Which Way Now
RENEWED CONCERNS OVER THE WORLD ECONOMY
ARE DEMANDING NEW APPROACHES TO WEALTH
PRESERVATION. THREE OF CITI PRIVATE BANK’S
INVESTMENT AND WEALTH PLANNING EXPERTS, AS
WELL AS RESULTS FROM OUR ATTITUDES SURVEY,
PROVIDE SOME INSIGHT INTO CURRENT THINKING
PORTFOLIO REBALANCING CONTINUES
The shift in our clients’ attitudes towards their investments that we saw in 2008 and 2009 continues. They are still focused on reducing risk, increasing transparency and improving liquidity.
Clients are asking far more questions than ever before and really want to examine the risk profile of their portfolios. Not only do they want more detail about the overall structure of an investment product, but they are also probing into the various constituents within it. For example, if we were looking at a fund with exposure to emerging markets, they would want to know the individual risk profiles of the various countries covered.
To minimise risk, many of our private investors have increased the allocation towards cash, or cash-like products, in their core portfolios. This creates a dilemma because high inflation means you inevitably end up compromising your returns by following this strategy. On balance, however, there is an acceptance that this is a price worth paying. It also leaves people well positioned to make an opportunistic investment when the value of a target asset drops below a certain level.
A lot of cash is simply being held on deposit, but there has been some demand for long-duration, mostly five-year, sovereign debt. Unsurprisingly, it is only German bunds, UK gilts and US treasuries that are of real interest. Returns rely on capital gains because yields are so low.
Gold is by no means featured in all our clients’ portfolios, but this traditional “safe haven” has proved attractive to a number of them over the past year. There was a particularly active period when it was priced between $1,200 and $1,600/oz. Interest waned when it hit $1,700/oz.
Some investors do consider the precious metal something of a relic, but it is still hugely popular in Asia, and quantitative easing measures tend to increase demand. Because of this we think gold will remain of interest to the investment community as long as the economic uncertainty continues and governments around the world continue to adopt loose fiscal policies in a bid to stimulate economic growth.
High-grade corporate fixed bonds are viewed as a relatively risk-free and liquid asset by a number of clients, but when it comes to investing in the equity of specific companies, few sectors have jumped out as being particularly attractive. However, a carefully selected basket of well capitalised, high-cashflow healthcare, food staples and telecoms companies has been able to deliver relatively attractive dividend returns in 2011 and also, in a number of cases, managed capital appreciation.
Clients are asking
more questions and really want to examine the risk profile of their portfolios. They want more detail about the structure of investments
Currency has attracted some clients who have sold euros aggressively in favour of the dollar. Over $1.5tr is traded on forex markets every day and around half of the trades have been in the world’s three main currencies. Private client activity has followed a similar pattern, but interest in emerging-market and Scandinavian currencies is growing.
INNOVATIVE RISK SPREADING
Last year was all about finding cleverer, more efficient ways for our clients to invest their money. That search continues in 2012.
Building a diversified portfolio of risk exposures is much more complicated than it used to be. Markets and asset classes are more closely correlated than they have ever been. Some portfolios diversified along traditional lines have actually proved to be very volatile. For some, this has meant maintaining a highly cautious portfolio in order to protect and preserve capital, although this has not always been successful either due to the impact of inflation.
To take one example, equity portfolios and their corresponding stock weightings are usually allocated based on market capitalisation, the total value of a company’s tradable shares. This system is the foundation of many of the indices most commonly used around the world today.
However, we think this approach gives rise to certain biases and inefficiencies, and can increase risk as it often leads to a “clustering” effect, by sector, capitalisation and type. A very significant percentage of the S&P 500 index is actually accounted for by the S&P 100, for example. And if one sector, such as telecoms, is performing well you can end up overweight in that area, tending to buy at the top of the market when market capitalisation is highest.
In response, we prefer to make allocations by equalising risk; each component of an investment portfolio will carry an equal share of risk. We have found this approach can potentially improve risk-adjusted returns, limit downside risks and correct some of the biases previously mentioned.
In addition to this, we identify opportunities for our clients that are market- or sector-neutral. Asset classes don’t have to be mainstream – for example we have helped some of our clients invest in the carbon emissions market. This was less to do with the outlook for that particular market at the time and more about the timing of the investment, utilising market dislocations and market volatility. In the commodity markets, we have looked to bring value to clients by capitalising on the contract selection methodology employed by some of the largest index providers.
We have developed a solution based on the Citi Cubes Index that has been able to deliver relatively high risk-adjusted returns against a low correlation with the majority of asset classes.
In EMEA, we have made available several other such potential opportunities for clients in index rebalancing strategies. An example of this exists on the major equity markets – tracked by many passive index funds that, by definition, have to rebalance their portfolios as close as possible to the point that a company enters or leaves the index. The increase in demand for a new entrant into an index can potentially lead to a boost in stock prices. However, if the entrants to the index are announced before they actually join, buying them before the passive indexers, trackers and other funds means investors could be well placed to benefit if there is any uplift.
Finally, potentially suitable for those investors wishing to mitigate market downside risk at a time when protection costs have been high are a number of other tail-risk strategies that apply risk analysis and structuring to gain cheaper exposure to correlated markets. There is, for example, a high correlation between the Australian dollar and Japanese yen exchange rate and equity markets that has made this an alternative strategy for hedging in some situations.
With such a broad set of opportunities, risks vary. Working closely with our clients, we look to provide appropriate, timely and tailored solutions.
FINDING VALUE IN EQUITIES
Japan recorded the lowest long-term interest rates in recorded history when the yield on its 30-year bonds fell to 91 basis points, or 0.91%, in June 2003. The previous record had been set in Genoa in 1619 when yields on far shorter bonds fell to 1.125%. Bond yields that fell to such alarmingly low levels told investors that the country’s potential growth rate had fallen precipitously. Although Japanese equities went up and down, they have been devalued for more than two decades. Almost every sector now trades at below book value.
Investors ignore falling yields at their peril. Falling yields reflect falling potential growth rates, meaning equities are likely to continue to be downgraded
This is, alas, of more than passing historical interest. Thirty-year Swiss yields have recently been vying with their Japanese counterparts for a place in the hall of infamy. At the time of writing, they too, yield less than 1%. Yields on other bond markets look positively toothsome by comparison. Thirty-year US treasuries and UK gilts yield a couple of percentage points more than their Swiss counterparts. For how much longer? Against all expectations, yields have fallen sharply over the past 12 months. Indeed, yields have continued to fall in recent months even as equities have rallied.
Investors ignore those falling yields at their peril. We suspect that falling yields reflect falling potential growth rates. And, as with Japan, falling potential growth rates mean that equities are likely to continue to be downgraded over time. That doesn’t mean that they can’t go up in the short term. What it does mean though is that investors should think about which region and which sort of equities they are invested in. In a world where growth slows, investors will want more of their returns up front. That is why high-dividend stocks with stable balance sheets have outperformed so strongly over the past year or so.
Geography matters too. Having already been devalued and their dividend yields risen, Japan’s shares are, for the first time in many years, cheap. So too are European equities. At 11, the cyclically adjusted priceto- earnings ratio (price to the last 10 years of profit) for European equities is half that of their US counterparts. European shares trade at book value. In the US they are trading at twice book.
Europe has more than its fair share of systemic risks, but at least investors are paid for this. This is not true for the US, even if you thought Europe was a little local difficulty. US profit margins that are at record highs are far more likely to come down than go up.
Not the least of the reasons why is that there are many leagues to go before private sector deleveraging is done. Its malign effects have been cushioned by record loose fiscal policy and the actions of the Federal Reserve. The first of those, at least, will end next year. What those low treasury yields mean is that the economy will not be on a sustainable footing when it does. Value not only promises better long-term rewards, it can also help protect against downside risks.