Continental European commercial real estate has lagged the U.S. and U.K. cycles significantly. For the first time, listed real estate investors can position themselves for the evolution in these cycles—and we believe they may want to consider doing so soon.

Opinion by Gillian Tiltman | Portfolio Manager, U.K. and Continental European Real Estate – Real Estate Securities Group –Neuberger Berman

Brazil: The End of the Carnival?

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Brasil: ¿se acabó el carnaval? — Photo: Prefeitura de Olinda . Brazil: The End of the Carnival?

For months positive headlines about the Brazilian economy have been scarce. Real gross domestic product (GDP) is contracting, inflation has soared, and the Real has now lost over 50% of its value since 2014. The country is also facing one of the most pervasive political scandals in recent memory. At present, Brazil is a far cry from being the paragon of Latin American growth.

The economic malaise facing the country is the culmination of long-term structural issues accentuated by short-term cyclical and political factors. A series of policy mistakes has resulted in an imbalanced economy, formerly disguised by the positive effects of booming commodity prices. Brazil’s aggressive taxation regime has discouraged business investment and quelled productivity, while a sprawling social security system has redirected funds away from infrastructure.

The end of the commodity super-cycle has exposed Brazil’s deteriorating fiscal position and dependence on cheap borrowing. It has also undermined confidence in a political system still digesting the fallout from the Petrobras scandal. In a recent poll, President Rousseff’s approval rating had fallen to just 8%.

A tough nut to crack

From a monetary perspective, the central bank is unable to loosen policy for fear of stoking inflation that is already running at over 9%. Fiscal measures are also unlikely as the government embarks on a period of reform to repair past excesses. The current political dislocation, atop an already fragile coalition government, is proving an impediment to substantive economic policy action. In short: a solution remains elusive.

From a market perspective, some commentators argue that the rapidly depreciating exchange rate will provide economic stimulus via exports. We don’t think this sufficient to significantly increase growth. Brazil’s export markets are relatively price inelastic and are largely dependent on a revival in commodity demand. We feel that only a recovery in China can really help the Brazilian economy right now. China is Brazil’s largest trading partner and its thirst for raw materials has been a key driver of Brazilian growth in the past.

Feeling hot, hot, hot

Such stresses are already evident in bond markets. The yield on Brazil’s 10-year local currency debt is over 16% and corporate bond spreads have widened. This pressurises financing requirements for the government, companies and households alike. Households are particularly vulnerable given the recent rise in private sector debt. Equity markets are also struggling as falling company revenues and rising interest rates erode net profit margins.

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The speed of the deterioration may catch market participants off guard; Brazilian government yields have already increased by a third over the past two months (see chart) and the potential spillovers may not be fully reflected in markets. One area we are monitoring is the Spanish banking sector, which has a significant exposure to Latin America.

Brazil has fallen a long way since its ‘momento magico’. It must now embark on the long path to fiscal and political reform if it wishes to restore investor confidence and the belief of ordinary Brazilians in the political system. We remain cautious on Latin America and emerging markets in general, particularly of the potential for a systematic event. We await an improvement in cyclical headwinds and political stability in the short-term, as well as a commitment to structural reform over a longer horizon.

Navigating The Storm: In Risk Budgeting and Alpha We Trust

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Confiar en el alpha, el secreto para navegar en este contexto de mercado — Photo: Arek Olek. Navigating The Storm: In Risk Budgeting and Alpha We Trust

Sailors and mountaineers know it: weather can vary all of a sudden and change a nice family journey into a dangerous endeavour. 2015 started like a beautiful year, blessed by as many as fourteen central banks’ simultaneous efforts to support the economy, with the BoJ and ECB at the forefront. The family picture on 31 March was great: equities and bonds were up during the first quarter; European equities were finally catching up with US equities (up 22%), while Asian stocks were also posting double digit gains, led by China and Japan.

Then, storm clouds gathered. Having bottomed out at 7 bps on 20 April, the 10-year bund yield soared unexpectedly to 98 bps in just a month and a half, generating an unprecedented loss in value of 8.3%. As soon as bond markets stabilised, the Grexit drama came back to haunt investors and policymakers. These clouds dissipated eventually after another marathon all-night summit. But this was a short term relief. Concerns over China’s foreign exchange regime and uncertainties over the Fed’s stance caused unprecedented movements in equity markets in August.

There are fundamental weaknesses that justify market jitters. The economic recovery in Europe and in Japan is weak, large emerging markets ranging from Brazil to China and Russia are experiencing a severe growth deceleration and deflation risks remain significant across the board. Meanwhile, the Federal Reserve will sooner or later have to reverse an unprecedented accommodative stance. The valuation of US equities signals that they are now historically expensive, whether measured by the price-to- book ratio or by the cyclically adjusted price-earnings ratio.

That said, it seems to us that in the medium term, the positive developments on the US recovery front will outweigh the negative implications of the above. Overall, the world economy is likely to be supported by buoyant growth conditions in the United States. However, the sharp growth deceleration in emerging markets implies that aggregate demand will likely remain depressed. In this environment we continue to prefer European and Japanese equities. Their valuation remains attractive in relative terms and earnings momentum has recently been supportive. For the reasons listed above we maintain a neutral stance on fixed income: a low growth environment and deflation fears are supportive but valuations are expensive.

It is precisely because there are bad times that there is a long-term premium in investing into markets. If our scenario is correct, markets will keep on conveying the value generated by the growth of the global economy, possibly in a perturbed manner.

More than ever we believe that combining risk-budgeting and alpha strategies delivers returns in the long run. Risk- budgeting generates sound risk-adjusted returns. Aside from this Market Premia harvesting, diversified Hedge Fund portfolios contribute to smoothing the ride. Let us review why.

Alpha strategies

Hedge Fund strategies have proven very resilient this year. Event Driven/ Risk arbitrage have suffered but most Equity L/S or Global Macro managers have managed to smoothen the global turmoil. As of end-September, the Lyxor L/S Equity Broad index is up 1% year to date, while global equity indices are down almost 10%. The HFR Fund of Fund was still positive end of August even if September moves will likely bring it in negative territories. At that date, some Funds of Hedge Funds were displaying positive performances, some of them above 2%, which is quite remarkable in this environment.

Alpha strategies have been under pressure over the 6-year market rally. But over the course of 2015, investors have increasingly allocated to such funds due to traditional long- only funds being less attractive in relative terms. Interestingly, inflows into liquid alternatives in 2015 are reaching record levels in Europe, at EUR 50bn between January-August 2015. This confirms, if any proof was needed, the long-term hedging properties of Hedge Funds as long as investors put enough emphasis on due diligence matters.

Risk budgeting strategies

The short term case for risk budgeting strategies is more involved. They have been roasted by some commentators recently for two reasons:

they have contributed to downward market movements
they have posted disappointing performances. Not only risk budgeting has been wrongly charged of exacerbating market movements but we point out the remarkable long-term properties of these strategies.

Certainly risk budgeting strategies can lead the manager to sell despite having a positive outlook on the market. But this is like reducing the sail surface of a boat when the wind picks up. It might prove costly if the wind falls back but might also avoid a very difficult situation if the wind picks up again.

Ampliar

As the VIX soared brutally from 13% on 17 August to 41% on 24 August, some people judged that risk budgeting strategies would have immediately cut their position in the same proportion (by 3) hence worsening the sell-off. In our view, this is very much exaggerated.

As far as their performance are concerned, risk- budgeting strategies cannot escape the global market sell-off, particularly when they are long-only. This said, most of them deliver returns above traditional balanced funds since they have reduced gradually their exposure as long as market risk was increasing.

On top of that, the remarkable long-term properties of risk budgeting should be kept in mind. AQR Asness, Frazzini and Pedersen (2012) published a very long-term simulation of a typical risk parity strategy in a article in the Financial Analyst Journal.

Interestingly, these simulations show that not only risk parity strategies do extremely well since 1980 but they would have also been quite resilient between 1930 and 1980. Similar results can be found in many textbooks such as the authority on the matter published by T. Roncalli in 2013.

Even if not doing it in a systematic manner, we definitely recommend thinking in terms of risk allocation more than in terms of dollar allocation since this has proven to be and will likely remain much more efficient.

Nicolas Gaussel is Chief Investment Officer for Lyxor Asset Management.

Made in China 2025: Opportunities and Challenges

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Los nueve objetivos estratégicos para la China de 2025 — Photo: Dennis Jarvis. Made in China 2025: Opportunities and Challenges

Made in China 2025 released by Chinese State Council in early May this year, has established a guiding principle for China’s transformation from a “manufacturing giant” to a “manufacturing powerhouse” in next 10 years. Based on the “Industry 4.0” in Germany, this plan introduces the “three step” strategy. By taking 30 years, which is divided into 10 years of three, it aims to build China into a manufacturing powerhouse in the year 2045 when China celebrates its 100th anniversary.

Develop China from a manufacturing “giant”to a manufacturing “powerhouse”

9 strategic objectives are put forward in Made in China 2025, which include improve innovation ability, promote the integration of informatization and industrialization, establish high-quality brand, implement green manufacturing comprehensively and vigorously promote breakthroughs and development in key areas etc. And it also has 10 key areas covering information technology, energy conservation and new energy, aviation and navigation and biological medicine etc.

The central government will provide special funds and tax preferences for 10 key areas. Although the details are not released, it is believed that the whole planning will improve the influence of Chinese enterprises in global industries and enhance the ability of enterprises to meet the different needs of customers at the same time.

Industry 4.0 can be achieved directly by taking existing advantages

Made in China 2025 is released at this very time and it is of certain advantage for China from the perspective of development process. Compared with developed countries, China and other emerging markets are able to combine industrial systems with the Internet earlier and faster due to the fact that they have invested heavily on infrastructure. This would help emerging markets to promote efficiency and enter the stage of “Industry 4.0” directly by skipping the stage of “Industry 2.0” and “Industry 3.0” which developed countries have experienced. For example, emerging markets do not bother to install electrical cable and wire but use wireless technology directly. By strengthening the connection between enterprises, it will be able to improve the overall economic scale of enterprises and ease the constraints on resources and finance, which makes enterprises more efficient and “smart.”

However, there are still many challenges to cope with in the future in order to achieve the ambitions in Made in China 2025. Firstly, current innovation ability of China is still not high. Although China has 223,000 patent applications in 2014, which make it a country where the most patents are applied for four consecutive years, China is still highly dependent upon importing core materials. In addition, China’s spending on R & D is, all the time, only 2.0% GDP (2013). And it leads to the fact that the added value of the manufacturing industry is only 21.5%, which is far lower than 35% or more in other developed countries.

Innovation ability and image are to be improved

In addition, Chinese brand image has been very poor. There are nearly 10% products which do not conform to the standards within China, and the ratio of Chinese products which need to be recalled is as high as 65% abroad (2012), which is the largest in the world. As far as toys are concerned, on average there are 20 cases where Chinese manufactures are required to recall their toys every month in EU.

Environmental sustainability is also a challenge. Poorly efficient and irresponsible behavior of manufacturing industry in the past has caused heavy environmental pollution. Apart from fog, haze and heavily polluted underground water, utilization ratio of energy per unit is also very high. Therefore, it is not easy for China to achieve significant decrease in energy and material consumption and pollutant emissions so as to fully implement green manufacturing within 10 years.

Capital and talents need to cooperate

Huge capital expenditure could also become obstacles to the implementation of the planning. Although the central government will provide financial and tax preferences, the capital might be very few compared with the funds required in training, machinery and R & D. Talent supply might also be insufficient. Universities may also fail to provide appropriate training facilities. In addition, during the past 30 years, China has been introducing technology and management structure from abroad by taking advantage of its low cost, which results in weak investment and strength in R & D. Furthermore, China has been depending on and developing resource intensive industry such as steel, aluminum, cement etc. It then results in the fact that technology intensive industries such as solar and wind energy industry are underdeveloped. Therefore, the key lies in how to transform the industrial structure and capacity.

China also faces restrictions in order to expand the market. Traditional manufacturing powers such as USA, Japan and Germany have been dominating the market for medium and high-end products globally. So it is not easy for China to seize market share. And developing countries which have relatively weak financial strength may not be able to support products of these kinds or have insufficient demand.

Upgrading the manufacturing industry is helpful for economic restructuring

In addition to market space, China also faces competition from other countries. Over the past two years, the United States has been implementing plans to attract US companies to move manufacturing industry back to the United States. It is estimated that China’s production cost is only 5% lower than that of the United States at present. But this situation is likely to reverse in the future. Due to low efficiency, high logistics cost and poor technology of China, the production cost in the United States is likely to be 2%-3% lower than that in Chinain 2018. At that time, competitiveness of China’s industry will be further weakened.

Overall, there has being a major adjustment in the pattern of global manufacturing industry: On the one hand, developed countries have carried out “re-industrialization” in order to enhance the competitive advantage of manufacturing after financial crisis; on the other hand, other developing countries expand their international markets with costs lower than China. And it leads to the fact China is “facing a severe two-way challenge”, as is written in Made in China 2025. Successfully overcoming the above challenges and gradually transforming China to a manufacturing giant which is characteristic of high-end products, high quality and environmental protection can benefit industries and enterprises which are related to the ten key areas, in overall, as well ashelp to ease the impact of labor cost increase, environmental pollution, limited resource, excess capacity and slowdown in exports and promote economic restructurings.

Victoria Mio is the Lead Portfolio Manager of Robeco Chinese Equities.

Why High Yield? Significant Opportunities for Credit Selection

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The high degree of idiosyncratic risk in high yield bonds means good credit analysis is rewarded, making it fertile ground for active managers.

Broader opportunity set: The growth of the market is presenting more choice when constructing a portfolio. For example, in 2005, there were 216 issues in the European high yield market; by 2015, this had grown to 7553.

Under-researched issuers: Bonds trade over-the-counter (OTC) rather than on standard exchanges. The lack of transparency in the OTC market means exchange-traded funds (ETF) and larger investors are forced to focus the bulk of their trading activity on the larger issuers in the indices. This leaves a wealth of opportunities for active investors, such as Henderson, to identify value among the smaller underresearched issuers.

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Ratings mismatch: Within the credit cycle, ratings agencies tend initially to review the larger issuers in the high yield market, taking time to progress to the smaller, often lower rated issuers, so can be slow to appreciate improvements among CCC-rated companies. Henderson, historically, has held a higher-than-benchmark portion of CCC issuers in its high yield strategies, believing that many of these credits are mis-rated. We also believe that since the financial crisis ratings agencies have sought to deflect criticism that they were too generous before 2008 by applying a cautious bias to ratings in recent years. Again, this allows good credit analysis to identify mis-rated opportunities.

Accessing the asset class

Henderson offers three strategies within the high yield space: global, US and European currency, as well as offering access to the high yield market through off-benchmark exposure in investment grade strategies.

A truly global approach

Unlike many global high yield funds, which are run solely out of one location, the Henderson global high yield strategy is run jointly by Chris Bullock and Tom Ross in London and Kevin Loome in Philadelphia, together with credit analysts on both sides of the Atlantic. As the high yield market expands globally, Henderson believes it is vital that analysts are closer to the companies they research.

High conviction portfolios

Henderson’s high yield funds are run as ‘best-ideas’ funds. Rather than attempting to replicate the indices against which the strategies are benchmarked, the portfolio managers, in conjunction with the credit analysts, choose their top 75-150 issuers to include in a portfolio. This makes for a high-conviction approach that captures the strength of our analytical expertise.

Flexible and active

We believe that credit selection and analysis are key to structuring portfolios but that top-down factors cannot be ignored. Henderson’s high yield strategies, therefore, asset allocate nimbly across ratings,

geographies and industries. Henderson is also adept at using derivatives, which can be used for hedging purposes or to express short positions.

Experienced team

The Henderson Global Credit team numbers more than 30 investment professionals with an average of 13 years’ experience. Its strong performance has led to several accolades and awards.

Tom Ross joined Henderson in 2002 and has been co-managing Henderson’s absolute return credit funds since 2006.

Mutually Inclusive

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A quiet revolution is happening in hedge funds. Investors continue to allocate to the asset class, but the way they are allocating is changing, while its investor base is growing broader and becoming more inclusive.

With both bond and equity markets facing major challenges, investors are increasingly seeking out strategies that are not tied so tightly to the performance of the broader equity and fixed income markets. This trend has been picked up over several years by the Morningstar and Barron’s Alternative Investment Survey of U.S. Institutions and Financials Advisors, the 2014-15 edition of which was recently released.

Reporting the views of nearly 400 investors, it found that 63% of advisors believe they will allocate more than one-tenth of client portfolios to alternatives over the next five years, compared with just 39% in the same survey for 2013.

But more interestingly, over several years the same survey has been showing continued growth in alternatives wrapped in more accessible registered fund structures that offer daily liquidity, as opposed to the more traditional, and exclusive, private funds. Assets in U.S. registered alternative funds have risen from less than $50 billion under management in 2008 to well over $300 billion as of mid-2015. While growth has slowed from what Morningstar and Barron’s described as the “eye-popping” rates of 2013, money is still flooding into “multi-alternative” and managed futures retail products, in particular, with many new funds having been launched to meet demand. Moreover, the trend is spreading outside the U.S.: Strategic Insight’s SIMFUND database reveals a similar trajectory, showing the number of liquid alternative European UCITS and U.S. ’40 Act mutual fund products tripling to well over 1,500 since 2008.

Structures, Not Just Strategies

Clearly, the latest developments in alternative investing are as much about investment structures as investment strategies. The survey report notes, for instance, that strong positive flows into multi-alternative regulated funds coincide with dwindling traditional fund-of-hedge-fund assets.

Indeed, while U.S. advisors, who tend to be heavier users of mutual funds for liquid hedge fund strategies, have been increasing their allocations, U.S. institutional investors more used to traditional hedge fund structures have been cutting back from the latter: The Morningstar and Barron’s survey found that those expecting to allocate more than 25% to alternatives declined from 31% a year ago to 22% today. The survey report suggested they “may be tempering their enthusiasm as a result of fees, lockups and poor transparency in traditional hedge funds, as was the case with CalPERS’ announced decision to withdraw from hedge funds,” and these concerns came up when investors were asked what makes them hesitate before making alternatives allocations.

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We believe that investors who are moving their exposure to hedge fund strategies into the regulated fund world are addressing these issues without throwing the baby out with the bathwater. Let’s take them one by one:

Fees. The typical fee for a hedge fund used to be a 2% asset-based management fee, with a 20% performance fee on top. Investing through a fund of funds at peak pricing could have added an additional 1% and 10%, respectively. Competition has brought costs down, but they remain high—and the addition of hurdle rates and high watermarks on performance fees adds complexity and variability.

While many UCITS still charge management and performance fees at higher, “hedge fund” levels, some providers are consciously bucking that trend and bringing fund expenses in line with typical U.S. practices. Although generally higher than those charged on most long-only mutual funds, management fees on alternative ’40 Act funds are generally set to compete with those on other specialist mutual funds, and are lower than fees charged by traditional hedge funds because they do not have performance fees, which are prohibited for funds offered to retail investors.

Redemption terms. Many hedge funds allow only monthly or quarterly redemption and often include longer-term lockups after initial commitments. During the stressed markets of 2008, some hedge funds “gated” redemptions, only allowing a certain amount of cash to be withdrawn at any one time.

Mutual funds are required to offer daily redemption at a fund’s next NAV. (Again, while this is required for U.S. mutual funds, it is not always the case for regulated funds in other jurisdictions.) While some of the less liquid parts of credit markets may be out of bounds for funds offering daily redemptions, a multi-strategy, multi-manager liquid alternatives product offering daily redemptions at NAV should have access to a substantial portion of the hedge fund strategies available, minimizing selection bias.

Transparency. Hedge funds often only report to investors once a month, with a delay, and position-level transparency is not the norm. Multi-manager alternative funds often utilize a separate account structure, as opposed to the traditional fund-of-funds model, and this ensures position-level transparency for the portfolio managers on a daily, or even real time, basis. It allows for greater risk oversight and improves the ability of the portfolio manager to react to changing market conditions. Additionally, certain regulatory requirements applicable to registered funds require that all securities be maintained at a custodian bank and, therefore, the fund maintains total control over its assets.

Corporate governance.I t is not always clear that hedge fund directors are sufficiently engaged in governance, and in traditional funds of funds investors have little oversight of the selection of prime brokers, administrators and auditors. As part of the comprehensive regulation provided by ’40 Act and UCITS, regulated funds’ boards, which include members that are independent of the manager, provide a much-improved governance framework. For multi-manager funds, they can help improve the process of monitoring the underlying managers and often allow the fund, and not the underlying managers, to select and directly oversee other fund service providers.

Encouraging Trend

The fact that more and more products are being rolled out to fit this investor-friendly profile is encouraging. Morningstar and Barron’s have tracked 475 launches since 2009, and the 118 new products for 2014 represented a significant jump from the 89 that appeared in 2013.

This reflects an increasingly competitive hedge fund industry: Managers are both more willing to adapt their hedge fund terms to match those of regulated funds and more willing to launch regulated funds to access a bigger pool of investors. This is happening largely without injurious hedge fund-style terms being smuggled into regulated fund structures, or the watering down of hedge fund strategies. That is why we believe this growing phenomenon has earned its distinguishing descriptor: “liquid alternatives.”

Opinion by Fred Ingham, Head of International Hedge Fund Investments, and Ian Haas, Head of Quantitative and Directional Strategy Research, NB Alternative Investment Management.

Why High Yield? Low Interest Rate Sensitivity and Default Rates

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El atractivo del high yield se mantiene: los niveles de impago seguirán siendo bajos — Photo: Lee. Why High Yield? Low Interest Rate Sensitivity and Default Rates

The high yield market typically has a lower duration than other fixed income markets due to a combination of higher coupons and shorter maturities. This helps to insulate it from movements in interest rates – a characteristic that is becoming increasingly valuable as the market anticipates a rise in US interest rates. The chart below shows how US high yield has historically provided better excess returns in periods where 10-year Treasury yields increase by more than 100 basis points (bps).

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High yield tends to exhibit a higher level of idiosyncratic risk than other areas of fixed income, with individual company factors proving a bigger determinant of the bond price than is the case for investment grade bonds. As the correlation table below demonstrates, high yield also has a stronger correlation with equity markets, making it a useful diversifier within a fixed income portfolio.

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Default rates expected to remain low

For a long-term investor, the heightened risk of default is the key driver of spread premia for high yield bonds. We expect default rates to remain low for an extended period given sensible leverage, lack of capex and historically-low interest rates – the exception to this being the energy sector which is troubled by over-investment meeting a collapse in oil prices.

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In a recent study, Deutsche Bank remarked that 2010-2014 is the lowest five-year period for high yield defaults in modern history (quality adjusted). To protect for default risk in BB and B-rated bonds over this period, investors would have required spreads of 27bp and 94bp respectively. To put this in context, current European/US BB spreads are 314/346 bp and B spreads are 528/518 bp2, suggesting high yield bonds in aggregate are more than compensating for a moderate pick up in defaults.

Although we are seeing evidence of late cycle activity in some sectors in the US, at a more broad level and globally companies are still using the proceeds of their high yield bond issues for non-aggressive activities such as refinancing. Bondholder unfriendly activities (issuing bonds to pay for leveraged buyouts or to pay dividends to equity holders) remain well below the worrying levels of 2005-07.

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Article by Kevin Loome, who joined Henderson Global Investors in 2013 as the Head of US Credit

Brazil’s Slumping Economy Likely To Decline Further

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A Brasil le espera más dolor — Photo: Caio Bruno. Brazil’s Slumping Economy Likely To Decline Further

Hurt by the global slump in commodities and mismanagement by government officials, Brazil’s economy has been battered both internally and externally. Given the current domestic political crises in Brazil over the alleged Petrobras payments to politicians, and the country’s current budget crisis, I believe it is unreasonable to expect any near-term recovery.

Gross domestic product (GDP) and industrial production have dropped

Over the past year, Brazil’s real GDP and industrial production have declined sharply, continuing a trend that began with the collapse of output and production following the Global Financial Crisis of 2008 and 2009. Since peaking in the first quarter of 2014, Brazil’s real GDP has fallen by a cumulative 3.5%, while industrial production has declined by 6.8% (on a 12-month moving average basis).1

The Brazilian economy is laboring under “twin deficits.”

The first is an external current account deficit that implies that the economy has lost some competiveness and/or that there’s a build-up of overseas debt.
The second is a growing fiscal deficit that the government appears very unwilling to bring under control.

The worrying aspect of Brazil’s macroeconomics is that both deficits are currently widening, suggesting a marked lack of discipline with respect to spending. Normally a government faced with this kind of situation would attempt to rein in fiscal expenditures by reducing the fiscal deficit or private expenditures, leading to an improvement in the current account balance. However, the fact that Brazil is not doing either of these two things is a major reason to expect the currency to weaken further.

With the government’s unwillingness to bring the country’s fiscal deficit under control, most of the burden of adjustment rests on the central bank’s interest rates, which are very high at 14.25%,2 and the currency, which has depreciated sharply despite high domestic interest rates.

Recession extension likely

Brazil’s economy is in a protracted slump. Given the weakness of demand abroad for Brazil’s key commodities, and the inability to revive the economy at home, it seems likely that the recession will be extended.

Key indicators of domestic spending show a gloomy picture:

New car sales were down 13.2% year-on-year in June
Industrial production was down 6.6% year-on-year in July
The latest comprehensive figures for retail sales show they were down by 3.0% in June.

Outlook

With high inflation eroding purchasing power and high interest rates curtailing credit growth, it is hard to envision any near-term upswing in the domestic economy for Brazil.

Going forward, I believe Brazil’s currency is likely to depreciate further, and interest rates will like stay high until the twin deficits are properly addressed.

Article by John Greenwood, Chief Economist of Invesco Ltd