Portfolio managers respond to uncertain times

The participants:

• Fabrice Cuchet, global head of alternative investments, Dexia Asset Management (€74bn assets under management)
• Antoine de Salins, chief investment officer, Groupama Asset Management (€90bn assets under management)
• Francisco Galiana, head of credit portfolio management, Banco Santander
• Anne Richards, chief investment officer, Aberdeen Asset Management ($322bn assets under management)
• Joseph Pinto, global head of markets and investment strategy at AXA Investment Management (€562bn assets under management)

Q: What are the biggest challenges stemming from current regulatory changes?

Antoine de Salins: First and foremost, the asset management industry has to deal with increasing regulatory pressure and instability. This reduces significantly the long-term visibility, which is indispensable to properly run our kind of business, as well as increasing the fixed costs associated with the normal activity. It will also raise at some stage the question of the ability of the asset management industry to provide long-term financing to the economy.

Also, our industry is in a situation of over-capacity in Europe, with structurally decreasing assets and increasing pressure on fees. As a result, we clearly see the need for asset managers to propose either beta at low cost, or alpha and/or high value-added services for a decent cost, and reach for the maximum efficiency of their structure.

Francisco Galiana: We are the credit portfolio management (CPM) unit of Santander Global Banking and Markets. From a CPM point of view, the biggest challenges from current regulatory changes affect the securitisation markets and the hedging tools available for portfolio managers to reduce balance sheet risk concentration and balance sheet usage.

European securitisations have performed really well during the crisis, not just the senior tranches but also the most junior and first-loss tranches. Yet a series of current and forthcoming regulations is building up to discourage European investors from investing in senior tranches (and, as a side effect, in junior tranches) across banks, insurers, pension funds and regulated funds. However, there are also indications from the European Commission that, in its own words, “reshaping the securitisation markets could help unlock additional sources of long-term financing”, plus the fact that “it can help financial institutions to free up capital”. So, we will have to wait and see.

Joseph Pinto: Many regulatory changes have already or will affect various aspects of our business in the next few years, but some of the biggest challenges stemming from them will be to reshape our product pipeline to benefit from new opportunities in the market, such as direct lending and bank disintermediation. We also need to address properly the new requirements of our large insurance client base through Solvency II [Directive]-friendly products and services, and to adapt our management companies to comply with the AIFMD [Alternative Investment Fund Managers Directive]. We will also have to tackle the consequences of the European Financial Transactions Tax, which is due to come into force from January 2014 and will add costs for our clients in certain markets.

Q: How has your asset allocation evolved in the past 12 months? Do you expect it to change further in the next 12 months? Towards what kind of allocation?

Fabrice Cuchet: First, it is worth noting that the current context, with close-to-zero interest rates for a long period of time, is in fact creating discrepancies within the markets, thus still providing investment opportunities. Therefore our asset allocation has evolved towards more diversification, and the need to identify alternative sources of return is key in order to keep on delivering attractive risk/return profiles. The ongoing trend is to increase our bucket allocated to both alternative asset classes such as high-yield, emerging or convertible bonds, and to absolute return strategies. In addition, over the past 12 months, we have increased our allocation to risky assets following the switch from a political and unpredictable environment towards a more fundamentally driven landscape. Our typical allocation today is 53% equities, 38% bonds (of which 23% is in credit and emerging bonds) and 9% absolute return strategies.

Anne Richards: Exact allocations depend on the particular mandate but we have broadly reduced our equity exposure across portfolios at various stages over the past year in response to the strong rally in markets from the lows in 2009. We have also built up our alternatives exposure via a core portfolio of infrastructure holdings.

Our multi-asset investment approach is to assess the market environment based on three key pillars: first, the momentum of global economic growth; second, market valuations; and third, the amount of liquidity support that policy-makers are providing. While global growth has had its moments over the past few years and is arguably the most fragile of all three of the factors, it does remain relatively robust. Although equity market valuations have risen across most markets, they are still attractive on a relative basis – certainly when you consider how overpriced many Western government bonds are. The third pillar has been the cornerstone, however. The willingness of central banks to pump liquidity into the system has kept risk assets supported and it is not surprising that investors are now paying great attention to the [US] Federal Reserve’s every move.

FG: Credit is our only asset class, but credit on a global basis, which means we manage rates and foreign exchange asset classes as well. Within credit, we give preference to portfolio trades and secured transactions for their lower risk profile, given diversification and current relative value to other single-name proposals. That has not changed in the past 12 months. Also, we manage peripheral risk based on our experience and expertise. That has not changed either and it is not expected to change in the near future. Nonetheless, the size of our current portfolio has decreased significantly from 12 months ago and given the opportunity we are willing to add. In terms of credit quality, we prefer the BBB rating range with short duration.

Q: What are your expectations for correlation between asset classes over the next 12 months, and how do you respond to that correlation in terms of asset allocation?

AR: For us, focusing on historic correlations and prospective returns is not enough – the past is prologue. Correlations need to be actively managed. Good managers should always be thinking about correlations between asset classes – managing correlations in normal times and anticipating correlations rising in times of market stress.

For example, the negative correlation between US Treasury [bonds] and the S&P 500 still holds but we will continue to monitor it closely. Meanwhile, there are signs that the dollar’s negative correlation with the S&P 500 is breaking down as the yen falls and the Japanese carry trade unwinds.

Correctly managing correlations should lower volatility, but even more important is looking through the volatility and correlation numbers to the underlying economic drivers of assets because, in the long run, that is how true diversity is achieved.

JP: In an environment of slightly stronger economic growth, our fund managers from multi-asset client solutions anticipate equity markets to rise and bond prices to fall, correlations between both asset classes should thus be negative over the next year. Commodities should re-correlate with equities as the economy recovers, even though we do not expect them to show a strong recovery in the short term. Correlations within equity markets should stay on the low side and allow stock-pickers to add performance through active management.

FC: Our main scenario is a lower average correlation between main asset classes, with steady equities and credit markets coupled with more volatile government bonds markets. The so-called ‘sideways’ scenario is the most probable one for the coming quarters, because on one hand uncertainties are still here – the unwinding of quantitative easing [QE], zero growth, and high and rising unemployment in Europe – and on the other hand there is more ‘hot money’ than ever; that is deep pools of liquidity constantly arbitraging markets. As a consequence, my conviction is that successful asset allocation first will be driven by an effective flexibility in order to capture short-term opportunities and abnormal moves, and second absolutely requires a very good understanding of the performance drivers within your diversification bucket.

Q: How do you cope with the current low rates/low yields environment? Do you expect it to change in the next 12 months?

AR: Investors are generally being forced to search further and further afield for yield. For diversification reasons, we do continue to hold some core government bonds in our portfolios. However, in a quest to uncover solid returns and income in this environment, we have looked to alternative holdings such as infrastructure, as well as well-run, cash-generative companies, in all parts of the globe. We also recognise the long-term potential of the fast-growing Asian and emerging markets, but the challenge remains how best to allocate to these areas and access this trend.

AS: This environment is a big challenge, first for the industry as a whole, where the business model of Money Market Funds is under pressure due to shrinking performances, and also for our clients and ourselves as investors, who have to deal with negative real rates across the curves. The natural answer is to diversify our product offering and investments, including, for instance, high yield or loans into the scope. We do not expect any changes soon, as central bankers will have to keep this very accommodative stance for 'an extended period of time', in the words of the Federal Reserve.

JP: The beginning of the end of QE is getting closer. We think that the normalisation of yields is well under way. Our year-end target for Treasury yields is now slightly higher (from 2.3% to 2.5%). Beyond year-end and into late 2014, our conviction is that long-dated US yields should normalise further as the economic recovery follows the script and thus offers the Fed the possibility of terminating QE in the first part of 2014. However, we remain convinced that the Fed will not sell the enormous stockpile of bonds it holds. This should limit the upward pressure on yields. In sum, our 2014 forecast is up to 3% but with an upside risk.

This should also lead the euro safe havens marginally higher, but the ongoing recession combined with the crowding-out effect of Japanese buying should put a natural cap on euro area yields. We are thus sticking to a 2% target for the second half of 2014.

FG: Although credit is our asset class, until now we favoured rates, adding to the performance of the basic credit component of our portfolio. That is going to change as a long-term trend, although quite slowly. We will have to focus more on hedging rates risk, which is like navigating against the wind. How well the central banks of this world manage this process will mark the timing and strength of the next financial crisis.

Q: Has your hedging policy changed in the past 12 months?

JP: Ample liquidity, due to very accommodative central bank policies, created an environment of low equity market volatility. In our mixed assets portfolios, our fund managers took advantage of this environment to buy cheap portfolio protection for example by purchasing put options on equity indices to protect our portfolios against major market corrections.

AS: Regarding currency risk, we usually do not hedge foreign currency exposures on our equity positions and, on our bond positions, hedge it structurally. This has not significantly changed over the past 12 months, except for some tactical moves. We think that currencies will remain highly volatile and subject to central bank moves and macroeconomic data.

FG: We have endured a tough deleveraging process in which credit hedging has played a significant part. We expect that as the process comes to an end, hedging will become more a business-as-usual issue, rather than a deleveraging tool. This is the reason why securitisation is key as it provides long-term financing and risk-mitigation techniques.

Q: How important is liability-driven investing [LDI] for your end-investor client base?

FC: It has been a growing trend over the past decades for our clients and it is definitely a must-have in such a low interest rate environment. A vast majority of the mandates we manage now have to take into account asset/liability management analysis in order to fulfil our client’s requirement. Fortunately we have developed since 2005 strong in-house actuarial capabilities in order to be able to propose adequate solutions to our clients.

AS: Groupama Asset Management manages roughly 50% of its assets with an LDI approach. Our first client is, of course, the insurer Groupama SA itself, as well as its affiliates, both for life and non-life mandates. But we are also responsible for managing assets for institutional clients, in France or internationally, mainly in the pension fund universe. That has two consequences: first, we define ourselves as very long-term investors, with a strong focus on responsible investment principles and tools. We also put a strong emphasis on developing a comprehensive understanding of our client needs in such a difficult environment. That is the reason why we have set up an investment solutions team including asset allocators, LDI management and financial engineering.

JP: With a large pension fund and insurance client base, liability-driven investing is at the heart of our clients’ investment strategy and concerns. In this low-rate environment, our clients are struggling to reduce deficits and improve their solvency ratios. Increasing longevity and regulatory scrutiny has compounded the need to focus on the liability side of the balance sheet. No one can afford to look at assets in isolation anymore. Increasingly we are also seeing clients looking to include assets such as infrastructure or real estate that can provide an element of interest rate and/or inflation hedging, while also providing the necessary returns on the asset side.