Bonds Offer Big Diversification Benefits

The emerging-market bond universe is growing and maturing. For example, roughly 55% of the JP Morgan EMBI Global Index is now rated investment grade, whereas a decade ago, most bonds were rated at the lower end of speculative grade. These bonds now behave like developed-market investment-grade corporate bonds, making them more effective than non-investment-grade bonds in offsetting the volatility of emerging-market stocks. Yet despite their quality and greater downside protection, emerging bonds are highly correlated with emerging stocks, underscoring the benefits of managing them together in a single, integrated portfolio.

Active currency management is another “lever” for a multi-asset strategy. A substantial portion of both the return and the risk of investing in emerging markets derive from currency exposure. Disaggregating the currency selection decision from the stock and bond selection decision creates new opportunities to improve portfolio efficiency. For example, you could invest in a Turkish exporting company in expectation that its competitiveness will improve as a result of a weaker Turkish lira, while simultaneously shorting the lira so that the currency’s depreciation won’t impact the principal value of the stock.

A Multi-Asset Strategy

Single-asset class managers don’t always see the bigger picture. For example, an emerging market bond manager will likely own some Venezuelan bonds, despite their tremendous political and economic risk, because the country represents a large proportion of the bond benchmark’s yield spread. Yet many emerging-market stock investments appear to offer similarly high return potential with lower levels of risk.

Simply bolting together emerging equity and debt portfolios would fail to capture the most attractive part of company capital structures when an issuer has marketable stocks and bonds. Take Petrobras, a Brazilian energy company with a strong cash flow and a solid balance sheet. Its fundamentals are attractive, and the company has a large weight in both the equity and debt benchmarks, so it would appeal to both stock and bond investors, and would probably be found in a strategy that bolted together a stock manager with a bond manager. But with an integrated multi-asset strategy, the focus could be on the part of the capital structure with the most attractive risk-adjusted return expectations. In this case, the stock would have been recently more attractive because the company’s strong balance sheet and low equity valuation suggest limited downside potential for the shares.

More Countries, More Opportunities

An unconstrained multi-asset strategy also allows a manager to invest in more emerging market countries, which are often absent from major stock indices or bond indices. For example, Taiwan and South Korea are among the larger country components of the emerging market stock benchmarks but are not included in some emerging market bond benchmarks. China accounts for 17% of the stock benchmark but just 1% of the bond benchmark. And some emerging markets are represented only in the bond market benchmark (such as Venezuela, Lebanon, Panama and Ukraine).

By broadening the opportunity set, an unconstrained approach gives investors access to more and different asset classes, countries, currencies and securities than a stand-alone debt or equity portfolio. With greater flexibility to seek higher risk-adjusted returns and greater diversification to reduce portfolio volatility, a multi-asset strategy provides investors with new ways to win in some of the world’s most exciting economies.

Morgan Harting is Senior Portfolio Manager, AllianceBernstein.

While some may turn to governments for aid, central banks cannot absorb the full impact of private sector deleveraging. Private capital is also insufficient in size to meet deleveraging needs. Thus, economies have two basic choices, a default/restructuring, such as Greece, or enacting repressive monetary policy, such as quantitative easing in the U.S. While the outlook may seem bleak, in a capital-starved, deleveraging, and complex world the return potential from credit investments can be substantial.

To unlock value in this economic scenario, an investor needs patient capital, the ability to analyze relative value opportunities, and the ability to understand politics. An investor can pursue this goal via two paths, opportunistic/directional or relative value/market neutral strategies. The former requires patient capital and creates value through focusing on senior parts of the capital structure or becoming an active investor. The latter aims to exploit market dislocations that are a direct consequence of deleveraging and regulation.

Of the three major balance sheets available to investors—consumers, governments, and corporations­—corporations are in the best shape. Corporations started with better initial conditions after the dot-com crash and have been better managed through the present crisis. For example within corporates, we prefer bank loans over high yield. Companies have cash flows tied to assets that are volatile and sensitive to changes in the macro environment. Loans are senior in the capital structure and have a priority claim to those cash flows, generally experiencing lower volatility and higher recovery. In our view, loans offer better volatility and loss-adjusted return in this “new normal” world.

Turning to relative value strategies, in order for investors to capitalize on opportunities they need to assess macro-economic and policy implications, understand the interconnectedness of the financial markets, and analyze relative valuations. For example, two seemingly independent asset classes, Greek sovereign risk and U.S. non-agency RMBS paper, turned out to be correlated after problems in Greece caused investors to fear that European financial institutions would sell their U.S. non-agency MBS positions. An additional area for relative value creation is within the financial sector, which remains extremely complicated and full of opportunities. Understanding credit losses on a bank’s mortgage portfolio is no longer sufficient. An investor must understand the origination of the loans, legal implications of various scenarios, and liability transfer at minimum. An investor who comprehends the bank’s assets can better understand where mispricing lie within the liabilities.

At a time when macro-economic and policy events dominate market movements, a prudent investor must be capable of understanding the complexities within the corporate credit universe. Despite low yields in the market, attractive opportunities are available within the relative value space and these do not require an investor to forecast where the market will be three months or a year from today. An investor who has resources to analyze the interconnectedness of the financial markets and has patient capital to deploy can capitalize on these opportunities despite the uncertain investment environment that surrounds us.

Rudy Pimentel is Executive vice-president, PIMCO.

Conventional wisdom: Diversification is dead. Since the early 1990s, globalization has contributed to rising correlations between the S&P 500 Index and stocks in emerging markets, Japan, Europe, and Asia ex-Japan. However, high correlation does not imply equal return. From 1999 through 2009, emerging markets, Asia ex-Japan, and European equities were highly correlated with the S&P 500, but annualized returns were markedly different: the MSCI Emerging Markets Index rose more than 10%, while the S&P 500 declined. Correlations rose further from December 1999 through December 2011, but major non-U.S. markets declined as the S&P 500 posted 10% annualized returns.

Practical implication: Diversify—or not—regardless of correlations.

Conventional wisdom: Avoid equity markets in times of stress. Most investors would say they disagree with this statement, but behavior tells a different story: beginning with the Asian crisis of 1996 through the European sovereign debt crisis of May 2011, net outflows from global equity mutual funds rose sharply at market stress points. Such stress points often emanate from political turmoil and other factors with little direct relationship to equity valuations. Not surprisingly, these crisis points have typically offered some of the best opportunities to buy stocks, with exceptional one-year forward returns over a broad range of equities.

Practical implication: Have the courage to buy stocks when it feels wrong.

Conventional Wisdom: Capital appreciation trumps capital return. Investors generally buy stocks expecting that increasing corporate earnings lead to higher share prices over time. Although capital appreciation is important, investors shouldn’t forget about capital return: according to Standard & Poor’s, dividends accounted for more than 40% of the S&P 500’s total return for the last 80 years. Dividend growers and payers also outperformed cutters and non-payers from 1979 through mid-2011, due in part to the financial discipline and shareholder-friendly management often associated with dividend-paying companies.

Practical implication: Don’t underestimate the power of capital return.

Conventional Wisdom: Consistent EPS growth is achievable by many growth companies. Most investors buy growth stocks anticipating that companies will be able to grow earnings consistently over several years. However, consistent earnings growth is not easy to find. Even Wall Street tends to be overly optimistic, with most companies in the Russell 1000 Index missing initial consensus EPS growth estimates in 23 of 33 years from 1979 through 2011. Only 2% of companies in the Russell 3000 Index were able to grow earnings above the median over five consecutive years from 1988 to 2011, and less than 5% of stocks generated above-median returns for five straight years.¹

Practical implication: Understand how growth managers achieve returns.

Conventional Wisdom: Markets with the best economic growth generate the best equity returns. From 1999 through 2009, total return in faster-growing emerging market economies significantly outpaced advanced economies. Over longer time periods, however, there is little relationship between equity returns and GDP growth. Japan’s economy, for example, grew nearly 4% a year from 1900 through 2011, with only slightly higher annualized equity returns. In contrast, annual GDP growth in the UK was under 2%, but real equity returns exceeded 5% per year. Higher equity returns seem to depend more on mature political systems, predictable regulatory regimes, and stable legal frameworks than on economic growth. ²

Practical implication: Allocate capital considering fundamentals, not just forecast economic growth.

Ray Mills is Non-U.S. Equity Portfolio Manager, T. Rowe Price.

¹ Sources: IBES, Russell, Thomson Reuters, analysis by T. Rowe Price.

² Sources: Credit Suisse Global Investment Research, Dimson, Marsh, and Staunton data, IMF, Morgan Stanley, MSCI Indices, analysis by T. Rowe Price.

While this phenomenon is investment bank-driven, a short-term approach to bonds has also affected asset management practices. This is perverse because academic research suggests that our predictive ability for interest rate and currency movements is extremely poor over short periods. While it cannot guarantee superior performance, we suggest that investing on the basis of sustainable trends in economics, politics and other social factors should provide a firmer foundation.

The Balassa-Samuelson Effect is a good example of longer-term trends. It theorises that developments in a country’s productivity will drive its real effective exchange rate as workers’ relative spending power improves. This tends to occur as a country industrialises and there have been several example in history such as Japan in the 1950s and ‘60s and South Korea more recently. If one can identify and follow a similar path then portfolios could be positioned to gain from exchange rate trends. The test is whether the country’s politics allow it to develop its potential without dissipating returns through high inflation.

In the past many emerging market countries failed to fulfil their potential because they were locked into vicious circles where volatile economic developments stymied reform of weak political institutions. The shock of the Asian crisis of 1998, however, led many countries to reform their approach, for example issuing bonds in domestic currencies rather than dollars. The subsequent growth in wealth has encouraged grass-roots support for political and economic reform and created a virtuous circle in some countries.

Political settlements – the combination of institutions and formal and informal practices in a country – are key to long-term economic developments. Consider the contrasting developments in Chile’s and the United States’ fiscal positions. Chile’s institutionalised fiscal conservatism, supported by a political consensus has seen debt and GDP ratios fall below 10%. In contrast the U.S.’s political conflicts and impasses have helped its deficit balloon.

Investors taking a longer-term approach should look for signs that political trends may take a helpful direction. Occasionally this will be baked in from the beginning. For example the robust approach to repaying state debts with federal money introduced by Alexander Hamilton. The first US Secretary to the Treasury established a creditor friendly approach that persisted for centuries. Sometimes a charismatic politician such as Deng Xiaoping in China or Lula da Silva in Brazil can change an economy’s course. Often, however, it takes a crisis such as Asia or Canada in the 1990s or Europe today to precipitate a change.

As a live example, global economic imbalances may be a source of bond and currency movements that persist for a considerable period, perhaps opening up investment possibilities. Developed economies must achieve competiveness and this may drive exchange rate appreciation in emerging market currencies. However there is a lingering tendency towards inflation in emerging markets despite reforms. This suggests that inflation-linked bonds may have merit, particularly since real yields are relatively high.

Kenneth Barker CFA is a partner with Baillie Gifford Overseas.

Rehearsing the theoretical arguments for emerging market stocks, Zev Frishman, senior vice-president with Open Access Ltd., told delegates at the 2012 Benefits & Pension Summit that conventional investing wisdom often doesn’t hold up.

Over the past 20 years, emerging market equities “should have given you higher returns than developed market equities,” because “many emerging markets have experienced really spectacular growth.” Now emerging markets account for almost half of global GDP.

But, in emerging markets, there is little to no correlation between economic growth and equity returns. GDP growth is correlated with corporate earnings in the aggregate, but not with earnings per share (EPS) growth. Frishman cited a number of reasons for why this would be. Earnings growth can show up in new, unlisted businesses and in initial public offerings. But, by definition, this growth escapes existing public market investors. Frishman estimated that there’s a leakage of about 2% between GDP growth and EPS growth.

Another caveat is that much depends on valuations. China, for example, has had the fastest GDP growth of any emerging market in the past two decades. It also has had the second-worst-performing stock market, after Pakistan. The reason? People tend to overpay for recent growth.

Perhaps a cheaper way to gain exposure to emerging markets is through multinational companies. Yum Brands, which franchises Pizza Hut and KFC, among others, is deriving a significant portion of its revenues from China. Similarly, Avon is seeing half of its earnings coming from Brazil, where it is effectively part of a duopoly. But Avon trades at 12 times earnings, whereas its competitor sports a price/earnings ratio of 24.

That said, in aggregate, emerging market valuations look attractive. But, he warned, “this is not a free lunch.” While emerging markets have indeed outpaced developed market investments recently—by about 200 basis points—volatility is still higher than in developed markets, and tail events are more severe.

Peter Marber, chief emerging market debt strategist with HSBC Global Asset Management, echoed Frishman on wrong-headed “collective wisdom.” Emerging market growth hasn’t translated into outsized equity returns, but it has for bonds and currencies.

Investors aren’t aware of this because they aren’t looking at the risk-adjusted returns. They rely on the tenets of finance theory, among them that stocks beat bonds. Looking at the data from the past decade, that isn’t true. Bonds have beat stocks, with lower volatility.

For an institutional investor, the natural place to have been for the past decade was Canadian and U.S. bonds. But with yields at 2% for 10-year bonds and 3% for 30-year bonds, there’s not much yield—and, with interest rates at historic lows, not much room for a capital gain either.

Global bond diversification doesn’t really work either, Marber suggested, because the index is dominated by “the crappiest economies in the world”: to wit, the countries that have issued the most debt. Developed markets, even before the financial crisis, had 80% debt-to-GDP ratio.

“I’d rather diversify into the growth story,” Marber said. Emerging markets have a 40% debt-to-GDP ratio, and that is tracking lower. And emerging market debt is more likely to get a credit rating upgrade. But markets are pricing in a 3% premium for emerging market debt. Because of the euro crisis, he said, investors are not going to bid up emerging market bonds, even though Mexico and Brazil may be better credits than Spain, Italy and Ireland.

Diversifying can also take advantage of different interest rate and inflation cycles in emerging markets; some have room to lower interest rates. High growth, while normally a sign of impending inflation, has another upside. For every 1% advance in GDP, there’s a 0.3% appreciation in currency. This played out with the growth of the U.S. against Britain, where the pound in 1912 was valued at $5 and is now $1.55, and with the yen since 1962, which has appreciated to 80 yen from 360 yen to the dollar.

By measures of purchasing power parity against the U.S., most developed market currencies are overvalued—the Canadian dollar is 10% above where it should be. By contrast, emerging market currencies are undervalued by around 30%.

“You’re going to see the convergence over time,” Marber argued.

Scot Blythe is a freelance writer in Toronto. rsblythe@hotmail.com

This article originally appeared on Benefitscanada.com

Read Part 1: Whither the equity risk premium

Infrastructure is one long-term asset class that is well-suited to meeting the long-term liabilities of pension funds. However, it has traditionally been available to the largest pension funds only, those with the capital and contacts to access the best deals. In Canada, however, a new consortium approach has given a handful of smaller pension funds a leg up in the growing infrastructure space.

Two delegates at Canadian Investment Review’s 2011 Investment Innovation Conference shared their experience with using the consortium model to access infrastructure. Presenters Terri Troy, CEO with Halifax Regional Municipality Pension Plan, and Dan Goguen, head of private investments with New Brunswick Investment Management Corp., presented on how their group of pension plans pooled their money together to invest alongside the Canada Pension Plan Investment Board (CPPIB). The group banded together for two recent infrastructure deals, including an interest in the 407 toll road in Toronto.

“Infrastructure is an important asset class for us because the assets are long term and a good match for long-term pension liabilities,” Troy explained. “With high barriers to entry, these assets bring stable cash yields, and are often indexed to inflation.”

The CPPIB deal looked like a great opportunity, but with a minimum ticket size of $100 million, it was out of the range of Troy’s plans. She, along with other like-minded pension plans, pooled their resources to reach the $100 million mark.

Today, consortium members are working with the CPPIB as a partner in this investment. The concept is working well and the investment partners are working on other deals together.

Watch: Terri Troy explains why pensions should consider infrastructure

The theme of volatility emerged again with Andrew Marchese, head of Canadian equities and portfolio manager with Pyramis Global Advisors. His presentation, “Market-Neutral Investing: A Canadian Perspective,” focused on how market-neutral strategies can be used to mitigate volatility risk.

“Consider that between 1990 and 2005, the standard deviation of market-neutral returns ranged from 3.1% to 3.9%, depending on the arbitrage strategy used by the portfolio manager,” Marchese explained. “Compare that to the S&P 500 during the same period, with a standard deviation of returns at about 14.4% (and nearly 18% for the TSX). These indices also tended to have much lower Sharpe ratios over the same period.”

However, in the Canadian context, a traditional market-neutral approach is a bit tougher to execute than in other markets. This is primarily because the market is highly concentrated in a handful of sectors.

“What makes the Canadian market truly unique is the role that sectors play. Canada’s equity market is highly concentrated in just three—energy, materials and financials—and there isn’t much liquidity in between,” Marchese said.

A market-neutral approach to Canada must therefore be “sector neutral,” he explained, going beyond energy, financials and materials and looking at the performance of “super sectors” that better reflect the fundamentals of the Canadian market.

Watch: Andrew Marchese discusses the advantages of market-neutral strategies

As plan sponsors continue to manage volatility in poor markets, some of the traditional tools they have turned to have been rendered obsolete—especially Modern Portfolio Theory, a staple of investment management that today has become all but useless for pension funds. In fact, it can be downright harmful to their health, according to presenter Thomas Schneeweis, Michael and Cheryl Philipp professor of finance and director of the Center for International Securities and Derivatives Markets, Isenberg School of Management, University of Massachusetts-Amherst.

His presentation, “Post-Modern Asset Allocation—A Risk-Based Analysis,” tackled Modern Portfolio Theory, which he believes is based on the wrong assets and correlations, which relate to outdated, 1950s market conditions.

While some pension funds understand this, Shneeweis warned that many still cling to the tenets of the theory simply because teaching textbooks are filled with assumptions based on it.

Until something changes, it’s going to remain the dominant paradigm, even though it no longer applies to a changed marketplace.

Watch: Thomas Schneeweis talks about Modern Portfolio Theory

Christoffersen’s main research areas are option valuation and risk management systems and his work with the Federal Reserve Board will help the organization carry out annual stress tests of banks as required under the new Dodd-Frank legislation. The Model Validation Council will be asked for input on the Board’s efforts to assess the effectiveness of the models used in the stress tests. The council is intended to improve the quality of the Federal Reserve’s model assessment program and to strengthen the confidence in the integrity and independence of the program.

“Liquidity will not take care of a balance sheet recession,” Menegatti said. “What is needed is balance sheet repair.” And that, he warns, will slow down economic growth for years to come. While policymakers have bought time through monetary policy choices, countries still need to figure out how to deleverage and ease themselves out of the “debt super cycles” which threaten growth.

So far Menegatti believes the U.S. has been doing a better job than Europe when it comes to dealing with the debt super cycle. The policy approach the U.S. has taken has been more successful in helping to pull that country through the balance sheet recession it faces. In contrast, Menegatti said austerity measures in the Euro zone have lead to higher savings rates and they have kept money out of the economy. All that has been a growth killer. In not choosing the austerity route, the US is in a better position today although he cautioned that there are still tough times ahead.

For now, however, solid policy in the U.S. will help that country avoid a Japan style scenario. Europe, on the other hand, might not be so lucky as policymakers push for continued austerity measures that will keep growth at bay for years.

In the coming months and years, Menegatti said the Euro zone faces huge challenges, not the least of which is Italy, the world’s third largest bond market. If that market has to be restructured and if the face value of bonds is reduced, he believes that this will lead to a crisis that makes Lehman Brothers look like a “walk in the park.” How likely is this scenario? “It’s not the baseline scenario,” he told the delegates, adding that Italy’s Prime Minister Mario Monti is committed to keeping politics out of the country’s finances at it seeks the best route to restructuring its debt.

However, Menegatti warned, political risk is huge right now and investors should not underestimate its potential to derail fragile financial markets.

In his keynote address, Roger Ibbotson, professor of finance at the Yale School of Management, presented research on how investors can and should use these differing risk premia to pick stocks. While Ibbotson believes the equity risk premium is still valid, he said investors must shift focus to other premia in the market—particularly liquidity, which according to Ibbotson can boost returns significantly over time while decreasing overall portfolio risk.

Ibbotson presented his own research findings, showing less liquid stocks outperforming over time because those same stocks tend to be valued at a “liquidity discount.” Stock pickers who focus on finding illiquid stocks can expect these stocks to excel as they return to normal trading volumes: “Stocks tend to migrate toward normal trading volume over time, increasing less liquid valuations while decreasing more liquid valuations,” Ibbotson concluded.

Liquidity, post-2008, is a risk that plan sponsors have been keenly aware of. And so is market volatility, which has taken its toll on the funded status of pension plans around the world. This has been pushing many plans to consider liability driven investment (LDI) strategies or other approaches to de-risking their plans to meet their liabilities over the long term.

Watch: Roger Ibbotson explains the liquidity premium

To address this, speaker Soami Kohly, vice-president and head of LDI with McLean Budden, discussed “dynamic de-risking”—a strategy that can help plan sponsors deal with market challenges—and the series of “perfect storms” that have gripped the investment landscape during the last decade.

Plan sponsors can use dynamic de-risking to adjust asset mix alongside the changing funded status of the plan. This type of approach is important in markets where stable, predictable returns are just not available.

In contrast to traditional LDI approaches, dynamic de-risking doesn’t require plan sponsors to make a one-time adjustment to their asset mix, explained Kohly. As an alternative to LDI, “dynamic de-risking gradually removes market-based risk from the pension plan based on the sponsor’s financial objectives and current market conditions,” Kohly said. “This gradual approach is more palatable because it provides a balanced approach, where investment returns and cash contributions are used to close the funding gap.”

Yes, de-risking is important, Kohly admitted, but the process needs to be affordable. Therefore, choosing the right moments is key. This can be done through a pre-approved asset mix schedule that allows an investment manager to alter the plan’s asset mix as the funded status of the plan changes—even on a daily basis.

Watch: Soami Kohly discusses dynamic de-risking

As plan sponsors de-risk to design stable return streams, other presenters looked at tools and strategies to generate consistent returns over the long term.

Roland Austrup, CEO and CIO with Integrated Managed Futures, presented on commodity trading advisors (CTAs), specifically on research showing how CTAs as a group have been able to generate stable predictable returns for a 30-year time period. In this talk, Austrup illustrated three main approaches for using CTAs to boost returns and manage portfolio volatility: diversification, quantitative asset allocation and active long/short investing.

The diversification strategy, said Austrup, is marked by the growing allocation to commodities, real estate and external managers that pursue a variety of absolute return strategies that are uncorrelated to underlying market returns.

The second strategy employed by CTAs is risk management based on quantitative asset allocation models focused on downside volatility and correlation—as opposed to dollar-based asset allocation.

Finally, Austrup discussed a third CTA strategy involving long/short investing to limit losses and maximize profits by investing on the right side of the market.

“Understanding the strategies employed by CTAs can offer valuable insight into available tools that generate stability and predictability in portfolio returns,” Austrup concluded.

Watch: Roland Austrup talks about managing volatility

The discussion of risk management and mounting liabilities continued with Damian Handzy, chair and CEO with Investor Analytics. His presentation, “Liabilities as Part of Risk Management,” focused on how risk management is undergoing a profound transformation, moving from a narrow focus on asset mix and relative risk to a new way of thinking about pension liabilities.

“Today, plan sponsors are taking lessons from the alternative space,” said Handzy, who pointed out that factors like absolute measures of risk, value at risk and stress testing are now being applied to better estimate pension liabilities.

Accurate data about those liabilities, he said, is fundamental to the health of pension plans. Even small mistakes in estimating the discount rate used can mean pension funds do not have a handle on how much they need to be fully funded for the long term.

Watch: Damian Handzy discusses liability risk and asset risk

Originally published on BenefitsCanada.com

As he points out, measures like volatility and mean reversion are becoming increasingly irrelevant as plan sponsors focus on key threats to their liabilities, right down to basics such as what discount rate they are using. At the same time, fallout from the 2008 Financial Crisis will continue to change how we understand economics and markets, says Handzy. “We finally recognize that it’s time to redefine the game.”

Click on the image to watch our interview with Handzy.