STRATEGIC PERSPECTIVES
A PRACTICAL PORTFOLIO FRAMEWORK
FOR LONG-TERM INVESTORS
HOW TO USE THIS DOCUMENT
Many investors seek to set investment strategies that reflect their long time horizon. Designing a ‘core’ asset allocation that meets these strategic investors’ needs and risk constraints can be challenging. The purpose of this new series of papers is to assist investors in this endeavour by analysing current global market opportunities and suggesting practical responses they can apply to their strategic portfolio.
As such, this paper complements the investment outlook and market specific analysis from the BlackRock Investment Institute, which is typically focused on a 12 to 18 month time horizon, as well as the views on asset classes, regulation and risk from dedicated teams within BlackRock. For ease of use we have divided the paper in three related sections that, if required, can be read on a stand-alone basis:
Strategic portfolio and asset class views
Our strategic portfolio aims to be a practical illustration of our medium-term (five years) views reflecting both economic fundamentals and the cyclical and structural factors currently affecting global markets. These views are produced and used within BlackRock Solutions as an important element of portfolio construction and strategic asset allocation. The framework is dynamic, illustrating how strategic asset allocation evolves as market conditions change.
Portfolio spotlights
The strategic portfolio is designed to be applicable to a wide range of investors across geographies. However, we recognise that investors face specific challenges such as liabilities. Portfolio spotlights aim to address these so that investors can adjust the portfolio to their circumstances. Topical perspectives
In each issue of Strategic Perspectives, we highlight different topical issues that are of particular interest to strategic investors.
This paper has been prepared within BlackRock Solutions, in conjunction with colleagues across BlackRock.
ABOUT BLACKROCK SOLUTIONS
BlackRock Solutions is responsible for developing, assembling and managing investment solutions involving multiple strategies and asset classes. The team focuses on providing clients with tailored investment strategies based on specific market views. As such, they work in close partnership with a wide range of pension funds, insurers and endowments, helping them meet their long-term obligations through better investment outcomes.
Executive summary
CONTENTS
PORTFOLIO FRAMEWORK
Executive summary 1 The strategic portfolio 2 Tactical views and strategic asset allocation 6 Asset class views 12
1
PORTFOLIO SPOTLIGHT
Risk spotlight:
Investors with liabilities 18
2
TOPICAL PERSPECTIVES
Fundamental factors
within equities 22 What is private market
debt? 28
3
APPENDIX
Scenarios 32
Methodology and caveats 34
4
Market movements of major asset classes were muted over the quarter, withmost assets grinding moderately higher and our long-term expectations for global asset markets largely unchanged. There is now, however, some evidence that we are approaching stretched valuations in credit assets, and in certain equity sectors. The key features of this edition:
`
` We continue to believe that risk is rewarded, though less attractively than it has been over most of the past five years.
`
` In our strategic portfolio, we decrease our allocation to investment grade corporate bonds, high yield and dollar denominated emerging market debt in favour of equities.
`
` A material further contraction in credit spreads should prompt investors to review the size of their credit allocation.
`
` We continue to believe that some modest unhedged liability risk remains appropriate.
`
` We discuss how institutional investors can formulate and incorporate tactical asset allocation tilts within a strategic asset allocation framework.
`
` We discuss the recent sector rotation within equities and assess the evidence for fundamental equity factors generating persistent outperformance. `
` We examine the opportunities in private market debt. Regulatory restrictions and constrained bank balance sheets have resulted in an attractive supply of private market debt investments. Investors who can accept a degree of illiquidity are well placed to exploit the supply and demand mismatch. We would be happy to discuss how the themes in the strategic portfolio may be applied to specific investment situations. Please contact your usual BlackRock representative.
Our strategic portfolio assumes an absolute return objective,
a global opportunity set, and a desire for liquid assets. It is
designed for investors with a time horizon of five years or
more. In our central view of the world, we expect the portfolio
to have a return of around 5%. The portfolio is likely to perform
poorly in shock events such as a fiscal crisis or a credit
crunch, but we believe these to be low probability events. The
portfolio allocations are based primarily on our long-term
asset class views and return forecasts, as well as judgments
around economic and market risks, asset price correlations
and volatilities.
In reviewing the portfolio at 30 June, we target similar levels of risk-adjusted return to last quarter (c5% return for c10% risk). As shown in our Strategic Risk Barometer Index (see Figure 11 on page 17), there has been no material change in how attractively rewarded risk is, and so the market environment does not necessitate major portfolio shifts. Our main change this quarter is to increase the allocation to equity risk at the expense of credit risk, reflecting the compression in credit spreads over the quarter.
FIGURE 1: STRATEGIC PORTFOLIO
EQUITIES Global developed equity 46.1% Emerging market equity 5.6% BONDS Global treasuries 9.5% Global corporates 10.3% Emerging market bonds 5.5% High yield bonds 2.0% ALTERNATIVES Alternatives 21.0% Up from last quarter ~ Down from last quarter Same as last quarter =
~ ~ =
21.0%
51.7%
27.3%
Source: BlackRock. As at end of June 2014.
1
The strategic portfolio
PORTFOLIO FRAMEWORK
KEY POINTS
` Increased allocation to equity relative to credit since last quarter. ` Reduction in high yield
debt, emerging market debt and investment grade corporate bonds due to compressed spreads.
` Maintained a modest allocation to sovereign bonds, and diversification from equity into hedge funds and real estate.
` No allocation to commodities.
Key views expressed in the portfolio:
`` Relative to last quarter, we have increased the allocation to equity at the expense of credit assets, given our lower expected returns (relative to last quarter) from credit risk. The increased allocation to equities is
proportionally split between developed and emerging markets. `
` Our decision to increase the equity allocation is not driven by a significant change in view of the attractiveness of equities. We continue to believe equities are broadly fairly valued, though as we discuss later, certain sectors/styles appear expensive. Rather, it is reflective of our overall moderate ‘risk-on’ positioning, and the fact that we expect higher returns from equities relative to credit than previously.
`
` We continue to have low return expectations for global sovereign debt compared to other asset classes, as evidenced through the low allocation. `
` We reduce the allocation to credit assets reflecting the compression in spreads across both geographies and the credit spectrum (see Figure 6 on page 12). Our reduced allocation to dollar-denominated emerging market debt ($EMD) reverses last quarter’s increased tilt towards $EMD, and is driven by the compression of spreads (around 40bps) since 31 March 2014 in this asset class. At current spread levels, however, we see less scope for future strong returns.
`
` We still maintain a diversified, although reduced, set of credit exposures – investment grade, high yield and emerging market debt.
`
` We continue to diversify our return-seeking assets through allocations to real estate and hedge funds, and our allocation to these assets within the portfolio have been held constant to reflect their less liquid nature and the lack of change in our view of the asset classes.
`
` We regard inflation-linked bonds and nominal bonds as fairly priced relative to one another (i.e. implied inflation is in line with our expectations) in the major markets.
`
` There is no allocation to commodities, as we continue to believe the supply/ demand dynamics and diversification characteristics do not provide portfolios with attractive risk-adjusted returns relative to other asset classes. Private equity has been excluded from the strategic portfolio due to its lower liquidity.
The portfolio is positioned to have a moderate ‘risk-on’ bias. As we later show in our Strategic Risk Opportunity Barometer, risk is less well rewarded than it has been in the past, and so we expect lower returns and higher volatility from the
SPECIFIC PORTFOLIO
IMPLICATIONS
`
`Investors with liabilities –
may make a higher allocation to domestic bonds or swaps than shown in the strategic portfolio, to manage interest rate and inflation risk relative to those liabilities. Determining an optimal size of the interest rate/inflation ‘hedge’ is an investor specific decision. `
`Non-traditional assets –
such as hedge funds and private equity, have noticeably more idiosyncratic risk than traditional asset classes. Any decision to include non-traditional assets is dependent on the specific requirements of each investor.
`
`Currency hedging –
The strategic portfolio has been designed to be applicable to institutional investors across different geographies. In showing our scenario analysis in Figure 2, we assume that developed equities have been currency hedged 50% into the investor’s domestic currency, with a 100% hedge for fixed income assets and 0% for emerging market assets.
SCENARIO ANALYSIS – STRESS TESTING THE PORTFOLIO
Investors need to consider the performance of the portfolio in a number of scenarios. This is particularly relevant in an economic environment where there are diverse plausible future economic regimes, with very different outcomes for assets. A portfolio that is calibrated to perform well if markets behave as expected may perform poorly in one of a number of shock events, and testing this helps to build a more robust portfolio.
The benefits of considering diverse scenarios include an understanding of: `
` How asset risk and return assumptions are formulated. `
` The range of possible outcomes, particularly in an environment of uncertain investment regimes and secular change within markets.
`
` How specific investor views can be incorporated into an investment strategy, by determining the scenarios that they identify with most strongly.
`
` The behaviour of assets and liabilities in the investor’s circumstances. We have identified nine conceivable scenarios, in addition to our core scenario, and defined the impact for the asset classes in this paper. Scenarios have been chosen to focus on negative shocks for the portfolio, rather than as a balanced assessment of likely outcomes. Figure 2 shows how the strategic portfolio would perform in each of the scenarios.
FIGURE 2: IMPACT OF SHOCKS TO THE STRATEGIC PORTFOLIO
-25 -20 -15 -10 -5 0 5 10 15 Low probability event Medium probability event
Growth disappoints -9%
Demand driven inflation -12%
Credit crunch -23%
Euro break-up -14%
EM shock -4%
Fiscal shock -21%
Central bank inflation 4%
Global ultra soft landing 11%
Cyclical divergence 0%
Source: BlackRock. As at end of June 2014.
1
“
The most
likely cause of
underperformance
of the portfolio
continues to be
disappointing
growth in the
global economy.
”
Unsurprisingly, the portfolio performs worst in environments of extreme stress, such as a financial shock such as in 2008 (shown above as credit crunch), or a fiscal crisis in developed countries. The credit crunch scenario is the most damaging, leading to potential losses of 23%, given the tilt towards equities in the strategic portfolio. The negative figures here are even higher than the corresponding shocks last quarter, given the increased allocation to risky assets in the Strategic Portfolio this quarter.
The portfolio performs less poorly in the emerging market shock or the euro break-up scenario, given that some of the worst affected asset classes in these shocks i.e. developed treasuries and emerging market debt, are minority holdings within the portfolio.
We continue to regard the most likely cause of underperformance of the portfolio as being disappointing growth in the global economy. Unlike the last few years, many investors now expect a positive, if still low, rate of economic growth. As a result, growth disappointments may be more likely to lead to equity market corrections and bond market rallies. Given this key risk to the portfolio, we have retained some government bond exposure and also diversified equities into less strongly cyclical assets such as real estate and liquid market-neutral hedge funds.
Strategic asset allocations (SAA) are set with a long-term investment view, usually of five years or more. Reviews of the strategic portfolio are typically annual, with a low likelihood of intermittent changes. Tactical asset allocations (TAA) look to generate excess returns over the strategic benchmark by taking advantage of shorter-term investment opportunities with an investment time horizon of usually less than one year. The focus of TAA is relative value between asset classes, sectors and regions over the short term, with security selection within asset classes the purview of the individual asset class manager. Tactical views and level of conviction in those views need to be continually reassessed with allocations adjusted accordingly. The TAA process can be incorporated into the SAA framework through tilts applied to the strategic benchmark. There are two key types of tilts that can be applied:
1. Asset class tilts reflecting views on the relative value between asset classes, sectors and regions.
2. Risk level tilts altering the risk profile of the asset portfolio to reflect the view on the environment for taking risk.
In this article we focus on how tactical views can be formulated and tilts incorporated within an SAA framework.
FORMULATING TACTICAL INVESTMENT VIEWS
Short-term tactical switches require highly liquid markets to avoid prohibitive transaction costs. This constrains tactical switches on illiquid asset classes such as fund of hedge funds or private debt. The focus of the TAA process is formulating investment views and tilting allocations on liquid asset classes. When formulating and assessing the conviction of investment views, it is important to consider the following three key factors:
1. Economic cycle 2. Valuation metrics
3. Market environment for risk
Tactical views to
complement strategic
asset allocation
PORTFOLIO FRAMEWORK1
KEY POINTS
` Tactical asset allocation (TAA) can be incorporated through tilts applied to the strategic benchmark. ` The TAA views need
to be grounded in a deep understanding of the economic cycle, valuations and the market risk environment. ` A robust TAA process
needs to be able to adapt quickly to fast moving markets, with tactical views and positions being continually challenged.
Economic cycle
A key factor in formulating tactical investment views is assessing themes in the economic cycle within countries and regions. A driver of short-term market movements is the market’s changing assessment of the macro-economic environment. This has been particularly the case in recent years, where there have been very distinct phases of markets being risk averse and risk seeking, with changing perceptions of economic conditions having a substantial impact in defining these phases.
A key driver of the economic cycle and outlook is monetary policy (setting of interest rates) and fiscal policy (government spending). Regional differences in asset class performance can be driven by the differing economic policies within those areas. For example, central bank short-term interest rate policy directly affects bond prices and indirectly influences equity levels and other asset classes. Part of the TAA process should assess likely future policy, factoring in inflation, growth and capacity estimates to formulate a view of the differences in the short-term path of asset classes.
It is important to incorporate into the view key leading indicators such as purchasing managers indices (PMI) and economic surprise indices which monitor growth and risk sentiment split by countries and regions. PMI indices are a short-term indicator of the level of economic health and confidence within the manufacturing sector, with readings above 50 representing expansion of the sector. Current PMI levels and momentum of the levels can indicate where a region is in an economic cycle which can be used to assess relative value of asset classes tied to that region. Figure 3 shows a BlackRock Solutions tool that uses PMI index readings to monitor market sentiments. The outright PMI level for each country is compared to the momentum of the readings. Readings in the top right quadrant indicate the growth outlook is positive and has been improving in recent periods.
There is a large range of economic cycle indicators, with a propensity for market views to change rapidly in response to regular updates of these indices. Longer-term themes can also be identified, for example differences in momentum in emerging and developed markets. It is important to combine views on shorter-term indicators with the identified longer-shorter-term themes to inform tactical views.
Valuation metrics
Asset class valuation metrics are a key driver of returns. In conjunction with a qualitative overlay, they can be used to identify undervalued and overvalued asset classes and make tactical tilts to strategic asset allocations. Valuation metrics typically drive returns over a longer time period than economic cycle factors, with much less certain links to very short-term movements unless valuations are demonstrably extreme. Therefore valuation metrics have a higher weighting in strategic asset allocation and longer-term tactical tilts as opposed to shorter-term views.
For example, leading up to the dotcom crash in 2000, equity valuation factors could have provided a warning that certain technology stocks were overvalued with price/earnings ratios (market price of company divided by annual earnings) reaching record highs. However, timing was key as valuations were stretched for a long period of time1.
FIGURE 3: MONITOR MARKET SENTIMENTS AND IDENTIFY TRENDS THROUGH LEADING INDICES
PMI – developed PMI – emerging
Gr
owth
Economic activity
France Japan
Positive & decelerating Positive & accelerating
Negative& decelerating Negative & accelerating Germany World Euro US UK Spain Italy Netherlands -6 -3 3 6 -8 -6 -4 -2 0 2 4 6 8 10 Gr owth Economic activity
Positive & decelerating Positive & accelerating
Negative& decelerating Negative & accelerating Czech Republic Brazil Poland Korea India Taiwan China Russia South Africa -5 -2.5 2.5 5 -8 -6 -4 -2 0 2 4 6
Source: BlackRock, Bloomberg, Thomson Reuters – Datastream, 18 July 2014.
1 In line with the famous John Maynard Keynes quotation “Markets can remain irrational longer than you can remain solvent”.
Owing to the prevalence of data, equity and bond markets can be assessed on a wide range of metrics. Figure 4 shows a BlackRock tool that assesses some commonly analysed equity factors. The tool ranks by percentile equity factors based on historical data to indicate whether an equity market is cheap or expensive on a valuation basis relative to history. For example based on this metric, some emerging and Japanese markets have attractive valuations. Russia also has an attractive valuation based on this metric, highlighting the need for a qualitative overlay, as events in Ukraine will need to be factored into an investment view.
Market environment for risk
When formulating and evaluating the level of conviction of investment views, it is important to assess the market environment for taking risk. Monitoring of risk indicators, volatility and asset class correlations can be used to assess tactical views and identify downside scenarios.
FIGURE 4: PERCENTILE RANK OF EQUITY VALUATION FACTOR LEVELS BASED ON HISTORICAL DATA
Earnings
yield adjusted EYCyclically Trend real earnings Dividend yield Price to book cash flowPrice to Forward 12-M earnings yield Total Developed markets US 57% 68% 60% 40% 39% 59% 63% 55% UK 61% 42% 6% 43% 38% 27% 58% 39% Germany 36% 44% 25% 41% 47% 72% 42% 44% France 47% 41% 18% 40% 30% 56% 51% 40% Italy 93% 45% 5% 61% 27% 30% 46% 44% Spain 78% 33% 9% 26% 29% 44% 76% 42% Japan 7% 42% 41% 16% 28% 25% 19% 26% Canada 77% 42% 7% 19% 59% 91% 64% 51% Hong Kong 47% 63% 54% 75% 34% 52% 41% 52% Australia 34% 43% 48% 17% 48% 30% 61% 40% Singapore 25% 14% 19% 14% 17% 55% 35% 25% Switzerland 41% 59% 43% 14% 42% 56% 68% 46% Emerging markets Brazil 86% 11% 2% 27% 58% 87% 90% 52% Mexico 98% 25% 4% 78% 83% 98% 100% 70% China 12% 11% 40% 16% 28% 48% 16% 25% Taiwan 39% 55% 59% 47% 41% 47% 52% 49% India 70% 43% 7% 62% 53% 59% 79% 53% Korea 27% 7% 14% 90% 26% 31% 46% 35% South Africa 97% 78% 23% 53% 83% 94% 100% 76% Turkey 61% 27% 18% 77% 23% 69% 87% 52% Russia 18% 3% 15% 0% 11% 15% 17% 11% Lowest Highest
Source: FactSet and BlackRock – as at 18 July 2014.
Even in the absence of changes to asset allocation, risk levels of a portfolio are changing continuously through time as volatility and correlation patterns between asset classes alter. The attractiveness of taking risk varies with phases of investor sentiment being risk seeking or risk averse. It is important that tactical allocations reflect an investor’s view of the future risk environment and seek to adjust the overall portfolio risk accordingly.
Figure 5 shows one of the tools BlackRock Solutions uses to monitor market risk sentiment and concentration of risk 2. Observations in the top half of the
square indicate a ‘risk on’ environment where allocation to risky assets have been rewarded with higher returns. Observations in the right half of the square indicate the level of market concentration. In highly concentrated markets asset classes move in tandem. This results in low diversification and therefore higher expected portfolio risk. Economic regimes in the top left quartile (green box) are typically the most attractive for taking risk, with diversified returns and risk being rewarded. This analysis tells us that from 2002 to 2007. the market environment indicated that risk was mostly rewarded with significant scope for diversification. The market changed post 2008 to 2013, as highlighted by the second chart in Figure 5 with long periods of high risk aversion and market concentration.
FIGURE 5: THE ATTRACTIVENESS OF TAKING RISK VARIES OVER TIME AND MANAGING EXTREME
MARKET ENVIRONMENTS IS KEY TO ADDING VALUE IN A TACTICAL ASSET ALLOCATION FRAMEWORK
Risk tolerance and concentration framework Levels from 2008 to 2013
Less
|
R
etur
n f
or risk
}
Mor
e
High
|
Diversification
}
Low
Diversified
risk taking
Concentrated
risk taking
Concentrated
risk aversion
Diversified
risk aversion
Less
|
R
etur
n f
or risk
}
Mor
e
High
|
Diversification
}
Low
Lehman bankruptcy US debt ceiling crisis (2011) Draghi’s “Whatever it takes” speech S&P 500 jumps 30% in one year Source: BlackRock.
2 For further details of BlackRock risk monitoring framework, please see BlackRock paper ‘The Elements of Risk; Analysing Changing Market Risk Conditions’.
Tactical tilts are set with reference to a core view of market moves over the coming period. Scenario analysis enables investors to assess risks to that view. In line with the scenario stress tests conducted in strategic asset allocation, it is important to analyse the effect of plausible negative shocks to a portfolio. Whilst a portfolio cannot be constructed to hedge against all tail risks, an investor should be aware of the effect of plausible extreme economic scenarios on performance and monitor the probability of those scenarios over time.
INCORPORATING INVESTMENT VIEWS WITHIN AN
ASSET PORTFOLIO
Following a robust analysis of the economic cycle, valuation metrics and the market environment for risk, insights and views formulated can be aggregated into a set of overall asset class views and conviction levels in those views. The importance and weighting of each factor in formulating the overall view is dependent on the market dynamics. If macro-economic momentum or policy is anticipated to significantly change, economic cycle factors are the key driver behind future asset class performance and should have more weight in deciding the asset class view. However in environments where investor sentiment is displaying extreme trends to being risk averse or risk seeking, the view on the market environment for taking risk is increasingly important.
The output of the TAA process is a set of tactical tilts to the strategic portfolio reflecting the short term asset class view and conviction in that view. To translate the views into an investor’s portfolio, a desired level of active risk over the strategic benchmark needs to be defined. The level of underweighting and overweighting of assets class should reflect this risk budget and needs to be considered on a portfolio level, reflecting expected correlations and other investment restrictions.
Review of tactical views is an ongoing process and need to be regularly updated to reflect changing environments and market moves. A robust TAA process needs to be able to adapt quickly to fast moving markets, with tactical views and positions continually challenged. Regularly monitoring risk and performance is a large part of this process, assessing whether the sizing and risk contribution of each underlying position remains consistent with an investor’s view.
1
Asset class views
PORTFOLIO FRAMEWORK
GLOBAL MARKET VALUATIONS AND THEMES
3Over the quarter, there were few significant market
movements, with most major asset classes moving modestly
higher in value – equities ended the quarter slightly higher,
government bond yields slightly lower and credit spreads
lower. We believe we continue to be in a ‘muted risk-on’
environment. Few asset classes are ‘cheap’, and while there
are some that are now approaching stretched levels (as we
discuss in more detail below), overall we do not believe that
there is much evidence of irrational exuberance from investors.
We still expect higher returns from more volatile assets.
FIGURE 6: VALUATIONS OF DIFFERENT ASSET CLASSES
RELATIVE TO THE LONG-TERM HISTORIC RANGE
4CURRENT V AL U ATION A S A PERCENTILE OF L ONG-TERM HIS TORIC RANGE (%) 100 80 60 40 20 0 Developed
equities Emergingequities Globalcredit Highyield $EMD sovereignGlobal
Equities Fixed income Cheaper Average More expensive
Source: BlackRock. As at end June 2014.
The previous quarter saw nominal interest rates fall slightly across the US, Germany and Japan, though yields fell more markedly in peripheral Europe, driven by the supportive monetary policy easing announced by the ECB in June. The major exception to the falling yields theme across the developed world was in the UK, where mixed signals over the timing of interest rate rises from the Bank of England saw bond yields higher at the ultra-short end of the curve. The effect was negligible at the long end of the UK curve.
KEY POINTS
` Our forecasts for bonds and equities are broadly unchanged this quarter. ` Small cap equities, on a
relative basis, are at high multiples.
` Credit spreads have continued to contract. They are not yet at very stretched levels, but further contraction from here should prompt investors to review their positioning.
` Our Strategic Risk Opportunity Barometer has decreased
marginally.
3 The asset class views expressed here are from the perspective of the long-term investor. For our 12-to 18-month horizon asset class views, please refer to the latest BlackRock Investment Institute Outlook.
4 The equity valuations are an average of percentile ranks versus history back to 1995 of price earnings, cyclically adjusted price earnings, trend real earnings, dividend yield, price to book, price to cash flow and forward 12m-price earnings. Bond valuations are percentile ranks of yields for global sovereigns and spreads for global credit, high yield and EMD, once more versus history back to 1995. For developed equities, we have used the MSCI World Index. For emerging equities, we have used a market cap weighted average of countries, and the MSCI Index for each country.
1
Although broad equity markets were modestly higher across geographies,of particular interest is that performance within each market index was not uniform – with small cap underperforming large cap stocks in the US, UK, Europe and emerging markets. For further discussion of the recent sector rotation within equities, please see the topical perspectives section. Figure 7 shows that the US and UK small cap price earnings (PE) ratios are as high relative to market PE ratios as they have ever been (note we have used PE ratios calculated relative to trend earnings). While we note that high PE multiples in specific sectors can persist over time, and that skilled managers can always supplement performance / manage downturns, investors should be aware of how rare this relative differential between small cap and the broader market is in a historical context. Over a five year horizon, we anticipate lower returns from an average small cap equity manager than an average broad market index manager.
FIGURE 7: SMALL CAP VALUATIONS ARE HISTORICALLY HIGH
Small cap PE / Market PE (US) Small cap PE / Market PE (UK) 40 90 140 190 240 SMAL L C AP PE RA TIO / BRO AD MARKET PE RA TIO (%)
Dec 82 Dec 87 Dec 92 Dec 97 Dec 02 Dec 07 Dec 12
Source: BlackRock. As at end June 2014.
In previous editions of Strategic Perspectives, we have highlighted that while credit markets were not cheap, they were not at unsustainable levels. This remains our core view. As discussed in our April edition, we believe credit assets should play a notable role in strategic portfolios in neutral or even slightly adverse market conditions, and hence we continue to retain a sizeable credit allocation in our strategic portfolio. However, we now believe we are closer to the levels at which institutional investors should start to re-think passive credit allocations. Figure 8 shows that most credit assets have become steadily more expensive relative to their own history over the course of the past six months.
“
Investors should
be aware of the
relative differential
between small cap
and the broader
market.
1
5 ‘The Global Multi-Asset Market Portfolio, 1959–2012’, Doeswijk, Lam, CFA, Swinkels, Financial Analysts Journal Volume 70 Number 2, 2014.
FIGURE 8: CREDIT HAS BECOME STEADILY MORE EXPENSIVE
CURRENT V AL U ATION A S A PERCENTILE OF L ONG-TERM HIS TORIC RANGE (%) 100 80 60 40 20 0
UK credit Euro credit US credit US AA credit US high yield EMD June 14 March 14
January 14
Source: BlackRock. As at end June 2014.
How should investors tackle such an environment? As we have previously discussed, adopting an unconstrained approach to fixed income can be part of the solution, and the asset mix of our strategic portfolio implicitly reflects this view in passive form. Relative to a global market neutral benchmark allocation5,
our credit allocation is slightly below the level implied by a market portfolio, and the mix within those credit assets is positioned away from traditional passive investment grade credit and towards high yield and EM debt.
If credit spreads continue to tighten, we believe there would be a case for reducing the overall allocation to credit assets further. In our view a further material contraction in investment grade credit spreads would justify reducing exposure – either through derivatives written on credit indices or by physical sales. Although spreads have reduced to lower levels than in previous cycles, it is arguable that the illiquidity premium investors need is larger than in previous cycles, given bank balance sheet constraints and reduced dealer inventory of corporate bonds.
“
Adopting an
unconstrained
approach to fixed
income can be part
of the solution
1
FIGURE 9: REDUCED MARKET LIQUIDITY
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 250 200 150 100 50 0 10,000 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000
US dealer’s inventory of corporate bonds (RHS) Outstanding US corporate bonds (LHS)
$BN
$BN
Source: DB, SIMFA, Federal bank of New York. As at end June 2014. Estimates only.
Deciding how best to reduce credit exposure, should market conditions justify this, is not a trivial exercise – the basis risk and governance implications of derivative approaches should be weighed against the challenges of trying to sell relatively illiquid physical assets at a time when many other investors may be looking to do the same, and the round trip costs of reintroducing these assets to the portfolio later. We encourage investors to think now about:
`
` What credit spread levels would justify reducing credit exposure in their portfolios.
`
` How best to implement a reduction, if needed.
ASSET FORECASTS
While current valuations are informative, investors cannot rely solely on these to base asset allocation decisions. We set out below our asset forecasts, which have a notional return horizon of five years. Clearly, point forecasting is hazardous when evaluating the outlook for very volatile and hence risky asset classes, and a wide range of forecasts are plausible.
FIGURE 10: FIVE YEAR RISK AND RETURN FORECASTS
EXPE CTED RETURN (%) 12 10 8 6 4 2 0 0 5 10 15 20 25 30 EXPECTED VOLATILITY (%) Cash Dev. treasuries Dev. credit Private equity Emerging equities Dev. equities Emerging bonds Hedge funds (aggressive) High yield Commodities InfrastructureDev. real estate
Hedge funds (defensive) Less attractiv e More attractiv e
Source: BlackRock. As at end June 2014.
Our asset class forecasts fall into three broad categories: `
` High quality sovereign bonds still have very low expected returns over five years. This has implications for investors with liabilities – see the relevant portfolio spotlight.
`
` Investments with a spread over high quality government bonds, such as investment grade credit, high yield and emerging market debt are expected to outperform sovereign bonds, but with a relatively low absolute return. We note that high yield bonds and emerging market debt are now noticeably less attractive on a risk return basis.
`
` Expected returns of equities and other growth assets, such as real estate, are higher, although significantly lower than a year ago. Emerging equities is one of the most attractive asset classes.
We also compare the current slope of the best-fit line to recent years. We analyse whether we believe taking investment risk in the current environment offers better or worse opportunities then our long-term expectations of value6.
As shown in figure 11, our estimates suggest that risk-taking still appears rewarded,but is less attractive compared to a longer-term history. This largely reflects the lower than usual expected returns of higher-quality sovereign bonds, rather than strong returns to riskier assets.
6 The Strategic Risk Opportunity Barometer reflects the difference between the sharpe ratio of the current strategic portfolio using five year and term assumptions. A positive reading implies risk is better rewarded than our long-term assumptions at that time.
FIGURE 11: STRATEGIC RISK OPPORTUNITY BAROMETER
SL OPE OF THE F ORE C A S T RISK/REW ARD TRENDLINE 0.6 0.4 0.5 0.3 0.2 0.1 0.0 –0.1 2013 2012 2011 2010 2009 2008 Q2 20072008 2009 2010 2011 2012 2013 2014 Q2 2007} Our forecasts suggested that risk was becoming less well rewarded leading up to the eurozone crisis
} Risk is now less well rewarded than it has been for a number of years
~ We estimated that risk was poorly rewarded prior to the credit crunch
Risk is increasingly well rewarded Risk is increasingly poorly rewarded
Source: BlackRock. As at end June 2014.
Note: the current format of our asset forecasting process was implemented in March 2009, which is why we do not show figures prior to this date. The exception to this is the June 2007 figure, which we have backtested using the same process, to illustrate that our forecasts would have estimated poor risk-adjusted returns prior to the credit crunch. While our approach does not reveal perfect forecasts (for instance, in March 2009, market conditions were, with the benefit of hindsight, even more attractive than we predicted), it does pick up important trends – such as the decrease in the attractiveness of risk in the period leading up to the European crisis of 2011.
Risk spotlight:
Investors with liabilities
Many institutional investors have bond-like, fixed or
inflation-linked liabilities, the present value of which is sensitive to
changes in long-term nominal or real interest rates. The
low bond yield environment across developed markets has
encouraged some investors to postpone hedging these
liabilities, due to an expectation that yields will rise over the
next few years relative to market expectations, and hence more
attractive hedging rates can be achieved in the future. The
‘hedging decision’ is unique to each investor; and for this reason
we have not reflected the hedging decision in the strategic
portfolio (which assumes a liability-agnostic investor).
HOW HAS THE OUTLOOK FOR HEDGING CHANGED GIVEN MARKET
EVENTS LAST QUARTER?
Nominal sovereign bond yields fell slightly across the US, Germany and Japan over the quarter, with more marked falls in peripheral Europe, driven by the supportive monetary policy easing announced by the ECB in June. The main exception to the falling yields theme across the developed world was in the UK, where mixed signals over the timing of interest rate rises from the Bank of England saw bond yields move higher at the ultra-short end of the curve. The effect was negligible at the long end of the UK curve.
Developed market real yields remain considerably below historical average levels, and we note that there is no stable level to which real yields have converged to historically. No single developed market can be viewed in isolation; higher or lower US or euro yields are likely to drag UK yields alongside them. The key factors remain:
1. The fiscal position of developed economies 2. Structural demand
3. Expected inflation and the inflation risk premium 4. Monetary policy and quantitative easing (‘QE’)
Persistent weak inflation prints in the eurozone were the catalyst for the ECB policy action in June. As widely expected, the ECB announced an interest rate cut (with the refinancing rate reduced from 0.25% to 0.15% and the deposit rate cut from 0.0% to -0.1%) and a new Long-Term Refinancing Operation to help support corporate lending. Further, the door was left open to a potential quantitative easing programme in the future. These actions chime with our view that major central banks will take appropriate policy action where necessary to meet inflation targets. Accordingly, we have not altered our core views on long-run inflation.
PORTFOLIO SPOTLIGHT
KEY POINTS
` Developed market nominal and real bond yields are low relative to history, and fell over the quarter. ` Over the medium term, we
anticipate that bond yields will rise in line with or more than is implied by current market expectations.
` Our outlook for real and nominal interest rates supports investors with liabilities running some interest rate and inflation risk (i.e. an under-hedge relative to liabilities) as part of a balanced medium-term strategy.
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The two critical factors in assessing the attractiveness of hedging liabilitiesare the ‘equilibrium’ level of long-term yields (i.e. when yields reach a stable, sustainable level) and the speed with which rates are expected to converge to these long-term equilibrium levels. While our view on the equilibrium level of rates has not altered, we believe that the ECB policy actions support the idea that it will take now take longer for long-dated European yields to revert to equilibrium levels. The net impact of this on our assumptions is to increase the attractiveness of hedging European liabilities (we examine the mechanics of this in more detail in the section below), though we note that overall we still anticipate a negative return impact from hedging European liabilities. Our view on the attractiveness of hedging US and UK liabilities has not fundamentally altered.
WHAT IF IT TAKES LONGER FOR ‘NORMAL’ CONDITIONS
TO RETURN?
Let us consider the impact of slower reversion to long-term levels on the expected returns over the next five years on cash and on long-dated bonds:
`
` Cash rates across developed economies are extremely depressed. The slower these return to historic/sustainable levels, the lower the expected return on cash over the next five years.
Example: Suppose equilibrium cash rates are 3% p.a. and current cash rates
are 1% p.a. The table below shows the anticipated return from holding cash depending on whether it takes five years or 10 years to return to equilibrium – slower reversion to equilibrium levels decreases expected return.
Assume 5 year reversion
to equilibrium levels Assume 10 year reversion to equilibrium levels
Cash rate today 1% 1%
Assumed cash rate
in year 5 3% 2% (only has risen half way to equilibrium levels) Expected return from holding
cash over the next 5 years (from today to year 5)
2% (i.e. average return
over period) 1.5%
Source: BlackRock.
`
` Long-term bond yields are also at historically low levels. Increases to long-term yields decrease the value of these bonds, because the higher average return from holding the bond is dwarfed by the negative valuation impact of the yield rises (this effect is greater the longer the bond duration). The slower the pace of yield rises, the higher the expected annual bond return over the next five years.
Example: Suppose equilibrium 10 year bond yields are 4% pa, current 10 year
bond yields are 2% p.a. The table on page 20 shows the anticipated return
“
Taking a five
year view, slower
reversion to
long-term levels
increases the
attractiveness of
hedging today.
”
Assume 5 year reversion
to equilibrium levels Assume 10 year reversion to equilibrium levels
10 year bond yield today 2% 2%
10 year bond yield in year 5 4% 3% (only has risen half way to equilibrium levels) Average return from
holding 10 year bonds over the next 5 years
3% (i.e. average yield) 2.5% (i.e. average yield)
Annual valuation impact of
the yield rises -4% (10 years x 0.4% average annual change in yields)
-2%
(10 years x 0.2% change in yields)
Expected return from holding 10 year bonds over the next five years (from today to year 5)*
-1% 0.5%
Source: BlackRock.
* We have ignored the impact of other factors such as rolling down the curve for the sake of illustration. These factors have materially less impact than the valuation impact shown, so the overall message is unchanged.
Our core view remains that, looking at a five year horizon, there is some value in delaying hedging in across all major developed markets. We have previously expressed this view by stating that we anticipate long-dated bond yields in those markets to rise quicker than market pricing implies. An entirely equivalent statement is that we anticipate that cash will have a higher return than long-dated bonds over the next five years. Figure 12 shows that increasing the expected time taken for yields to revert to equilibrium conditions. This reduces and eventually reverses the benefit from delaying hedging as the relative cost of holding matching assets falls.
Over the quarter, the policy actions of the ECB have prompted us to increase our expectation of the time taken for European yields to revert to equilibrium levels. We still believe that hedging European liabilities has a negative return impact but we believe this negative impact is less than it previously was, and is now broadly in line with the return shortfall from hedging UK and US liabilities.
Note: the arguments above only consider the return impact from hedging. The risk impact is also crucial, but investor-specific. Overall, we continue to advocate hedging liabilities for investors running sizeable interest rate and inflation risk.
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FIGURE 12: IMPACT OF TIME ON ATTRACTIVENESS OF HEDGING
EXPE
CTED RETURN
INCREASING TIME FOR YIELDS TO REVERT TO SUSTAINABLE LEVELS
CASH RETURNS DE CREASE
LONG DATED BOND RETURNS INCREA SE
WHERE THESE LINES CROSS, HEDGING LIABILITIES HAS A NEUTRAL RETURN IMPACT
HEDGING HAS A NEGATIVE RETURN IMPACT HEDGING HAS POSITIVE RETURN IMPACT
CONCLUSION: YIELD OUTLOOK AND THE HEDGING DECISION
Our outlook continues to support running some interest rate and inflation risk (i.e. an under-hedge relative to liabilities) as part of a balanced-medium term strategy. We believe that nominal and real yields will rise faster than markets currently expect over a medium-term time horizon. The factors described previously will likely limit the extent of this, particularly for long-dated real yields in the UK where real yields tend already to be lower (by 1% or more) due to the RPI/CPI ‘wedge’.
We estimate that a sustainable range for nominal yields in the medium term is 4.0% to 4.5% pa, with real yields of 2.0% to 2.5%. However, we note that UK real yields are the most likely to remain significantly below this range for the reasons described, and European yields will take longer to revert to these levels than US and UK yields. Current 10 and 20 year yields are all currently below this range.
For investors unwilling to delay hedging, corporate bonds or ‘secure income’ assets (such as long lease real estate or infrastructure debt) can provide attractive cashflow characteristics at a higher yield. For those that wait,
investors should ensure that the level of interest rate and inflation risk they bear is reflective of their specific circumstances and views, and is commensurate with the other investment risks (e.g. equity, credit, currency and illiquidity risks) that their portfolios contain. Scenario analysis and value at risk measures are valuable tools for investors to calibrate their positioning.
FIGURE 13: YIELD OUTLOOK
-1.0 0.0 1.0 2.0 3.0 4.0 5.0 UK Nom EUR Nom US
Nom RealUS RealEUR RealUK 10 YEAR YIELDS UK Nom EUR Nom US
Nom RealUS RealEUR RealUK 20 YEAR YIELDS
Five years forward Current yields -1.0 0.0 1.0 2.0 3.0 4.0 5.0
Sustainable range* Sustainable range* YIELD (%) YIELD (%)
Source: BlackRock as at end of June 2014.
*We anticipate UK and US yields to be in this range in five years, with European yields reverting to these levels a few years later.
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In the first half of 2014 there was a material rotation in equity
markets. A feature of this rotation was the underperformance of
a number of fundamental equity styles or factors
7. These styles
or factors, e.g. ‘small cap’, ‘value/growth’ and ‘momentum’, can be
used to explain the performance of equities, and some claim
that they systematically underperform or outperform market
indices. In this article we discuss the evidence for fundamental
equity factors generating persistent outperformance, and
assess how equity factors can be incorporated within an
investor’s asset allocation process.
Understanding these factors better could yield significant benefits. For example, U.S. biotech stocks – up roughly 65% in 2013 – fell 15% from their February peak by the end of March. By contrast, ‘large cap’ and ‘value’ stocks outperformed the market. This was particularly evidenced in the final week of Q1, as shown below.
FIGURE 14: S&P 500 1-WEEK PERFORMANCE
(%) 0.5 -0.5 0 -2.0 -3.0
2013 Best performers 2013 Worst performers -1.0
-1.5 -2.5
Each column in the chart above shows performance of a decile of S&P 500 stocks, based on 2013 performance. Source: BlackRock. As at 27 March 2014.
ANALYSIS OF EQUITY FACTORS
The capital asset pricing model (CAPM) is the foundation of modern financial theory. It was the first model of portfolio returns and is still referenced and used by many practitioners today. Under CAPM, the key driver of portfolio return is exposure to market risk (‘beta’). The other factor in portfolio returns is idiosyncratic risk, which in a diversified portfolio over the long term, is expected
Fundamental factors
within equities
TOPICAL PERSPECTIVESKEY POINTS
` Understanding fundamental equity factors is an important asset allocation consideration.` We find that performance is time and regime-dependent.
` Factor indices can be used as part of the investment toolkit or to express market views.
7 In last quarter’s Strategic Perspectives, we defined and discussed macroeconomic risk factors that could in aggregate explain the performance of all asset classes. Fundamental equity factors can be loosely viewed as risk factors for equities, in that they are explanatory variables for performance, though we note that they differ from our core risk factor definition (as outlined in the previous article) in that a) not all are directly investible and b) whether or not they have an economic rationale is debatable (and is the focus of this article).
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to have an average contribution of zero. Therefore, differences in returnsbetween portfolios can be predominantly explained by different levels of risk taken and exposure to beta, with higher risk portfolios expected to produce higher returns over the long term.
However, a large body of academic research has questioned the validity of CAPM. Other theories were developed, including Arbitrage Pricing Theory, which recognises that the return of a stock can be explained by a linear combination of multiple factors. Research into the performance of fundamental equity factor indices, which contain equities with specific common properties, has led to the identification of certain factors that have historically outperformed the market even when adjusting for risk – again, something that cannot be readily explained by CAPM.
Our analysis of fundamental equity factors in this article focuses on four main factor groups: ` ` Value/growth ` ` Market capitalisation ` ` Momentum ` ` Low volatility
FIGURE 15: FACTORS EXPLAINED
Factor Definition
Value /Growth Stocks are identified to be value stocks if the stock price is lower relative to the company fundamentals (i.e. dividends, sales, earnings).
Conversely, growth stocks have a higher price relative to fundamentals, implying an expectation of above average company growth relative to the wider market.
Market
capitalisation Stocks are selected based on the size of a company’s market capitalisation. The focus in this article is on small and large companies (small cap and large cap).
Momentum Momentum stocks are those that have outperformed the market over a defined time frame.
Low volatility These stocks have low historic volatility. Source: BlackRock.
Figure 16 on page 24 plots the relative performance of the MSCI All World factor indices against the full MSCI All World Index since 2001. An index level below 100 shows underperformance when compared to the wider market with a score of over 100 demonstrating outperformance. Note that we have deliberately chosen the time period shown to highlight some of the conclusions that are often drawn about fundamental equity factors. As we discuss later, the time period chosen is critical
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FIGURE 16: RELATIVE PERFORMANCE OF FACTOR INDICES TO
THE MSCI ALL WORLD
70 190 160 130 100 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
MSCI All World Min Vol MSCI All World Small Cap MSCI All World Value
MSCI All World Growth MSCI All World Momentum MSCI All World Large Cap
INDEX
LEVEL
Source: Thomson Reuters – Datastream. As at end June 2014.
It can be seen that over the chosen period the small cap, low volatility, momentum and value indices all outperformed, with returns on the small cap index being substantially higher. We performed statistical analysis to see whether or not this outperformance could be explained within the CAPM framework; that is to say, whether or not it was merely the higher volatility of some of these indices that was being compensated by higher return. We found that the small cap outperformance is the only one of these factors that displays statistically significant8 outperformance over this time period. In other words, the size of the
outperformance of the small cap factor index is unlikely to be purely explained by CAPM. There is weaker evidence to imply that low volatility and value also statistically outperform9.
The ‘outperformance’ (or lack thereof) of equity factors has been much debated in academic literature – with some academic research10 demonstrating the
outperformance of certain factors beyond what one would expect due to random variations. Others, however, query various aspects – for instance, the lesser impact in non-US markets (see Figure 17), the importance of the time period considered (see next section) and whether or not factor outperformance merely reflects an additional risk premium that investors are being compensated for rather than being a ‘free lunch’.
8 Linear regression analysis on risk-adjusted performance of MSCI factor indices vs. MSCI All World Index, confidence interval 5%.
9 10% and 15% confidence intervals respectively.
10 See papers ‘Betting Against Beta’ by Frazzini and Pedersen, ‘Momentum’ by Jegadeesh and Titman and ‘Cross-Section of Expected Stock Returns’, Journal of Finance June 1992 by Fama and French.
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FIGURE 17: RELATIVE PERFORMANCE OF MOMENTUM FACTOR IN
DIFFERENT REGIONS
0 50 100 150 200 250 300 2014 2012 2010 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980MSCI Momentum Japan MSCI Momentum USA MSCI Momentum Europe
INDEX
LEVEL
Source: Thomson Reuters – Datastream. As at end June 2014.
REGIME DEPENDENT FACTOR PERFORMANCE
We believe that the relative performance of fundamental equity factors, and statistical significance of the performance, is dependent on the time period considered. If in Figure 16, we had the analysed time period starting in 2007, low volatility stocks would have shown large outperformance, as investor sentiment became risk averse for a long period with the onset of the financial crisis in 2008. Small cap stocks, previously identified as having statistical outperformance, in fact underperformed in this environment. Indeed, Figure 16 starts from a position when the small cap valuations were at their cheapest relative to large cap; and the normalisation of these valuations over the past decades is more likely to explain the outperformance of small cap than any inherent persistent premium. In fact, as discussed in greater detail in the portfolio framework section, US small cap equities are arguably now the most overvalued sector of the equity market – which would imply underperformance, rather than outperformance, over the coming years.
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FIGURE 18: HISTORICAL TREND OF US SMALL CAP AND LARGE
CAP PRICE/EARNINGS RATIO
10 15 20 25 30 35 Feb 14 Apr 13 Jun 12 Aug 11 Oct 10
MSCI USA Large Cap MSCI USA Small Cap
PRICE/EARNINGS RA
TIO
Source: Datastream, BlackRock. As at end June 2014.
Similarly, there are strong arguments to suggest that the outperformance of low volatility stocks can be explained by the prevailing market environment. Strong low volatility index performance has coincided with the continued fall in bond yields over recent decades, which has boosted the performance of bond-like assets. If one believes that investors view low volatility indices, with their more stable returns than traditional equity, as bond-like assets, then it is natural that they perform well in a bond bull market. This would imply that this outperformance would be removed or reversed if bonds were to enter a bear market. In fact, within a CAPM framework it can be shown mathematically that portfolios with a beta of less than 1 (such as low volatility stocks, almost by definition) will underperform in a rising rate environment11.
FACTOR INVESTING AS PART OF AN INVESTOR’S ASSET
ALLOCATION PROCESS
In determining whether to allocate to factor indices, it is important that
investors are aware of the transfer of responsibility for investment performance when compared to active management. Factor indices are rules-based and the investment performance relative to the broader market is the responsibility of the investor. This differs from active management where the fund manager takes responsibility for relative performance.
In our view, equity factors do not provide time independent, ubiquitous premiums that are a free lunch. Rather, they can provide higher than market returns in favourable market conditions. The risk-on environment of 2013, supported by ultra-loose financial conditions with no clear end in sight, was conducive to growth and small cap stocks performing well. In the beginning of 2014, where sentiment started to become more mixed as investors worried about the impact of tapering on certain industries and sectors, markets shifted sideways, and defensive, large cap value stocks became more attractive. This led to a break in the prevailing momentum. Valuations of these fundamental equity factors change over time; at times some become relatively expensive and others relatively cheap.
We believe that investors should be aware of equity factor exposure within a portfolio when setting strategic and tactical asset allocations. Equity factor performance will reflect changing economic environments and valuation metrics and factor indices can be used as part of the investment toolkit to express market views.
Private market debt is the provision of non-publicly traded
debt financing to small and mid-sized companies. Specific
examples of these opportunities include asset-backed
investments, direct lending, distressed investments and
bank portfolio liquidations. In this article we discuss the
opportunities available within private market debt and
outline why we believe this asset class is well suited to
institutional investors.
Private market debt investments can take a number of forms: `
` Lending alongside a bank or hedge fund – A loan by an institutional investor alongside an existing senior secured loan.
`
` Replacement of a bank – A single tranche with typically higher total commitment, higher leverage and additional covenants to reflect the challenges of lending to companies who struggle to obtain conventional bank financing.
`
` Subordinated lender – Mezzanine lending to corporations that tend to have an equity ‘kicker’, i.e. some degree of equity participation/incentive to boost the expected returns to the lender.
Opportunities are available across a variety of industry and geographic
segments. We focus on private market debt opportunities of intermediate term, typically with a two- to six-year holding period, which fall outside traditional asset classes but which often also do not fit neatly within the customary ‘hedge fund’ or ‘private equity’ classification. As a result, these opportunities are often overlooked by institutional investors.
FIGURE 19: INVESTING IN THE MIDDLE
INTERMEDIATE-TERM STRATEGIES
HEDGE FUND STRATEGIES PRIVATE EQUITY STRATEGIES
0
YEARS10
YEARS6
YEARS2
YEARSFor illustrative purposes only. Source: BlackRock.
What is private
market debt?
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TOPICAL PERSPECTIVES
KEY POINTS
` Private market debt offers a wide range of
opportunities for long-term investors to gain additional yield and diversification. ` We currently see an
attractive supply given the reduced role of traditional providers of non-publicly traded debt.
` Implementation is a major hurdle and requires specialist expertise.
WHY IS IT TOPICAL?
In the current market environment, we see an attractive supply of private market debt investments. This phenomenon results from acute supply and demand imbalances, caused by:
`
` Constrained balance sheets of traditional market participants (e.g. banks). `
` Limited hedge fund capital in many strategy segments. `
` Regulatory restrictions such as the Volcker Rule and Basel III. `
` Investor constraints including asset allocation imbalances and liquidity preferences.
Many financial institutions are subject to a combination of these factors, and their responses have created opportunities for alternative capital providers. Global deleveraging has reduced the lending base for certain borrowers while many banks are terminating lending operations in non-core markets.
This has resulted in opportunities for non-traditional lenders to capture an illiquidity premium by directly originating loans that are smaller and involve more complex collateral where strong structuring capabilities can help to isolate risks. High barriers to entry as a result of structuring complexity, infrastructure and resource needs serve as an additional source of premia that can be extracted by informed investors.
Investors who can accept a degree of illiquidity are well placed to exploit the supply and demand mismatch in the market. Private market debt can allow investors to exploit these structural imbalances without being wedded to any one particular market or sector – instead, a skilled manager with a strong opportunity sourcing network in this asset class should be able to identify opportunities wherever they occur.
FIGURE 20: OPPORTUNITIES ACROSS THE CREDIT SPECTRUM
SING PO TENTIAL T O ADD VAL UE Investment grade corporate debt TRADITIONAL
PRIVATE MARKET DEBT
High yield bonds/ leveraged loans
Hybrid securities
Distressed/ default debt
Commercial real estate whole loans
Direct corporate lending
Structured/asset backed credit
MARKET OVERVIEW
There is a wide range of opportunities in private market debt, ranging from energy investments to shipping. This contributes to the natural diversification within this asset class. We discuss the opportunities in some of the most currently attractive markets below.
Within the global energy sector, a meaningful capital imbalance exists as demand for financing far outpaces the funding available from the traditional banking system. New technologies to access conventional resources (such as horizontal drilling for natural gas), aging infrastructure and geopolitical factors are leading to sustained, heightened demand for financing. In North America alone, the International Energy Agency projects that $7.5 trillion is needed by 2035. Loans collateralised by energy resources and infrastructure companies can present equity-like upside with the potential for downside protection. Opportunities also exist in the commercial real estate (CRE) market. There is a significant tranche of commercial real estate debt that matures between now and 2017, and traditional lenders have reduced CRE lending volumes, restricted maximum loan-to-value ratios, and generally tightened underwriting standards. Additional regulatory restrictions on commercial banks have made CRE lending less profitable. These factors leave a considerable funding gap in the market that create a better entry point for lending capital with the potential to earn above-average returns with reduced downside risk. We discussed mezzanine CRE debt in greater detail in the April edition of Strategic Perspectives.
A distressed shipping sector, driven by decreasing fleet and shipyard utilisation rates, low day rates and the disappearance of traditional sources of financing has created opportunities for less traditional providers to step in at attractive pricing. Over-levered corporate institutions, with large and midsize tanker fleet, have accumulated losses of more than $26 billion since 2009. This creates opportunities for non-traditional lenders to offer loan-to-own financing (i.e. loans giving the borrowers the option of future purchase). Portfolios can be supplemented with hard asset purchases – i.e. assets purchased at distressed pricing levels, usually via a joint venture with the operator, which creates upside optionality (assuming prices normalise) with the security of the intrinsic value of the asset.
AN EXTENSION OF ‘TRADITIONAL’ ALTERNATIVE ASSET CLASSES
Private market debt can be an attractive asset class for institutional investors, and can offer targeted exposure to particular strategies, geographies or investment opportunities. They allow investors to further diversify their alternatives portfolios and obtain higher returns through both an illiquidity premium and a complexity premium – compensation for the high barriers to entry to this asset class. Given the idiosyncratic nature of investments, the more prevalent risks are often highly deal-specific rather than market-related, and so have a different risk profile to the majority of traditional investments.
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IMPLEMENTATION
CONSIDERATIONS
Accessing suitable private debt assets is one of the biggest challenges in investing in this space. Three common routes for institutional investors are: ` Multi-client funds
offered by managers with a particular speciality, e.g. in direct lending ` Special purpose
vehicles that are effectively bespoke funds for large investors, working in conjunction with a manager ` Direct co-investment with a manager The choice of implementation route depends on the constraints and requirements of an investor. Scale is a limiting factor on the second and third routes listed above, with smaller investments best suited to multi-client funds. Investors who are able to use the second or third routes benefit from the ability to create bespoke solutions that are not tied to any one particular industry or sector. Some asset managers offer ‘aggregator’ access whereby they create multi-client funds which themselves access the market in each of the methods listed.
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Key challenges around investing in private debt include sourcing attractivedeals, and the difficulties in managing and monitoring the risk being taken over time.
Benefits Risks Risk mitigants
Different risk profile to traditional market assets and opportunity to capture an illiquidity premium and a complexity premium
Idiosyncratic deal-specific risks Difficulty in accessing opportunities
Strong underwriting process
Deep sourcing network for opportunities
Stable cashflows
protected by collateral LiquidityCredit quality of issuer Investment horizon of between two and four years, considerably less than other alternative investments Some institutional investors are well placed to take on
liquidity risk
Thorough investigation and critical assessment of debt issuer’s creditworthiness
Diversification from other alternative investments
Exposure to market risks
Ability to monitor and manage risk over time
If investments have equity market or interest rate sensitivity, a skilled investor can potentially establish an appropriate hedge Each deal’s sensitivity to various economic factors should be assessed as a part of the underwriting process in an effort to ensure that the deal provides an adequate level of return for the risk that is taken
Consider a risk factor approach to monitoring private market assets
Investors need to consider the performance of the portfolio in a number of scenarios. This is particularly relevant in an extreme economic environment where there are diverse plausible future economic regimes, with very different outcomes for assets. A portfolio that is calibrated to perform well if markets behave as expected may perform poorly in one of a number of shock events, and testing this helps to build a more robust portfolio.
The benefits of considering diverse scenarios include an understanding of: `
` How asset risk and return assumptions are formulated. `
` The range of possible outcomes, particularly in an environment of uncertain investment regimes and secular change within markets.
`
` How specific investor views can be incorporated into an investment strategy, by determining the scenarios that they identify with most strongly.
`
` The behaviour of assets and liabilities in the investor’s circumstances.
Scenarios
APPENDIX
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Scenario Description Likelihood Nemesis shock The world economy is hit by a recession, credit crunch and social upheaval. Developed economies are
plunged into another recession and China slows significantly. A market sell-off ensues and there are steep losses across asset classes. A flight to quality assets from investors across the board sees only a few asset classes perform.
Low
Global ultra-soft landing
The global economy avoids a contraction due to successful fiscal and moneta