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Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
1
Multi Asset Strategy Global September 2012
abc
The 10 trends shaping the investment world We are in a very unusual investment world Interest rates are at historical lows equities more volatile
than normal different assets classes abnormally correlated and demographics are altering savings patterns
in rich countries
These developments have already caused big shifts in investment flows over the past five years Investors
have switched massively from equities into bonds moved their money into index funds and ETFs and
searched for new ways to achieve return without too much risk
In this report we look at how investor behaviour is changing and what this means for investment
management businesses We identify 10 themes that we believe will shape the future of the industry over
the coming years Not only is an understanding of these important for strategy planners at investment
management firms (and we held discussions with many CEOs and CIOs of investment firms in the
preparation of this report) we think these trends will affect asset prices too Will the search for income
push down yields on credit to ridiculous levels Will investors completely abandon equities because of
their volatility Will demand for alternative assets (infrastructure financing distressed debt derivative
structures) push up their prices
We believe that understanding these sorts of deep underlying trends in investment is important for asset
allocation It is too easy to get caught up in the day-to-day movements of the economic cycle Thinking
about long-term drivers such as demographics changes in wealth or market micro-dynamics can help
improve investment decision-making We believe the ideas and copious data in this report will prove
thought-provoking for anyone interested in understanding these shifts
After an introductory section which analyses the macro background and describes the state of the
investment management industry today ndash including projections for its future growth ndash each chapter of this
report details one of the trends with our assessment of its implications of each for asset prices
There are some common threads running through the trends In brief these are the struggle to produce
income in a low interest-rate world (via credit high dividend yield equities or illiquid investments) the
desire to tailor risk (though risk-minimising products and absolute return multi-asset funds) and the shift
to passive investments such as index funds and ETFs which has begun to hurt hedge funds too
Summary
How is a world of low interest rates risk aversion and unusually high correlations affecting the investment management industry We identify 10 trends changing how investors invest and assess their impact on the price of assets
2
Multi Asset Strategy Global September 2012
abc
Our 10 trends are
1 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
The search for yield With risk-free rates so
low investors are desperate for income They
have already piled into bonds Credit remains
in a sweet spot though issuers are attracted
by the low interest rates but for investors
spreads over government bonds remain
decent (Chart 1) We think dividend yield
stocks remain attractive too Many investors
argue itrsquos too late to buy them but in the US
in particular income funds still comprise only
3 of equity mutual funds Page 13 Source Bloomberg
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
The death ndash or rebirth ndash of equities Bill
Gross of Pimco says the cult of equity is
dead But equities have actually outperformed
bonds over the past 10 years although
admittedly with high volatility (Chart 2)
Perhaps a bigger risk ndash which bond houses
are worrying about ndash is the bursting of the
bond bubble could 2014 be another 1994 At
the very least with cash yielding zero and
high-quality government bonds 15 it
seems likely that equity returns will beat
these over the next 10 years Page 17 Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan
Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
Risk minimising strategies Investors ideally would like equity-style returns with bond-like
volatility Thatrsquos rarely possible But fund managers are developing products that offer different
combinations of risk and return Such strategies include multi-asset funds longshort equity
strategies risk parity products minimum volatility equity funds and using options to target a level of
risk Page 20
The growth of multi-asset The fastest growing type of risk minimising strategy especially in the
UK is the absolute return fund most famously Standard Lifersquos GARS Such funds target Libor-plus
absolute returns with bond-like volatility and costs lower than hedge funds They have their
detractors (do they really create alpha or are they just leveraged bond funds) but look likely to grow
further even in the US where they have yet to take off Page 22
3
Multi Asset Strategy Global September 2012
abc
3 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
The shift to passive A third of active equity
money has shifted into passive funds in the
past 10 years (Chart 3) We think passive
encroachment is likely to continue since
active funds empirically underperform on
average (with higher costs) But indexing
strategies are likely to get smarter some
indexes outperform others for example the
equal-weighted SampP500 has beaten the
regular (market cap weighted) SampP500 by
37 in the past decade Page 24 Source EPFR
4 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
The relentless rise of ETFs ETFs have
reached USD15trn (up from USD105bn in
2001 ndash Chart 4) But there are issues with
these too Are ETFs suitable for bonds
Some overly sophisticated ETFs have blown
up spectacularly will this invite the
regulatorsrsquo attention The two keys for future
growth are (1) whether active ETFs take off
and (2) the trend of retail financial advisors
being remunerated by fees rather than
commissions on the products they sell (ETFs
donrsquot pay a commission) Page 28 Source Blackrock (end-Jun)
5 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
The decline of the hedge fund Hedge funds
have struggled to perform recently (Chart 5)
The average hedge fund is up only 25 so
far this year The underlying problem is that
the hedge fund community has become so big
that it has arbitraged out most of the alpha
Like active equity funds hedge funds in
aggregate cannot by definition outperform
Moreover ldquotraditionalrdquo fund managers are
increasingly converging with large hedge
funds ndash and they donrsquot charge fees of 2 and
20 Page 31
Source Bloomberg EurekaHedge
4
Multi Asset Strategy Global September 2012
abc
6 Illiquidity premium estimate by asset class
0
100
200
300
400
500
Equity Corporate
bonds
Gov ernment
bonds
Cov ered
bondsbp
Harvesting the illiquidity premium Most
investors have a strong preference for
liquidity But some ndash notably pension funds
and insurers ndash donrsquot always need it and may
be overpaying for it Amid the desperate
search for income they may see the attraction
of the extra yield available in illiquid assets
(Chart 6) such as infrastructure real estate
finance and ldquoprivate debtrdquo (structured like
private equity but providing debt financing)
Page 34 Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
7 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Where will the money come from Defined
benefit pensions are dwindling (Chart 7) The
growth areas for investment management
companies in the next few years will be
personal pensions Asian high net worth
individuals and sovereign wealth funds But
each of these will demand more sophisticated
products and solution-based services Page 36
Source OECD
8 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
The challenge of ESG Plan sponsors
particularly public pension funds in Europe
are increasingly focusing on environmental
social and governance issues So far most
fund managers pay only lip-service to this
But momentum is building (Chart 8) and
companies with superior ESG policies and
disclosure might start to outperform After
all who wants to buy a company with poor
corporate governance which pollutes or treats
its staff badly Page 42 Source US SIF Eurosif (definitions differ slightly)
5
Multi Asset Strategy Global September 2012
abc
Implications for asset prices
The search for yield should be positive for credit and for high dividend yield stocks both of which remain
attractive in our view Equities in general may struggle for a few more years as global economic growth
remains low but the basic concept that equities have a risk premium ndash and therefore generate greater
returns in the long run ndash will not disappear If investors become more willing to buy illiquid assets to
boost yield the pricing of long-term loans commercial real estate and infrastructure finance should be
positively affected The development of multi-asset funds should aid the development and liquidity of
more esoteric asset classes and derivatives products We believe the further growth of passive funds and
ETFs will keep inter-market and intra-market correlations high
6
Multi Asset Strategy Global September 2012
abc
Introduction an unusual world 7 Cyclical or evolutionary 7
The search for yield 13 hellipin credit and dividends 13
The death ndash or rebirth ndash of equities 17 Problem is volatility not return 17
Risk-minimising strategies 20 Tailoring risk not return 20
The growth of multi-asset 22 GARS and all its friends 22
The shift to passive 24 Itrsquos hard to beat an index 24
The relentless rise of ETFs 28 Attractive ndash but problems too 28
The decline of the hedge fund 31 Is there any alpha left 31
Harvesting the illiquidity premium 34 Do you really need liquidity 34
Where will the money come from 36 The sources of growth 36
The challenge of ESG 42 Unavoidable momentum 42
Disclosure appendix 46
Disclaimer 48
Contents
7
Multi Asset Strategy Global September 2012
abc
Cyclical or evolutionary We are in a very unusual investment world
Interest rates are at historical lows equities more
volatile than normal different assets classes
abnormally correlated (the ldquorisk on-risk offrdquo
phenomenon) and demographics are altering
savings patterns in rich countries
These developments have already caused a big
shift in investment flows over the past five years
Investors have
Sold equities and bought bonds in huge
volumes in the US since end-2007 bond
mutual funds have seen inflows of USD920bn
and equity funds outflows of USD430bn
Loaded up on risk-free assets But the supply
of these has shrunk (according to the BIS
AAA-rated government paper now totals only
USD12trn compared to USD26trn in early
2011 ndash Chart 1) This has pushed down their
nominal yields to below zero in some cases
Increasingly understood that active equity
fund managers in aggregate underperform
benchmarks (even before fees) and so moved
heavily into index funds and ETFs
Searched for new ways other than equities to
achieve a decent return without too much risk
This has led to the development of absolute
return (or diversified beta) funds and risk-
minimising strategies
1 Credit risk of pool of government debt
0
5
10
15
20
25
30
35
40
01 02 03 04 05 06 07 08 09 10 11
AA to below AA+AA+ to below AAAAAA
Source BIS (Ratings used are the simple averages of the long-term foreign currency sovereign ratings from Fitch Moodyrsquos and SampP)
Is this a permanent structural change or will we
eventually go back to the old normal Probably a
bit of both The side-effects of the 2007-9 Global
Financial Crisis will eventually wear off (though
Introduction an unusual world
Low rates high volatility high correlation ndash the world has changed
Fund managers are struggling to cope how to find returns without
too much risk and provide solutions to investors with new needs
We indentify three threads the search for income tailoring risk
and the continuing shift from active to passive
Garry Evans Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6916 garryevanshsbccomhk
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registered qualified pursuant to FINRA regulations
8
Multi Asset Strategy Global September 2012
abc
this may take a few more years) with interest
rates volatility and correlations returning to their
historical norms
But there has been some evolution too Investorsrsquo
behaviour is likely to have changed permanently
Investors will increasingly question whether
hedge funds can generate alpha and whether
they deserve fees of 2 and 20 even if
they can
Retail investors will demand access to the sort
of absolute return strategies that hedge
funds previously specialised in ndash and at a
reasonable cost
There will be more demand for solutions
whether liability-matched investments for a
defined benefit (DB) pension fund that is
winding down or a ldquoto-and-throughrdquo
personal pension plan for an individual due
to retire in five years who wants to fix
post-retirement income
Interest in buying stocks in companies with a
strong ESG (environmental social and
governance) record will increase This is not
idealistic green talk ndash after all who wants to
own a company with poor corporate
governance or which treats its staff badly
Many of these themes are fairly obvious and have
been under way for a number of years But how
the fund management industry will be affected by
them is not yet at all obvious Like any business
an investment management firm has to pick a
strategy should it rush into all these new areas
(ETFs absolute return funds pension solutions
ESG) or should it decide to focus Is it better to
be a large global investment house or a focused
boutique ndash or hedge onersquos bets by becoming a
multi-boutique umbrella organisation
These trends will affect asset prices too If
investors abandon equities for a generation PE
multiples would contract further as they did in the
1970s or after the Great Depression Further
growth in ETFs and index products could push
correlations up further A rise in demand for
alternative assets (infrastructure financing
distressed debt derivative structures) could shift
the prices of these assets As banks in Europe
deleverage infrastructure lending leasing and
other forms of long-term finance could pass to
institutional investors in a form of
disintermediation which could bring down
borrowing costs
2 Demographic trends of population aged 35-54 in DM 3 Demographic trends of population aged 35-54 in EM
20
22
24
26
28
30
1990 2000 2010 2020 2030 2040 2050
Dev eloped markets
20212223242526272829
1990 2010 2030 2050
Emerging
Source HSBC UN Population Division NB MSCI World markets Source HSBC UN Population Division
9
Multi Asset Strategy Global September 2012
abc
Why this matters
This is a topic that HSBCrsquos strategy team has
tackled before We believe that understanding the
deep underlying trends in investment are
important for asset allocation It is too easy to get
caught up in the day-to-day vicissitudes of the
economic cycle Thinking about long-term
drivers such as demographics changes in wealth
or market micro-dynamics can help improve
investment decision-making
Earlier this year for example we published a
report (Who will buy by Daniel Grosvenor 3
February 2012) which argued that demand for
equities is likely to remain structurally weak due
to prolonged risk aversion regulatory changes and
deteriorating demographics In particular ageing
populations in the developed world (Chart 2) will
tend to own fewer equities This the report
argued could keep DM valuations depressed but
EM should be immune (partly because of its
better demographics ndash Chart 3)
We also described the growing importance of
emerging markets investors in Asia buys Asia by
Herald van der Linde and Devendra Joshi June
2012 Asian equity markets have traditionally been
dominated by foreign investors or speculative local
individuals But this is changing as Asians diversify
their wealth into financial assets and pension
systems develop across the region
Our colleagues in quantitative strategy have also
looked at the risk on-risk off phenomenon (their
latest report is Risk On ndash Risk Off Fixing a
broken investment process by Stacy Williams
Daniel Fenn and Mark McDonald April 2012)
They suggest ways in which fund managers can
adapt their investment process to cope with the
phenomenon and take advantage of it
For this present report we met with CEOs chief
investment officers and senior business managers
at almost 20 investment firms in the US and
Europe These ranged from niche long-only equity
specialists to opportunistic macro hedge funds
from major ETF providers to large global multi-
asset investment managers Naturally most of the
senior managers had a bias based on what they
specialised in equity houses tend to believe that
actively managed equity will come back and
passive specialists argue that in future everything
will be indexed
But our conversations gave us a good idea of the
sort of concerns investment managers have when
they are being candid Bond houses worry about
how to cope with the crash in bond prices that we
believe is inevitable in the future Active
managers worry whether itrsquos too late to enter the
index ETF business ndash or whether they should try
to structure their active funds as ETFs Many
managers are struggling to create innovative
products ndash risk-hedged funds absolute return
strategies pension-friendly structures ndash in a world
where their revenues have stagnated and so RampD
budgets have been cut
The global investment industry today
Before we try to draw out some threads from the
10 trends in investment management we have
identified some background
4 Assets under management (USDtrn end-2010)
Insurance
funds 246
Pension
funds 299
HFs 18
SWFs 42
ETFs 13
Mutual
funds 247
PE 26
Source TheCityUK estimates
How big is the global investment industry
Conventional assets (pension funds mutual funds
10
Multi Asset Strategy Global September 2012
abc
and insurance) total about USD80trn split
roughly evenly between the three (Chart 4) The
AUM of these institutions has doubled since
2000 Hedge funds manage around USD2trn and
private equity funds a little more than that Add to
this sovereign wealth funds which in their pure
form have assets of about USD5trn include FX
reserve managers and other sovereign institutions
(such as national pensions or development funds)
and the total reaches about USD20trn ETFs
comprise another USD15trn or so Private wealth
is harder to figure out various estimates put it at
between USD26trn and USD120trn At the top
end of estimates the total amount of money
available for investment firms to manage exceeds
USD200trn ndash almost 3x global GDP
The US is still the largest source of funds with
USD35trn out of the USD79trn in conventional
assets globally (Chart 5) That is 224 of US GDP
The UK though much smaller in absolute terms at
USD65trn is the biggest in proportion to GDP with
conventional funds representing 257 of GDP
(although some of that comes from money
domiciled in the UK but not from UK nationals)
5 Source of conventional assets by country (USDtrn)
05
10152025303540
US
UK
Japa
n
Fran
ce
Ger
man
y NL
Switz
Oth
er
Pension funds Insurance assets Mutual funds
Source TheCityUK estimates based on OECD Investment Company SwissRe and UBS data (Figures are for domestically sourced funds regardless of where they are managed No reliable comparisons are available for total funds under management buy country)
hellipand the chances of it growing
There is no reason to suppose that the rate of
growth of institutional assets will slow over the
coming years Over the past decade conventional
assets have grown at a compound annual rate of
71 While it is likely in our view that global
economic growth will be lacklustre in coming
years as the after-effects of the Global Financial
Crisis are worked off this does not mean that
global savings will be stagnant Indeed quite the
opposite Households and companies are likely to
increase their savings as they stay risk averse (and
governments are likely to reduce fiscal deficits
albeit slowly)
The IMF projects that US and UK gross national
savings which have already improved modestly
since 2009 (to 129 of GDP from 115 in the
case of the US) will continue to increase over the
next five years with the US reaching 178 by 2017
(Chart 6) China meanwhile is unlikely to reduce its
savings rate much despite efforts to get households
to spend Australia has already made some headway
in raising its savings rate since its bubble in the early
2000s Japan is the only major economy where the
ratio may fall as retirees start to eat into their
savings All this suggests that the savings glut which
drove the fall in interest rates and strong equity
performance in 2003-7 will not disappear
6 Gross national savings rate selected countries ( of GDP)
0
10
20
30
40
50
60
80 85 90 95 00 05 10 15
UK US AU CH JP
F
Source IMF
And at the same time as savings grow companies in
the developed world are unlikely to need to raise
much money for the next few years Corporate cash
holdings are at record highs especially in the US
and companies are being cautious about capex
11
Multi Asset Strategy Global September 2012
abc
Dividend payout ratios are very low (31 in the US
last year for instance) This suggests that large listed
companies at least will not need to raise much
capital either debt or equity for the next few years ndash
although capital-hungry emerging markets
companies of course will
As countries get richer they tend to increase the
amount of institutional assets under management
and increase the amount invested in equities and
bonds (rather than placed in bank deposits) as
shown in Charts 7 and 8
7 Increasing wealth brings growth in institutional assets
0102030405060708090
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in institutional assets
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
8 hellipamid withdrawals from bank deposits
0
10
20
30
40
50
60
70
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in bank deposits
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
This suggests that as long as emerging markets
continue to develop (which in most cases we think
likely) then not only should the pool of potential
savings grow but the proportion of the pool
available for international investment institutions
to manage should grow even faster Not that this
will be without challenges how do London or
New York-based investment managers get access
to wealth held in China or India which is still
highly restricted in where it can invest and mostly
off limits to them
Indeed a well-read report by the McKinsey
Global Institute The emerging equity gap Growth
and stability in the new investors landscape
December 2011 argued that the growth of
international securities ownership by emerging
market investors will be essential if the role of
equities in the global financial system is not to be
reduced in the coming decades In particular
emerging market investors will need to triple their
allocation to equities if companies in these
countries are not to be starved of equity capital
Common threads
In this report we highlight the 10 trends that we
think will drive the investment management industry
over the next few years Understanding these trends
ndash and considering their implications ndash will be
important both for investment institutions in
planning their strategies and for investors interested
in the impact of these trends on asset prices
12
Multi Asset Strategy Global September 2012
abc
Inevitably there are some overlaps between the
10 trends Broadly we see three threads running
between them
The search for income With interest rates so
low investors are desperate to generate
income This has triggered demand for credit
and high dividend yield equities which we
expect to continue It is also forcing investors
to consider whether they are overpaying for
liquidity and to look at harvesting a premium
for investing in illiquid instruments such as
infrastructure and ldquoprivate debtrdquo funds
Tailoring risk Modern derivative techniques
make it possible to tailor risk to an extent
Investors scared of drawdowns can hedge fat-
tail risk Fixing a return is not possible (except
for a very low return) tailoring a level of risk
may be easier This concept has spawned the
development of risk parity funds and a boom in
multi-asset absolute return funds
A continuing shift from active to passive
Academic evidence strongly suggests that
active equity fund managers in aggregate
underperform their benchmarks That has
pushed investors over the past decade from
active to passive funds especially ETFs ndash a
trend we expect to continue It is also forcing
a rethink of the role of hedge funds which
have grown so large that in aggregate they no
longer seem to be able to produce superior
performance either
In the following sections we describe in detail the
10 trends we have identified and analyse their
implications for asset prices
13
Multi Asset Strategy Global September 2012
abc
hellipin credit and dividends With cash yielding zero and top-quality
government bonds little more than 15 it is
unsurprising that investors are scrambling to pick
up yield Indeed one could even say that the
market has become obsessed with income
1 Cumulative net flows to bond funds worldwide by type
-100
-50
0
50
100
150
200
250
300
07 08 09 10 11 12
USD
bn
Gov tCreditOther
Source EPFR (ldquoOtherrdquo includes muni funds MBS funds total return bonds and funds able to invest in a mix of bond types)
Look at flows into bond mutual funds recently It
is well known that these have been very healthy
totalling USD580bn over the past three years
according to EPFR But for the past 12 months at
least bonds flows have been predominantly into
credit funds (for example corporate high yield or
EM bond funds) with even a small net outflow
from government bond funds (Chart 1)
The sort of funds selling well is clear from the list
of the largest fund launches year-to-date The top
20 new US-based funds ranked by assets under
management now (Table 2 overleaf) include 10
bond funds two asset allocation funds and only
eight with an equity focus (remember this is for
the heavily equity-centric US market) Three of
the best-selling funds include the word ldquoincomerdquo
in their names
Credit is in a sweet spot Interest rates at which
corporates can issue are at historic lows But at
the same time spreads over US Treasuries are
quite high making the bonds attractive for
investors too
In the US for example BBB-rated five-year
corporate bonds currently yield only about 28 ndash
the lowest for decades ndash but that represents a spread
over Treasuries of around 200bp well above the
average of 130bp from the 2003-7 period (Chart 3)
The same is true in emerging markets The HSBC
Asian Dollar Bond Index (Chart 4) currently has a
record low yield of 37 but the spread over
Treasuries is a still attractive 300bp
This is why lots of bonds have been issued this
year August for example with over USD120bn
of issuance according to Dealogic was the highest
August on record and more than double the
USD58bn average for August Sub investment
The search for yield
With risk-free rates so low investors are desperate for income
Credit is in a sweet spot with issuers enjoying record low
borrowing costs but investors finding decent spreads
We think dividend yield stocks remain attractive too
14
Multi Asset Strategy Global September 2012
abc
grade issuance in August totalled USD27bn up
from USD13bn the same month in 2011
3 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
Source Bloomberg
Investors are clearly now having to take more risk
to get yield Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield One
example is bonds from riskier emerging markets
Ten-year paper from the Philippines a BB-rated
issuer now yields only 25 Investors have been
buying bonds from countries such as Gabon
Belarus Nigeria and Vietnam But five-year
bonds even from Gabon (BB-rated) now yield
only 38 You have to stretch to Belarus (B-) to
get a decent yield just over 10
4 HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source HSBC
This could all go very wrong Credit spreads are
supposed to compensate investors for the
probability of default At the investment grade
part of the credit spectrum defaults are rare but at
the sub-investment grade end they are less so At
present the combination of low rates on high
quality government bonds and relatively wider
credit spreads combined with very low default
rates places credit in a sweet spot compared to
some other assets classes However in an
2 Largest mutual funds launched in the US this year
Ticker Name Manager Inception date
Asset class Objective AUM (USDbn)
TGIRX US Intl Value Fund Thornburg 512012 Equity International Equity 265 OIBIX US Intl Bond Fund Oppenheimer 1272012 Debt International Debt 126 WAPRX US Core Plus Fund Western Asset 512012 Debt GovtCorp Intermediate 96 OSIIX US Global Strategic Income Fund Oppenheimer 1272012 Debt GovernmentCorporate 86 OGLIX US Global Fund Oppenheimer 1272012 Equity Global Equity 83 PSTQX US Short Term Corp Bond Fnd Pridential 322012 Debt CorporatePreferred-Inv Grade 80 AEMSX US Emerging Markets Fund Aberdeen 2272012 Equity Emerging Market-Equity 75 OIGIX US Intl Growth Fund Oppenheimer 4272012 Equity International Equity 62 MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6152012 Equity Growth-Mid Cap 60 MSFKX US Total Return Fund MFS 612012 Asset Allocation Balanced 58 PEFAX US EM Fundamental IndexPLUS Pimco 5312012 Debt Index Fund-Debt 54 CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund Columbia 4202012 Debt GovernmentCorporate 47
OBBCX US Mortgage Backed Securities Fund JP Morgan 722012 Debt Asset Backed Securities 41 JQLAX US Life Aggressive Fund John Hancock 312012 Asset Allocation Flexible Portfolio 37 OEIIX US Equity Income Fund Oppenheimer 4272012 Equity Value-Large Cap 33 MIDLX US Intl New Discovery Fund MFS 612012 Equity International Equity 32 JIPPX US Strategic Income Opportunities Fund John Hancock 312012 Debt Global Debt 31 WABRX US Core Bond Fund Western Asset 512012 Debt GovtCorp Intermediate 30 MFBKX US Bond Fund MFS 612012 Debt GovernmentCorporate 28 JDVPX US Disciplined Value Fund John Hancock 2292012 Equity Value-Large Cap 28
Source Bloomberg
15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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1
Multi Asset Strategy Global September 2012
abc
The 10 trends shaping the investment world We are in a very unusual investment world Interest rates are at historical lows equities more volatile
than normal different assets classes abnormally correlated and demographics are altering savings patterns
in rich countries
These developments have already caused big shifts in investment flows over the past five years Investors
have switched massively from equities into bonds moved their money into index funds and ETFs and
searched for new ways to achieve return without too much risk
In this report we look at how investor behaviour is changing and what this means for investment
management businesses We identify 10 themes that we believe will shape the future of the industry over
the coming years Not only is an understanding of these important for strategy planners at investment
management firms (and we held discussions with many CEOs and CIOs of investment firms in the
preparation of this report) we think these trends will affect asset prices too Will the search for income
push down yields on credit to ridiculous levels Will investors completely abandon equities because of
their volatility Will demand for alternative assets (infrastructure financing distressed debt derivative
structures) push up their prices
We believe that understanding these sorts of deep underlying trends in investment is important for asset
allocation It is too easy to get caught up in the day-to-day movements of the economic cycle Thinking
about long-term drivers such as demographics changes in wealth or market micro-dynamics can help
improve investment decision-making We believe the ideas and copious data in this report will prove
thought-provoking for anyone interested in understanding these shifts
After an introductory section which analyses the macro background and describes the state of the
investment management industry today ndash including projections for its future growth ndash each chapter of this
report details one of the trends with our assessment of its implications of each for asset prices
There are some common threads running through the trends In brief these are the struggle to produce
income in a low interest-rate world (via credit high dividend yield equities or illiquid investments) the
desire to tailor risk (though risk-minimising products and absolute return multi-asset funds) and the shift
to passive investments such as index funds and ETFs which has begun to hurt hedge funds too
Summary
How is a world of low interest rates risk aversion and unusually high correlations affecting the investment management industry We identify 10 trends changing how investors invest and assess their impact on the price of assets
2
Multi Asset Strategy Global September 2012
abc
Our 10 trends are
1 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
The search for yield With risk-free rates so
low investors are desperate for income They
have already piled into bonds Credit remains
in a sweet spot though issuers are attracted
by the low interest rates but for investors
spreads over government bonds remain
decent (Chart 1) We think dividend yield
stocks remain attractive too Many investors
argue itrsquos too late to buy them but in the US
in particular income funds still comprise only
3 of equity mutual funds Page 13 Source Bloomberg
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
The death ndash or rebirth ndash of equities Bill
Gross of Pimco says the cult of equity is
dead But equities have actually outperformed
bonds over the past 10 years although
admittedly with high volatility (Chart 2)
Perhaps a bigger risk ndash which bond houses
are worrying about ndash is the bursting of the
bond bubble could 2014 be another 1994 At
the very least with cash yielding zero and
high-quality government bonds 15 it
seems likely that equity returns will beat
these over the next 10 years Page 17 Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan
Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
Risk minimising strategies Investors ideally would like equity-style returns with bond-like
volatility Thatrsquos rarely possible But fund managers are developing products that offer different
combinations of risk and return Such strategies include multi-asset funds longshort equity
strategies risk parity products minimum volatility equity funds and using options to target a level of
risk Page 20
The growth of multi-asset The fastest growing type of risk minimising strategy especially in the
UK is the absolute return fund most famously Standard Lifersquos GARS Such funds target Libor-plus
absolute returns with bond-like volatility and costs lower than hedge funds They have their
detractors (do they really create alpha or are they just leveraged bond funds) but look likely to grow
further even in the US where they have yet to take off Page 22
3
Multi Asset Strategy Global September 2012
abc
3 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
The shift to passive A third of active equity
money has shifted into passive funds in the
past 10 years (Chart 3) We think passive
encroachment is likely to continue since
active funds empirically underperform on
average (with higher costs) But indexing
strategies are likely to get smarter some
indexes outperform others for example the
equal-weighted SampP500 has beaten the
regular (market cap weighted) SampP500 by
37 in the past decade Page 24 Source EPFR
4 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
The relentless rise of ETFs ETFs have
reached USD15trn (up from USD105bn in
2001 ndash Chart 4) But there are issues with
these too Are ETFs suitable for bonds
Some overly sophisticated ETFs have blown
up spectacularly will this invite the
regulatorsrsquo attention The two keys for future
growth are (1) whether active ETFs take off
and (2) the trend of retail financial advisors
being remunerated by fees rather than
commissions on the products they sell (ETFs
donrsquot pay a commission) Page 28 Source Blackrock (end-Jun)
5 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
The decline of the hedge fund Hedge funds
have struggled to perform recently (Chart 5)
The average hedge fund is up only 25 so
far this year The underlying problem is that
the hedge fund community has become so big
that it has arbitraged out most of the alpha
Like active equity funds hedge funds in
aggregate cannot by definition outperform
Moreover ldquotraditionalrdquo fund managers are
increasingly converging with large hedge
funds ndash and they donrsquot charge fees of 2 and
20 Page 31
Source Bloomberg EurekaHedge
4
Multi Asset Strategy Global September 2012
abc
6 Illiquidity premium estimate by asset class
0
100
200
300
400
500
Equity Corporate
bonds
Gov ernment
bonds
Cov ered
bondsbp
Harvesting the illiquidity premium Most
investors have a strong preference for
liquidity But some ndash notably pension funds
and insurers ndash donrsquot always need it and may
be overpaying for it Amid the desperate
search for income they may see the attraction
of the extra yield available in illiquid assets
(Chart 6) such as infrastructure real estate
finance and ldquoprivate debtrdquo (structured like
private equity but providing debt financing)
Page 34 Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
7 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Where will the money come from Defined
benefit pensions are dwindling (Chart 7) The
growth areas for investment management
companies in the next few years will be
personal pensions Asian high net worth
individuals and sovereign wealth funds But
each of these will demand more sophisticated
products and solution-based services Page 36
Source OECD
8 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
The challenge of ESG Plan sponsors
particularly public pension funds in Europe
are increasingly focusing on environmental
social and governance issues So far most
fund managers pay only lip-service to this
But momentum is building (Chart 8) and
companies with superior ESG policies and
disclosure might start to outperform After
all who wants to buy a company with poor
corporate governance which pollutes or treats
its staff badly Page 42 Source US SIF Eurosif (definitions differ slightly)
5
Multi Asset Strategy Global September 2012
abc
Implications for asset prices
The search for yield should be positive for credit and for high dividend yield stocks both of which remain
attractive in our view Equities in general may struggle for a few more years as global economic growth
remains low but the basic concept that equities have a risk premium ndash and therefore generate greater
returns in the long run ndash will not disappear If investors become more willing to buy illiquid assets to
boost yield the pricing of long-term loans commercial real estate and infrastructure finance should be
positively affected The development of multi-asset funds should aid the development and liquidity of
more esoteric asset classes and derivatives products We believe the further growth of passive funds and
ETFs will keep inter-market and intra-market correlations high
6
Multi Asset Strategy Global September 2012
abc
Introduction an unusual world 7 Cyclical or evolutionary 7
The search for yield 13 hellipin credit and dividends 13
The death ndash or rebirth ndash of equities 17 Problem is volatility not return 17
Risk-minimising strategies 20 Tailoring risk not return 20
The growth of multi-asset 22 GARS and all its friends 22
The shift to passive 24 Itrsquos hard to beat an index 24
The relentless rise of ETFs 28 Attractive ndash but problems too 28
The decline of the hedge fund 31 Is there any alpha left 31
Harvesting the illiquidity premium 34 Do you really need liquidity 34
Where will the money come from 36 The sources of growth 36
The challenge of ESG 42 Unavoidable momentum 42
Disclosure appendix 46
Disclaimer 48
Contents
7
Multi Asset Strategy Global September 2012
abc
Cyclical or evolutionary We are in a very unusual investment world
Interest rates are at historical lows equities more
volatile than normal different assets classes
abnormally correlated (the ldquorisk on-risk offrdquo
phenomenon) and demographics are altering
savings patterns in rich countries
These developments have already caused a big
shift in investment flows over the past five years
Investors have
Sold equities and bought bonds in huge
volumes in the US since end-2007 bond
mutual funds have seen inflows of USD920bn
and equity funds outflows of USD430bn
Loaded up on risk-free assets But the supply
of these has shrunk (according to the BIS
AAA-rated government paper now totals only
USD12trn compared to USD26trn in early
2011 ndash Chart 1) This has pushed down their
nominal yields to below zero in some cases
Increasingly understood that active equity
fund managers in aggregate underperform
benchmarks (even before fees) and so moved
heavily into index funds and ETFs
Searched for new ways other than equities to
achieve a decent return without too much risk
This has led to the development of absolute
return (or diversified beta) funds and risk-
minimising strategies
1 Credit risk of pool of government debt
0
5
10
15
20
25
30
35
40
01 02 03 04 05 06 07 08 09 10 11
AA to below AA+AA+ to below AAAAAA
Source BIS (Ratings used are the simple averages of the long-term foreign currency sovereign ratings from Fitch Moodyrsquos and SampP)
Is this a permanent structural change or will we
eventually go back to the old normal Probably a
bit of both The side-effects of the 2007-9 Global
Financial Crisis will eventually wear off (though
Introduction an unusual world
Low rates high volatility high correlation ndash the world has changed
Fund managers are struggling to cope how to find returns without
too much risk and provide solutions to investors with new needs
We indentify three threads the search for income tailoring risk
and the continuing shift from active to passive
Garry Evans Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6916 garryevanshsbccomhk
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registered qualified pursuant to FINRA regulations
8
Multi Asset Strategy Global September 2012
abc
this may take a few more years) with interest
rates volatility and correlations returning to their
historical norms
But there has been some evolution too Investorsrsquo
behaviour is likely to have changed permanently
Investors will increasingly question whether
hedge funds can generate alpha and whether
they deserve fees of 2 and 20 even if
they can
Retail investors will demand access to the sort
of absolute return strategies that hedge
funds previously specialised in ndash and at a
reasonable cost
There will be more demand for solutions
whether liability-matched investments for a
defined benefit (DB) pension fund that is
winding down or a ldquoto-and-throughrdquo
personal pension plan for an individual due
to retire in five years who wants to fix
post-retirement income
Interest in buying stocks in companies with a
strong ESG (environmental social and
governance) record will increase This is not
idealistic green talk ndash after all who wants to
own a company with poor corporate
governance or which treats its staff badly
Many of these themes are fairly obvious and have
been under way for a number of years But how
the fund management industry will be affected by
them is not yet at all obvious Like any business
an investment management firm has to pick a
strategy should it rush into all these new areas
(ETFs absolute return funds pension solutions
ESG) or should it decide to focus Is it better to
be a large global investment house or a focused
boutique ndash or hedge onersquos bets by becoming a
multi-boutique umbrella organisation
These trends will affect asset prices too If
investors abandon equities for a generation PE
multiples would contract further as they did in the
1970s or after the Great Depression Further
growth in ETFs and index products could push
correlations up further A rise in demand for
alternative assets (infrastructure financing
distressed debt derivative structures) could shift
the prices of these assets As banks in Europe
deleverage infrastructure lending leasing and
other forms of long-term finance could pass to
institutional investors in a form of
disintermediation which could bring down
borrowing costs
2 Demographic trends of population aged 35-54 in DM 3 Demographic trends of population aged 35-54 in EM
20
22
24
26
28
30
1990 2000 2010 2020 2030 2040 2050
Dev eloped markets
20212223242526272829
1990 2010 2030 2050
Emerging
Source HSBC UN Population Division NB MSCI World markets Source HSBC UN Population Division
9
Multi Asset Strategy Global September 2012
abc
Why this matters
This is a topic that HSBCrsquos strategy team has
tackled before We believe that understanding the
deep underlying trends in investment are
important for asset allocation It is too easy to get
caught up in the day-to-day vicissitudes of the
economic cycle Thinking about long-term
drivers such as demographics changes in wealth
or market micro-dynamics can help improve
investment decision-making
Earlier this year for example we published a
report (Who will buy by Daniel Grosvenor 3
February 2012) which argued that demand for
equities is likely to remain structurally weak due
to prolonged risk aversion regulatory changes and
deteriorating demographics In particular ageing
populations in the developed world (Chart 2) will
tend to own fewer equities This the report
argued could keep DM valuations depressed but
EM should be immune (partly because of its
better demographics ndash Chart 3)
We also described the growing importance of
emerging markets investors in Asia buys Asia by
Herald van der Linde and Devendra Joshi June
2012 Asian equity markets have traditionally been
dominated by foreign investors or speculative local
individuals But this is changing as Asians diversify
their wealth into financial assets and pension
systems develop across the region
Our colleagues in quantitative strategy have also
looked at the risk on-risk off phenomenon (their
latest report is Risk On ndash Risk Off Fixing a
broken investment process by Stacy Williams
Daniel Fenn and Mark McDonald April 2012)
They suggest ways in which fund managers can
adapt their investment process to cope with the
phenomenon and take advantage of it
For this present report we met with CEOs chief
investment officers and senior business managers
at almost 20 investment firms in the US and
Europe These ranged from niche long-only equity
specialists to opportunistic macro hedge funds
from major ETF providers to large global multi-
asset investment managers Naturally most of the
senior managers had a bias based on what they
specialised in equity houses tend to believe that
actively managed equity will come back and
passive specialists argue that in future everything
will be indexed
But our conversations gave us a good idea of the
sort of concerns investment managers have when
they are being candid Bond houses worry about
how to cope with the crash in bond prices that we
believe is inevitable in the future Active
managers worry whether itrsquos too late to enter the
index ETF business ndash or whether they should try
to structure their active funds as ETFs Many
managers are struggling to create innovative
products ndash risk-hedged funds absolute return
strategies pension-friendly structures ndash in a world
where their revenues have stagnated and so RampD
budgets have been cut
The global investment industry today
Before we try to draw out some threads from the
10 trends in investment management we have
identified some background
4 Assets under management (USDtrn end-2010)
Insurance
funds 246
Pension
funds 299
HFs 18
SWFs 42
ETFs 13
Mutual
funds 247
PE 26
Source TheCityUK estimates
How big is the global investment industry
Conventional assets (pension funds mutual funds
10
Multi Asset Strategy Global September 2012
abc
and insurance) total about USD80trn split
roughly evenly between the three (Chart 4) The
AUM of these institutions has doubled since
2000 Hedge funds manage around USD2trn and
private equity funds a little more than that Add to
this sovereign wealth funds which in their pure
form have assets of about USD5trn include FX
reserve managers and other sovereign institutions
(such as national pensions or development funds)
and the total reaches about USD20trn ETFs
comprise another USD15trn or so Private wealth
is harder to figure out various estimates put it at
between USD26trn and USD120trn At the top
end of estimates the total amount of money
available for investment firms to manage exceeds
USD200trn ndash almost 3x global GDP
The US is still the largest source of funds with
USD35trn out of the USD79trn in conventional
assets globally (Chart 5) That is 224 of US GDP
The UK though much smaller in absolute terms at
USD65trn is the biggest in proportion to GDP with
conventional funds representing 257 of GDP
(although some of that comes from money
domiciled in the UK but not from UK nationals)
5 Source of conventional assets by country (USDtrn)
05
10152025303540
US
UK
Japa
n
Fran
ce
Ger
man
y NL
Switz
Oth
er
Pension funds Insurance assets Mutual funds
Source TheCityUK estimates based on OECD Investment Company SwissRe and UBS data (Figures are for domestically sourced funds regardless of where they are managed No reliable comparisons are available for total funds under management buy country)
hellipand the chances of it growing
There is no reason to suppose that the rate of
growth of institutional assets will slow over the
coming years Over the past decade conventional
assets have grown at a compound annual rate of
71 While it is likely in our view that global
economic growth will be lacklustre in coming
years as the after-effects of the Global Financial
Crisis are worked off this does not mean that
global savings will be stagnant Indeed quite the
opposite Households and companies are likely to
increase their savings as they stay risk averse (and
governments are likely to reduce fiscal deficits
albeit slowly)
The IMF projects that US and UK gross national
savings which have already improved modestly
since 2009 (to 129 of GDP from 115 in the
case of the US) will continue to increase over the
next five years with the US reaching 178 by 2017
(Chart 6) China meanwhile is unlikely to reduce its
savings rate much despite efforts to get households
to spend Australia has already made some headway
in raising its savings rate since its bubble in the early
2000s Japan is the only major economy where the
ratio may fall as retirees start to eat into their
savings All this suggests that the savings glut which
drove the fall in interest rates and strong equity
performance in 2003-7 will not disappear
6 Gross national savings rate selected countries ( of GDP)
0
10
20
30
40
50
60
80 85 90 95 00 05 10 15
UK US AU CH JP
F
Source IMF
And at the same time as savings grow companies in
the developed world are unlikely to need to raise
much money for the next few years Corporate cash
holdings are at record highs especially in the US
and companies are being cautious about capex
11
Multi Asset Strategy Global September 2012
abc
Dividend payout ratios are very low (31 in the US
last year for instance) This suggests that large listed
companies at least will not need to raise much
capital either debt or equity for the next few years ndash
although capital-hungry emerging markets
companies of course will
As countries get richer they tend to increase the
amount of institutional assets under management
and increase the amount invested in equities and
bonds (rather than placed in bank deposits) as
shown in Charts 7 and 8
7 Increasing wealth brings growth in institutional assets
0102030405060708090
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in institutional assets
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
8 hellipamid withdrawals from bank deposits
0
10
20
30
40
50
60
70
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in bank deposits
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
This suggests that as long as emerging markets
continue to develop (which in most cases we think
likely) then not only should the pool of potential
savings grow but the proportion of the pool
available for international investment institutions
to manage should grow even faster Not that this
will be without challenges how do London or
New York-based investment managers get access
to wealth held in China or India which is still
highly restricted in where it can invest and mostly
off limits to them
Indeed a well-read report by the McKinsey
Global Institute The emerging equity gap Growth
and stability in the new investors landscape
December 2011 argued that the growth of
international securities ownership by emerging
market investors will be essential if the role of
equities in the global financial system is not to be
reduced in the coming decades In particular
emerging market investors will need to triple their
allocation to equities if companies in these
countries are not to be starved of equity capital
Common threads
In this report we highlight the 10 trends that we
think will drive the investment management industry
over the next few years Understanding these trends
ndash and considering their implications ndash will be
important both for investment institutions in
planning their strategies and for investors interested
in the impact of these trends on asset prices
12
Multi Asset Strategy Global September 2012
abc
Inevitably there are some overlaps between the
10 trends Broadly we see three threads running
between them
The search for income With interest rates so
low investors are desperate to generate
income This has triggered demand for credit
and high dividend yield equities which we
expect to continue It is also forcing investors
to consider whether they are overpaying for
liquidity and to look at harvesting a premium
for investing in illiquid instruments such as
infrastructure and ldquoprivate debtrdquo funds
Tailoring risk Modern derivative techniques
make it possible to tailor risk to an extent
Investors scared of drawdowns can hedge fat-
tail risk Fixing a return is not possible (except
for a very low return) tailoring a level of risk
may be easier This concept has spawned the
development of risk parity funds and a boom in
multi-asset absolute return funds
A continuing shift from active to passive
Academic evidence strongly suggests that
active equity fund managers in aggregate
underperform their benchmarks That has
pushed investors over the past decade from
active to passive funds especially ETFs ndash a
trend we expect to continue It is also forcing
a rethink of the role of hedge funds which
have grown so large that in aggregate they no
longer seem to be able to produce superior
performance either
In the following sections we describe in detail the
10 trends we have identified and analyse their
implications for asset prices
13
Multi Asset Strategy Global September 2012
abc
hellipin credit and dividends With cash yielding zero and top-quality
government bonds little more than 15 it is
unsurprising that investors are scrambling to pick
up yield Indeed one could even say that the
market has become obsessed with income
1 Cumulative net flows to bond funds worldwide by type
-100
-50
0
50
100
150
200
250
300
07 08 09 10 11 12
USD
bn
Gov tCreditOther
Source EPFR (ldquoOtherrdquo includes muni funds MBS funds total return bonds and funds able to invest in a mix of bond types)
Look at flows into bond mutual funds recently It
is well known that these have been very healthy
totalling USD580bn over the past three years
according to EPFR But for the past 12 months at
least bonds flows have been predominantly into
credit funds (for example corporate high yield or
EM bond funds) with even a small net outflow
from government bond funds (Chart 1)
The sort of funds selling well is clear from the list
of the largest fund launches year-to-date The top
20 new US-based funds ranked by assets under
management now (Table 2 overleaf) include 10
bond funds two asset allocation funds and only
eight with an equity focus (remember this is for
the heavily equity-centric US market) Three of
the best-selling funds include the word ldquoincomerdquo
in their names
Credit is in a sweet spot Interest rates at which
corporates can issue are at historic lows But at
the same time spreads over US Treasuries are
quite high making the bonds attractive for
investors too
In the US for example BBB-rated five-year
corporate bonds currently yield only about 28 ndash
the lowest for decades ndash but that represents a spread
over Treasuries of around 200bp well above the
average of 130bp from the 2003-7 period (Chart 3)
The same is true in emerging markets The HSBC
Asian Dollar Bond Index (Chart 4) currently has a
record low yield of 37 but the spread over
Treasuries is a still attractive 300bp
This is why lots of bonds have been issued this
year August for example with over USD120bn
of issuance according to Dealogic was the highest
August on record and more than double the
USD58bn average for August Sub investment
The search for yield
With risk-free rates so low investors are desperate for income
Credit is in a sweet spot with issuers enjoying record low
borrowing costs but investors finding decent spreads
We think dividend yield stocks remain attractive too
14
Multi Asset Strategy Global September 2012
abc
grade issuance in August totalled USD27bn up
from USD13bn the same month in 2011
3 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
Source Bloomberg
Investors are clearly now having to take more risk
to get yield Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield One
example is bonds from riskier emerging markets
Ten-year paper from the Philippines a BB-rated
issuer now yields only 25 Investors have been
buying bonds from countries such as Gabon
Belarus Nigeria and Vietnam But five-year
bonds even from Gabon (BB-rated) now yield
only 38 You have to stretch to Belarus (B-) to
get a decent yield just over 10
4 HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source HSBC
This could all go very wrong Credit spreads are
supposed to compensate investors for the
probability of default At the investment grade
part of the credit spectrum defaults are rare but at
the sub-investment grade end they are less so At
present the combination of low rates on high
quality government bonds and relatively wider
credit spreads combined with very low default
rates places credit in a sweet spot compared to
some other assets classes However in an
2 Largest mutual funds launched in the US this year
Ticker Name Manager Inception date
Asset class Objective AUM (USDbn)
TGIRX US Intl Value Fund Thornburg 512012 Equity International Equity 265 OIBIX US Intl Bond Fund Oppenheimer 1272012 Debt International Debt 126 WAPRX US Core Plus Fund Western Asset 512012 Debt GovtCorp Intermediate 96 OSIIX US Global Strategic Income Fund Oppenheimer 1272012 Debt GovernmentCorporate 86 OGLIX US Global Fund Oppenheimer 1272012 Equity Global Equity 83 PSTQX US Short Term Corp Bond Fnd Pridential 322012 Debt CorporatePreferred-Inv Grade 80 AEMSX US Emerging Markets Fund Aberdeen 2272012 Equity Emerging Market-Equity 75 OIGIX US Intl Growth Fund Oppenheimer 4272012 Equity International Equity 62 MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6152012 Equity Growth-Mid Cap 60 MSFKX US Total Return Fund MFS 612012 Asset Allocation Balanced 58 PEFAX US EM Fundamental IndexPLUS Pimco 5312012 Debt Index Fund-Debt 54 CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund Columbia 4202012 Debt GovernmentCorporate 47
OBBCX US Mortgage Backed Securities Fund JP Morgan 722012 Debt Asset Backed Securities 41 JQLAX US Life Aggressive Fund John Hancock 312012 Asset Allocation Flexible Portfolio 37 OEIIX US Equity Income Fund Oppenheimer 4272012 Equity Value-Large Cap 33 MIDLX US Intl New Discovery Fund MFS 612012 Equity International Equity 32 JIPPX US Strategic Income Opportunities Fund John Hancock 312012 Debt Global Debt 31 WABRX US Core Bond Fund Western Asset 512012 Debt GovtCorp Intermediate 30 MFBKX US Bond Fund MFS 612012 Debt GovernmentCorporate 28 JDVPX US Disciplined Value Fund John Hancock 2292012 Equity Value-Large Cap 28
Source Bloomberg
15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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2
Multi Asset Strategy Global September 2012
abc
Our 10 trends are
1 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
The search for yield With risk-free rates so
low investors are desperate for income They
have already piled into bonds Credit remains
in a sweet spot though issuers are attracted
by the low interest rates but for investors
spreads over government bonds remain
decent (Chart 1) We think dividend yield
stocks remain attractive too Many investors
argue itrsquos too late to buy them but in the US
in particular income funds still comprise only
3 of equity mutual funds Page 13 Source Bloomberg
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
The death ndash or rebirth ndash of equities Bill
Gross of Pimco says the cult of equity is
dead But equities have actually outperformed
bonds over the past 10 years although
admittedly with high volatility (Chart 2)
Perhaps a bigger risk ndash which bond houses
are worrying about ndash is the bursting of the
bond bubble could 2014 be another 1994 At
the very least with cash yielding zero and
high-quality government bonds 15 it
seems likely that equity returns will beat
these over the next 10 years Page 17 Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan
Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
Risk minimising strategies Investors ideally would like equity-style returns with bond-like
volatility Thatrsquos rarely possible But fund managers are developing products that offer different
combinations of risk and return Such strategies include multi-asset funds longshort equity
strategies risk parity products minimum volatility equity funds and using options to target a level of
risk Page 20
The growth of multi-asset The fastest growing type of risk minimising strategy especially in the
UK is the absolute return fund most famously Standard Lifersquos GARS Such funds target Libor-plus
absolute returns with bond-like volatility and costs lower than hedge funds They have their
detractors (do they really create alpha or are they just leveraged bond funds) but look likely to grow
further even in the US where they have yet to take off Page 22
3
Multi Asset Strategy Global September 2012
abc
3 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
The shift to passive A third of active equity
money has shifted into passive funds in the
past 10 years (Chart 3) We think passive
encroachment is likely to continue since
active funds empirically underperform on
average (with higher costs) But indexing
strategies are likely to get smarter some
indexes outperform others for example the
equal-weighted SampP500 has beaten the
regular (market cap weighted) SampP500 by
37 in the past decade Page 24 Source EPFR
4 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
The relentless rise of ETFs ETFs have
reached USD15trn (up from USD105bn in
2001 ndash Chart 4) But there are issues with
these too Are ETFs suitable for bonds
Some overly sophisticated ETFs have blown
up spectacularly will this invite the
regulatorsrsquo attention The two keys for future
growth are (1) whether active ETFs take off
and (2) the trend of retail financial advisors
being remunerated by fees rather than
commissions on the products they sell (ETFs
donrsquot pay a commission) Page 28 Source Blackrock (end-Jun)
5 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
The decline of the hedge fund Hedge funds
have struggled to perform recently (Chart 5)
The average hedge fund is up only 25 so
far this year The underlying problem is that
the hedge fund community has become so big
that it has arbitraged out most of the alpha
Like active equity funds hedge funds in
aggregate cannot by definition outperform
Moreover ldquotraditionalrdquo fund managers are
increasingly converging with large hedge
funds ndash and they donrsquot charge fees of 2 and
20 Page 31
Source Bloomberg EurekaHedge
4
Multi Asset Strategy Global September 2012
abc
6 Illiquidity premium estimate by asset class
0
100
200
300
400
500
Equity Corporate
bonds
Gov ernment
bonds
Cov ered
bondsbp
Harvesting the illiquidity premium Most
investors have a strong preference for
liquidity But some ndash notably pension funds
and insurers ndash donrsquot always need it and may
be overpaying for it Amid the desperate
search for income they may see the attraction
of the extra yield available in illiquid assets
(Chart 6) such as infrastructure real estate
finance and ldquoprivate debtrdquo (structured like
private equity but providing debt financing)
Page 34 Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
7 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Where will the money come from Defined
benefit pensions are dwindling (Chart 7) The
growth areas for investment management
companies in the next few years will be
personal pensions Asian high net worth
individuals and sovereign wealth funds But
each of these will demand more sophisticated
products and solution-based services Page 36
Source OECD
8 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
The challenge of ESG Plan sponsors
particularly public pension funds in Europe
are increasingly focusing on environmental
social and governance issues So far most
fund managers pay only lip-service to this
But momentum is building (Chart 8) and
companies with superior ESG policies and
disclosure might start to outperform After
all who wants to buy a company with poor
corporate governance which pollutes or treats
its staff badly Page 42 Source US SIF Eurosif (definitions differ slightly)
5
Multi Asset Strategy Global September 2012
abc
Implications for asset prices
The search for yield should be positive for credit and for high dividend yield stocks both of which remain
attractive in our view Equities in general may struggle for a few more years as global economic growth
remains low but the basic concept that equities have a risk premium ndash and therefore generate greater
returns in the long run ndash will not disappear If investors become more willing to buy illiquid assets to
boost yield the pricing of long-term loans commercial real estate and infrastructure finance should be
positively affected The development of multi-asset funds should aid the development and liquidity of
more esoteric asset classes and derivatives products We believe the further growth of passive funds and
ETFs will keep inter-market and intra-market correlations high
6
Multi Asset Strategy Global September 2012
abc
Introduction an unusual world 7 Cyclical or evolutionary 7
The search for yield 13 hellipin credit and dividends 13
The death ndash or rebirth ndash of equities 17 Problem is volatility not return 17
Risk-minimising strategies 20 Tailoring risk not return 20
The growth of multi-asset 22 GARS and all its friends 22
The shift to passive 24 Itrsquos hard to beat an index 24
The relentless rise of ETFs 28 Attractive ndash but problems too 28
The decline of the hedge fund 31 Is there any alpha left 31
Harvesting the illiquidity premium 34 Do you really need liquidity 34
Where will the money come from 36 The sources of growth 36
The challenge of ESG 42 Unavoidable momentum 42
Disclosure appendix 46
Disclaimer 48
Contents
7
Multi Asset Strategy Global September 2012
abc
Cyclical or evolutionary We are in a very unusual investment world
Interest rates are at historical lows equities more
volatile than normal different assets classes
abnormally correlated (the ldquorisk on-risk offrdquo
phenomenon) and demographics are altering
savings patterns in rich countries
These developments have already caused a big
shift in investment flows over the past five years
Investors have
Sold equities and bought bonds in huge
volumes in the US since end-2007 bond
mutual funds have seen inflows of USD920bn
and equity funds outflows of USD430bn
Loaded up on risk-free assets But the supply
of these has shrunk (according to the BIS
AAA-rated government paper now totals only
USD12trn compared to USD26trn in early
2011 ndash Chart 1) This has pushed down their
nominal yields to below zero in some cases
Increasingly understood that active equity
fund managers in aggregate underperform
benchmarks (even before fees) and so moved
heavily into index funds and ETFs
Searched for new ways other than equities to
achieve a decent return without too much risk
This has led to the development of absolute
return (or diversified beta) funds and risk-
minimising strategies
1 Credit risk of pool of government debt
0
5
10
15
20
25
30
35
40
01 02 03 04 05 06 07 08 09 10 11
AA to below AA+AA+ to below AAAAAA
Source BIS (Ratings used are the simple averages of the long-term foreign currency sovereign ratings from Fitch Moodyrsquos and SampP)
Is this a permanent structural change or will we
eventually go back to the old normal Probably a
bit of both The side-effects of the 2007-9 Global
Financial Crisis will eventually wear off (though
Introduction an unusual world
Low rates high volatility high correlation ndash the world has changed
Fund managers are struggling to cope how to find returns without
too much risk and provide solutions to investors with new needs
We indentify three threads the search for income tailoring risk
and the continuing shift from active to passive
Garry Evans Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6916 garryevanshsbccomhk
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registered qualified pursuant to FINRA regulations
8
Multi Asset Strategy Global September 2012
abc
this may take a few more years) with interest
rates volatility and correlations returning to their
historical norms
But there has been some evolution too Investorsrsquo
behaviour is likely to have changed permanently
Investors will increasingly question whether
hedge funds can generate alpha and whether
they deserve fees of 2 and 20 even if
they can
Retail investors will demand access to the sort
of absolute return strategies that hedge
funds previously specialised in ndash and at a
reasonable cost
There will be more demand for solutions
whether liability-matched investments for a
defined benefit (DB) pension fund that is
winding down or a ldquoto-and-throughrdquo
personal pension plan for an individual due
to retire in five years who wants to fix
post-retirement income
Interest in buying stocks in companies with a
strong ESG (environmental social and
governance) record will increase This is not
idealistic green talk ndash after all who wants to
own a company with poor corporate
governance or which treats its staff badly
Many of these themes are fairly obvious and have
been under way for a number of years But how
the fund management industry will be affected by
them is not yet at all obvious Like any business
an investment management firm has to pick a
strategy should it rush into all these new areas
(ETFs absolute return funds pension solutions
ESG) or should it decide to focus Is it better to
be a large global investment house or a focused
boutique ndash or hedge onersquos bets by becoming a
multi-boutique umbrella organisation
These trends will affect asset prices too If
investors abandon equities for a generation PE
multiples would contract further as they did in the
1970s or after the Great Depression Further
growth in ETFs and index products could push
correlations up further A rise in demand for
alternative assets (infrastructure financing
distressed debt derivative structures) could shift
the prices of these assets As banks in Europe
deleverage infrastructure lending leasing and
other forms of long-term finance could pass to
institutional investors in a form of
disintermediation which could bring down
borrowing costs
2 Demographic trends of population aged 35-54 in DM 3 Demographic trends of population aged 35-54 in EM
20
22
24
26
28
30
1990 2000 2010 2020 2030 2040 2050
Dev eloped markets
20212223242526272829
1990 2010 2030 2050
Emerging
Source HSBC UN Population Division NB MSCI World markets Source HSBC UN Population Division
9
Multi Asset Strategy Global September 2012
abc
Why this matters
This is a topic that HSBCrsquos strategy team has
tackled before We believe that understanding the
deep underlying trends in investment are
important for asset allocation It is too easy to get
caught up in the day-to-day vicissitudes of the
economic cycle Thinking about long-term
drivers such as demographics changes in wealth
or market micro-dynamics can help improve
investment decision-making
Earlier this year for example we published a
report (Who will buy by Daniel Grosvenor 3
February 2012) which argued that demand for
equities is likely to remain structurally weak due
to prolonged risk aversion regulatory changes and
deteriorating demographics In particular ageing
populations in the developed world (Chart 2) will
tend to own fewer equities This the report
argued could keep DM valuations depressed but
EM should be immune (partly because of its
better demographics ndash Chart 3)
We also described the growing importance of
emerging markets investors in Asia buys Asia by
Herald van der Linde and Devendra Joshi June
2012 Asian equity markets have traditionally been
dominated by foreign investors or speculative local
individuals But this is changing as Asians diversify
their wealth into financial assets and pension
systems develop across the region
Our colleagues in quantitative strategy have also
looked at the risk on-risk off phenomenon (their
latest report is Risk On ndash Risk Off Fixing a
broken investment process by Stacy Williams
Daniel Fenn and Mark McDonald April 2012)
They suggest ways in which fund managers can
adapt their investment process to cope with the
phenomenon and take advantage of it
For this present report we met with CEOs chief
investment officers and senior business managers
at almost 20 investment firms in the US and
Europe These ranged from niche long-only equity
specialists to opportunistic macro hedge funds
from major ETF providers to large global multi-
asset investment managers Naturally most of the
senior managers had a bias based on what they
specialised in equity houses tend to believe that
actively managed equity will come back and
passive specialists argue that in future everything
will be indexed
But our conversations gave us a good idea of the
sort of concerns investment managers have when
they are being candid Bond houses worry about
how to cope with the crash in bond prices that we
believe is inevitable in the future Active
managers worry whether itrsquos too late to enter the
index ETF business ndash or whether they should try
to structure their active funds as ETFs Many
managers are struggling to create innovative
products ndash risk-hedged funds absolute return
strategies pension-friendly structures ndash in a world
where their revenues have stagnated and so RampD
budgets have been cut
The global investment industry today
Before we try to draw out some threads from the
10 trends in investment management we have
identified some background
4 Assets under management (USDtrn end-2010)
Insurance
funds 246
Pension
funds 299
HFs 18
SWFs 42
ETFs 13
Mutual
funds 247
PE 26
Source TheCityUK estimates
How big is the global investment industry
Conventional assets (pension funds mutual funds
10
Multi Asset Strategy Global September 2012
abc
and insurance) total about USD80trn split
roughly evenly between the three (Chart 4) The
AUM of these institutions has doubled since
2000 Hedge funds manage around USD2trn and
private equity funds a little more than that Add to
this sovereign wealth funds which in their pure
form have assets of about USD5trn include FX
reserve managers and other sovereign institutions
(such as national pensions or development funds)
and the total reaches about USD20trn ETFs
comprise another USD15trn or so Private wealth
is harder to figure out various estimates put it at
between USD26trn and USD120trn At the top
end of estimates the total amount of money
available for investment firms to manage exceeds
USD200trn ndash almost 3x global GDP
The US is still the largest source of funds with
USD35trn out of the USD79trn in conventional
assets globally (Chart 5) That is 224 of US GDP
The UK though much smaller in absolute terms at
USD65trn is the biggest in proportion to GDP with
conventional funds representing 257 of GDP
(although some of that comes from money
domiciled in the UK but not from UK nationals)
5 Source of conventional assets by country (USDtrn)
05
10152025303540
US
UK
Japa
n
Fran
ce
Ger
man
y NL
Switz
Oth
er
Pension funds Insurance assets Mutual funds
Source TheCityUK estimates based on OECD Investment Company SwissRe and UBS data (Figures are for domestically sourced funds regardless of where they are managed No reliable comparisons are available for total funds under management buy country)
hellipand the chances of it growing
There is no reason to suppose that the rate of
growth of institutional assets will slow over the
coming years Over the past decade conventional
assets have grown at a compound annual rate of
71 While it is likely in our view that global
economic growth will be lacklustre in coming
years as the after-effects of the Global Financial
Crisis are worked off this does not mean that
global savings will be stagnant Indeed quite the
opposite Households and companies are likely to
increase their savings as they stay risk averse (and
governments are likely to reduce fiscal deficits
albeit slowly)
The IMF projects that US and UK gross national
savings which have already improved modestly
since 2009 (to 129 of GDP from 115 in the
case of the US) will continue to increase over the
next five years with the US reaching 178 by 2017
(Chart 6) China meanwhile is unlikely to reduce its
savings rate much despite efforts to get households
to spend Australia has already made some headway
in raising its savings rate since its bubble in the early
2000s Japan is the only major economy where the
ratio may fall as retirees start to eat into their
savings All this suggests that the savings glut which
drove the fall in interest rates and strong equity
performance in 2003-7 will not disappear
6 Gross national savings rate selected countries ( of GDP)
0
10
20
30
40
50
60
80 85 90 95 00 05 10 15
UK US AU CH JP
F
Source IMF
And at the same time as savings grow companies in
the developed world are unlikely to need to raise
much money for the next few years Corporate cash
holdings are at record highs especially in the US
and companies are being cautious about capex
11
Multi Asset Strategy Global September 2012
abc
Dividend payout ratios are very low (31 in the US
last year for instance) This suggests that large listed
companies at least will not need to raise much
capital either debt or equity for the next few years ndash
although capital-hungry emerging markets
companies of course will
As countries get richer they tend to increase the
amount of institutional assets under management
and increase the amount invested in equities and
bonds (rather than placed in bank deposits) as
shown in Charts 7 and 8
7 Increasing wealth brings growth in institutional assets
0102030405060708090
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in institutional assets
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
8 hellipamid withdrawals from bank deposits
0
10
20
30
40
50
60
70
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in bank deposits
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
This suggests that as long as emerging markets
continue to develop (which in most cases we think
likely) then not only should the pool of potential
savings grow but the proportion of the pool
available for international investment institutions
to manage should grow even faster Not that this
will be without challenges how do London or
New York-based investment managers get access
to wealth held in China or India which is still
highly restricted in where it can invest and mostly
off limits to them
Indeed a well-read report by the McKinsey
Global Institute The emerging equity gap Growth
and stability in the new investors landscape
December 2011 argued that the growth of
international securities ownership by emerging
market investors will be essential if the role of
equities in the global financial system is not to be
reduced in the coming decades In particular
emerging market investors will need to triple their
allocation to equities if companies in these
countries are not to be starved of equity capital
Common threads
In this report we highlight the 10 trends that we
think will drive the investment management industry
over the next few years Understanding these trends
ndash and considering their implications ndash will be
important both for investment institutions in
planning their strategies and for investors interested
in the impact of these trends on asset prices
12
Multi Asset Strategy Global September 2012
abc
Inevitably there are some overlaps between the
10 trends Broadly we see three threads running
between them
The search for income With interest rates so
low investors are desperate to generate
income This has triggered demand for credit
and high dividend yield equities which we
expect to continue It is also forcing investors
to consider whether they are overpaying for
liquidity and to look at harvesting a premium
for investing in illiquid instruments such as
infrastructure and ldquoprivate debtrdquo funds
Tailoring risk Modern derivative techniques
make it possible to tailor risk to an extent
Investors scared of drawdowns can hedge fat-
tail risk Fixing a return is not possible (except
for a very low return) tailoring a level of risk
may be easier This concept has spawned the
development of risk parity funds and a boom in
multi-asset absolute return funds
A continuing shift from active to passive
Academic evidence strongly suggests that
active equity fund managers in aggregate
underperform their benchmarks That has
pushed investors over the past decade from
active to passive funds especially ETFs ndash a
trend we expect to continue It is also forcing
a rethink of the role of hedge funds which
have grown so large that in aggregate they no
longer seem to be able to produce superior
performance either
In the following sections we describe in detail the
10 trends we have identified and analyse their
implications for asset prices
13
Multi Asset Strategy Global September 2012
abc
hellipin credit and dividends With cash yielding zero and top-quality
government bonds little more than 15 it is
unsurprising that investors are scrambling to pick
up yield Indeed one could even say that the
market has become obsessed with income
1 Cumulative net flows to bond funds worldwide by type
-100
-50
0
50
100
150
200
250
300
07 08 09 10 11 12
USD
bn
Gov tCreditOther
Source EPFR (ldquoOtherrdquo includes muni funds MBS funds total return bonds and funds able to invest in a mix of bond types)
Look at flows into bond mutual funds recently It
is well known that these have been very healthy
totalling USD580bn over the past three years
according to EPFR But for the past 12 months at
least bonds flows have been predominantly into
credit funds (for example corporate high yield or
EM bond funds) with even a small net outflow
from government bond funds (Chart 1)
The sort of funds selling well is clear from the list
of the largest fund launches year-to-date The top
20 new US-based funds ranked by assets under
management now (Table 2 overleaf) include 10
bond funds two asset allocation funds and only
eight with an equity focus (remember this is for
the heavily equity-centric US market) Three of
the best-selling funds include the word ldquoincomerdquo
in their names
Credit is in a sweet spot Interest rates at which
corporates can issue are at historic lows But at
the same time spreads over US Treasuries are
quite high making the bonds attractive for
investors too
In the US for example BBB-rated five-year
corporate bonds currently yield only about 28 ndash
the lowest for decades ndash but that represents a spread
over Treasuries of around 200bp well above the
average of 130bp from the 2003-7 period (Chart 3)
The same is true in emerging markets The HSBC
Asian Dollar Bond Index (Chart 4) currently has a
record low yield of 37 but the spread over
Treasuries is a still attractive 300bp
This is why lots of bonds have been issued this
year August for example with over USD120bn
of issuance according to Dealogic was the highest
August on record and more than double the
USD58bn average for August Sub investment
The search for yield
With risk-free rates so low investors are desperate for income
Credit is in a sweet spot with issuers enjoying record low
borrowing costs but investors finding decent spreads
We think dividend yield stocks remain attractive too
14
Multi Asset Strategy Global September 2012
abc
grade issuance in August totalled USD27bn up
from USD13bn the same month in 2011
3 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
Source Bloomberg
Investors are clearly now having to take more risk
to get yield Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield One
example is bonds from riskier emerging markets
Ten-year paper from the Philippines a BB-rated
issuer now yields only 25 Investors have been
buying bonds from countries such as Gabon
Belarus Nigeria and Vietnam But five-year
bonds even from Gabon (BB-rated) now yield
only 38 You have to stretch to Belarus (B-) to
get a decent yield just over 10
4 HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source HSBC
This could all go very wrong Credit spreads are
supposed to compensate investors for the
probability of default At the investment grade
part of the credit spectrum defaults are rare but at
the sub-investment grade end they are less so At
present the combination of low rates on high
quality government bonds and relatively wider
credit spreads combined with very low default
rates places credit in a sweet spot compared to
some other assets classes However in an
2 Largest mutual funds launched in the US this year
Ticker Name Manager Inception date
Asset class Objective AUM (USDbn)
TGIRX US Intl Value Fund Thornburg 512012 Equity International Equity 265 OIBIX US Intl Bond Fund Oppenheimer 1272012 Debt International Debt 126 WAPRX US Core Plus Fund Western Asset 512012 Debt GovtCorp Intermediate 96 OSIIX US Global Strategic Income Fund Oppenheimer 1272012 Debt GovernmentCorporate 86 OGLIX US Global Fund Oppenheimer 1272012 Equity Global Equity 83 PSTQX US Short Term Corp Bond Fnd Pridential 322012 Debt CorporatePreferred-Inv Grade 80 AEMSX US Emerging Markets Fund Aberdeen 2272012 Equity Emerging Market-Equity 75 OIGIX US Intl Growth Fund Oppenheimer 4272012 Equity International Equity 62 MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6152012 Equity Growth-Mid Cap 60 MSFKX US Total Return Fund MFS 612012 Asset Allocation Balanced 58 PEFAX US EM Fundamental IndexPLUS Pimco 5312012 Debt Index Fund-Debt 54 CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund Columbia 4202012 Debt GovernmentCorporate 47
OBBCX US Mortgage Backed Securities Fund JP Morgan 722012 Debt Asset Backed Securities 41 JQLAX US Life Aggressive Fund John Hancock 312012 Asset Allocation Flexible Portfolio 37 OEIIX US Equity Income Fund Oppenheimer 4272012 Equity Value-Large Cap 33 MIDLX US Intl New Discovery Fund MFS 612012 Equity International Equity 32 JIPPX US Strategic Income Opportunities Fund John Hancock 312012 Debt Global Debt 31 WABRX US Core Bond Fund Western Asset 512012 Debt GovtCorp Intermediate 30 MFBKX US Bond Fund MFS 612012 Debt GovernmentCorporate 28 JDVPX US Disciplined Value Fund John Hancock 2292012 Equity Value-Large Cap 28
Source Bloomberg
15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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ESP 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FRA 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3
Multi Asset Strategy Global September 2012
abc
3 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
The shift to passive A third of active equity
money has shifted into passive funds in the
past 10 years (Chart 3) We think passive
encroachment is likely to continue since
active funds empirically underperform on
average (with higher costs) But indexing
strategies are likely to get smarter some
indexes outperform others for example the
equal-weighted SampP500 has beaten the
regular (market cap weighted) SampP500 by
37 in the past decade Page 24 Source EPFR
4 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
The relentless rise of ETFs ETFs have
reached USD15trn (up from USD105bn in
2001 ndash Chart 4) But there are issues with
these too Are ETFs suitable for bonds
Some overly sophisticated ETFs have blown
up spectacularly will this invite the
regulatorsrsquo attention The two keys for future
growth are (1) whether active ETFs take off
and (2) the trend of retail financial advisors
being remunerated by fees rather than
commissions on the products they sell (ETFs
donrsquot pay a commission) Page 28 Source Blackrock (end-Jun)
5 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
The decline of the hedge fund Hedge funds
have struggled to perform recently (Chart 5)
The average hedge fund is up only 25 so
far this year The underlying problem is that
the hedge fund community has become so big
that it has arbitraged out most of the alpha
Like active equity funds hedge funds in
aggregate cannot by definition outperform
Moreover ldquotraditionalrdquo fund managers are
increasingly converging with large hedge
funds ndash and they donrsquot charge fees of 2 and
20 Page 31
Source Bloomberg EurekaHedge
4
Multi Asset Strategy Global September 2012
abc
6 Illiquidity premium estimate by asset class
0
100
200
300
400
500
Equity Corporate
bonds
Gov ernment
bonds
Cov ered
bondsbp
Harvesting the illiquidity premium Most
investors have a strong preference for
liquidity But some ndash notably pension funds
and insurers ndash donrsquot always need it and may
be overpaying for it Amid the desperate
search for income they may see the attraction
of the extra yield available in illiquid assets
(Chart 6) such as infrastructure real estate
finance and ldquoprivate debtrdquo (structured like
private equity but providing debt financing)
Page 34 Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
7 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Where will the money come from Defined
benefit pensions are dwindling (Chart 7) The
growth areas for investment management
companies in the next few years will be
personal pensions Asian high net worth
individuals and sovereign wealth funds But
each of these will demand more sophisticated
products and solution-based services Page 36
Source OECD
8 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
The challenge of ESG Plan sponsors
particularly public pension funds in Europe
are increasingly focusing on environmental
social and governance issues So far most
fund managers pay only lip-service to this
But momentum is building (Chart 8) and
companies with superior ESG policies and
disclosure might start to outperform After
all who wants to buy a company with poor
corporate governance which pollutes or treats
its staff badly Page 42 Source US SIF Eurosif (definitions differ slightly)
5
Multi Asset Strategy Global September 2012
abc
Implications for asset prices
The search for yield should be positive for credit and for high dividend yield stocks both of which remain
attractive in our view Equities in general may struggle for a few more years as global economic growth
remains low but the basic concept that equities have a risk premium ndash and therefore generate greater
returns in the long run ndash will not disappear If investors become more willing to buy illiquid assets to
boost yield the pricing of long-term loans commercial real estate and infrastructure finance should be
positively affected The development of multi-asset funds should aid the development and liquidity of
more esoteric asset classes and derivatives products We believe the further growth of passive funds and
ETFs will keep inter-market and intra-market correlations high
6
Multi Asset Strategy Global September 2012
abc
Introduction an unusual world 7 Cyclical or evolutionary 7
The search for yield 13 hellipin credit and dividends 13
The death ndash or rebirth ndash of equities 17 Problem is volatility not return 17
Risk-minimising strategies 20 Tailoring risk not return 20
The growth of multi-asset 22 GARS and all its friends 22
The shift to passive 24 Itrsquos hard to beat an index 24
The relentless rise of ETFs 28 Attractive ndash but problems too 28
The decline of the hedge fund 31 Is there any alpha left 31
Harvesting the illiquidity premium 34 Do you really need liquidity 34
Where will the money come from 36 The sources of growth 36
The challenge of ESG 42 Unavoidable momentum 42
Disclosure appendix 46
Disclaimer 48
Contents
7
Multi Asset Strategy Global September 2012
abc
Cyclical or evolutionary We are in a very unusual investment world
Interest rates are at historical lows equities more
volatile than normal different assets classes
abnormally correlated (the ldquorisk on-risk offrdquo
phenomenon) and demographics are altering
savings patterns in rich countries
These developments have already caused a big
shift in investment flows over the past five years
Investors have
Sold equities and bought bonds in huge
volumes in the US since end-2007 bond
mutual funds have seen inflows of USD920bn
and equity funds outflows of USD430bn
Loaded up on risk-free assets But the supply
of these has shrunk (according to the BIS
AAA-rated government paper now totals only
USD12trn compared to USD26trn in early
2011 ndash Chart 1) This has pushed down their
nominal yields to below zero in some cases
Increasingly understood that active equity
fund managers in aggregate underperform
benchmarks (even before fees) and so moved
heavily into index funds and ETFs
Searched for new ways other than equities to
achieve a decent return without too much risk
This has led to the development of absolute
return (or diversified beta) funds and risk-
minimising strategies
1 Credit risk of pool of government debt
0
5
10
15
20
25
30
35
40
01 02 03 04 05 06 07 08 09 10 11
AA to below AA+AA+ to below AAAAAA
Source BIS (Ratings used are the simple averages of the long-term foreign currency sovereign ratings from Fitch Moodyrsquos and SampP)
Is this a permanent structural change or will we
eventually go back to the old normal Probably a
bit of both The side-effects of the 2007-9 Global
Financial Crisis will eventually wear off (though
Introduction an unusual world
Low rates high volatility high correlation ndash the world has changed
Fund managers are struggling to cope how to find returns without
too much risk and provide solutions to investors with new needs
We indentify three threads the search for income tailoring risk
and the continuing shift from active to passive
Garry Evans Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6916 garryevanshsbccomhk
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registered qualified pursuant to FINRA regulations
8
Multi Asset Strategy Global September 2012
abc
this may take a few more years) with interest
rates volatility and correlations returning to their
historical norms
But there has been some evolution too Investorsrsquo
behaviour is likely to have changed permanently
Investors will increasingly question whether
hedge funds can generate alpha and whether
they deserve fees of 2 and 20 even if
they can
Retail investors will demand access to the sort
of absolute return strategies that hedge
funds previously specialised in ndash and at a
reasonable cost
There will be more demand for solutions
whether liability-matched investments for a
defined benefit (DB) pension fund that is
winding down or a ldquoto-and-throughrdquo
personal pension plan for an individual due
to retire in five years who wants to fix
post-retirement income
Interest in buying stocks in companies with a
strong ESG (environmental social and
governance) record will increase This is not
idealistic green talk ndash after all who wants to
own a company with poor corporate
governance or which treats its staff badly
Many of these themes are fairly obvious and have
been under way for a number of years But how
the fund management industry will be affected by
them is not yet at all obvious Like any business
an investment management firm has to pick a
strategy should it rush into all these new areas
(ETFs absolute return funds pension solutions
ESG) or should it decide to focus Is it better to
be a large global investment house or a focused
boutique ndash or hedge onersquos bets by becoming a
multi-boutique umbrella organisation
These trends will affect asset prices too If
investors abandon equities for a generation PE
multiples would contract further as they did in the
1970s or after the Great Depression Further
growth in ETFs and index products could push
correlations up further A rise in demand for
alternative assets (infrastructure financing
distressed debt derivative structures) could shift
the prices of these assets As banks in Europe
deleverage infrastructure lending leasing and
other forms of long-term finance could pass to
institutional investors in a form of
disintermediation which could bring down
borrowing costs
2 Demographic trends of population aged 35-54 in DM 3 Demographic trends of population aged 35-54 in EM
20
22
24
26
28
30
1990 2000 2010 2020 2030 2040 2050
Dev eloped markets
20212223242526272829
1990 2010 2030 2050
Emerging
Source HSBC UN Population Division NB MSCI World markets Source HSBC UN Population Division
9
Multi Asset Strategy Global September 2012
abc
Why this matters
This is a topic that HSBCrsquos strategy team has
tackled before We believe that understanding the
deep underlying trends in investment are
important for asset allocation It is too easy to get
caught up in the day-to-day vicissitudes of the
economic cycle Thinking about long-term
drivers such as demographics changes in wealth
or market micro-dynamics can help improve
investment decision-making
Earlier this year for example we published a
report (Who will buy by Daniel Grosvenor 3
February 2012) which argued that demand for
equities is likely to remain structurally weak due
to prolonged risk aversion regulatory changes and
deteriorating demographics In particular ageing
populations in the developed world (Chart 2) will
tend to own fewer equities This the report
argued could keep DM valuations depressed but
EM should be immune (partly because of its
better demographics ndash Chart 3)
We also described the growing importance of
emerging markets investors in Asia buys Asia by
Herald van der Linde and Devendra Joshi June
2012 Asian equity markets have traditionally been
dominated by foreign investors or speculative local
individuals But this is changing as Asians diversify
their wealth into financial assets and pension
systems develop across the region
Our colleagues in quantitative strategy have also
looked at the risk on-risk off phenomenon (their
latest report is Risk On ndash Risk Off Fixing a
broken investment process by Stacy Williams
Daniel Fenn and Mark McDonald April 2012)
They suggest ways in which fund managers can
adapt their investment process to cope with the
phenomenon and take advantage of it
For this present report we met with CEOs chief
investment officers and senior business managers
at almost 20 investment firms in the US and
Europe These ranged from niche long-only equity
specialists to opportunistic macro hedge funds
from major ETF providers to large global multi-
asset investment managers Naturally most of the
senior managers had a bias based on what they
specialised in equity houses tend to believe that
actively managed equity will come back and
passive specialists argue that in future everything
will be indexed
But our conversations gave us a good idea of the
sort of concerns investment managers have when
they are being candid Bond houses worry about
how to cope with the crash in bond prices that we
believe is inevitable in the future Active
managers worry whether itrsquos too late to enter the
index ETF business ndash or whether they should try
to structure their active funds as ETFs Many
managers are struggling to create innovative
products ndash risk-hedged funds absolute return
strategies pension-friendly structures ndash in a world
where their revenues have stagnated and so RampD
budgets have been cut
The global investment industry today
Before we try to draw out some threads from the
10 trends in investment management we have
identified some background
4 Assets under management (USDtrn end-2010)
Insurance
funds 246
Pension
funds 299
HFs 18
SWFs 42
ETFs 13
Mutual
funds 247
PE 26
Source TheCityUK estimates
How big is the global investment industry
Conventional assets (pension funds mutual funds
10
Multi Asset Strategy Global September 2012
abc
and insurance) total about USD80trn split
roughly evenly between the three (Chart 4) The
AUM of these institutions has doubled since
2000 Hedge funds manage around USD2trn and
private equity funds a little more than that Add to
this sovereign wealth funds which in their pure
form have assets of about USD5trn include FX
reserve managers and other sovereign institutions
(such as national pensions or development funds)
and the total reaches about USD20trn ETFs
comprise another USD15trn or so Private wealth
is harder to figure out various estimates put it at
between USD26trn and USD120trn At the top
end of estimates the total amount of money
available for investment firms to manage exceeds
USD200trn ndash almost 3x global GDP
The US is still the largest source of funds with
USD35trn out of the USD79trn in conventional
assets globally (Chart 5) That is 224 of US GDP
The UK though much smaller in absolute terms at
USD65trn is the biggest in proportion to GDP with
conventional funds representing 257 of GDP
(although some of that comes from money
domiciled in the UK but not from UK nationals)
5 Source of conventional assets by country (USDtrn)
05
10152025303540
US
UK
Japa
n
Fran
ce
Ger
man
y NL
Switz
Oth
er
Pension funds Insurance assets Mutual funds
Source TheCityUK estimates based on OECD Investment Company SwissRe and UBS data (Figures are for domestically sourced funds regardless of where they are managed No reliable comparisons are available for total funds under management buy country)
hellipand the chances of it growing
There is no reason to suppose that the rate of
growth of institutional assets will slow over the
coming years Over the past decade conventional
assets have grown at a compound annual rate of
71 While it is likely in our view that global
economic growth will be lacklustre in coming
years as the after-effects of the Global Financial
Crisis are worked off this does not mean that
global savings will be stagnant Indeed quite the
opposite Households and companies are likely to
increase their savings as they stay risk averse (and
governments are likely to reduce fiscal deficits
albeit slowly)
The IMF projects that US and UK gross national
savings which have already improved modestly
since 2009 (to 129 of GDP from 115 in the
case of the US) will continue to increase over the
next five years with the US reaching 178 by 2017
(Chart 6) China meanwhile is unlikely to reduce its
savings rate much despite efforts to get households
to spend Australia has already made some headway
in raising its savings rate since its bubble in the early
2000s Japan is the only major economy where the
ratio may fall as retirees start to eat into their
savings All this suggests that the savings glut which
drove the fall in interest rates and strong equity
performance in 2003-7 will not disappear
6 Gross national savings rate selected countries ( of GDP)
0
10
20
30
40
50
60
80 85 90 95 00 05 10 15
UK US AU CH JP
F
Source IMF
And at the same time as savings grow companies in
the developed world are unlikely to need to raise
much money for the next few years Corporate cash
holdings are at record highs especially in the US
and companies are being cautious about capex
11
Multi Asset Strategy Global September 2012
abc
Dividend payout ratios are very low (31 in the US
last year for instance) This suggests that large listed
companies at least will not need to raise much
capital either debt or equity for the next few years ndash
although capital-hungry emerging markets
companies of course will
As countries get richer they tend to increase the
amount of institutional assets under management
and increase the amount invested in equities and
bonds (rather than placed in bank deposits) as
shown in Charts 7 and 8
7 Increasing wealth brings growth in institutional assets
0102030405060708090
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in institutional assets
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
8 hellipamid withdrawals from bank deposits
0
10
20
30
40
50
60
70
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in bank deposits
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
This suggests that as long as emerging markets
continue to develop (which in most cases we think
likely) then not only should the pool of potential
savings grow but the proportion of the pool
available for international investment institutions
to manage should grow even faster Not that this
will be without challenges how do London or
New York-based investment managers get access
to wealth held in China or India which is still
highly restricted in where it can invest and mostly
off limits to them
Indeed a well-read report by the McKinsey
Global Institute The emerging equity gap Growth
and stability in the new investors landscape
December 2011 argued that the growth of
international securities ownership by emerging
market investors will be essential if the role of
equities in the global financial system is not to be
reduced in the coming decades In particular
emerging market investors will need to triple their
allocation to equities if companies in these
countries are not to be starved of equity capital
Common threads
In this report we highlight the 10 trends that we
think will drive the investment management industry
over the next few years Understanding these trends
ndash and considering their implications ndash will be
important both for investment institutions in
planning their strategies and for investors interested
in the impact of these trends on asset prices
12
Multi Asset Strategy Global September 2012
abc
Inevitably there are some overlaps between the
10 trends Broadly we see three threads running
between them
The search for income With interest rates so
low investors are desperate to generate
income This has triggered demand for credit
and high dividend yield equities which we
expect to continue It is also forcing investors
to consider whether they are overpaying for
liquidity and to look at harvesting a premium
for investing in illiquid instruments such as
infrastructure and ldquoprivate debtrdquo funds
Tailoring risk Modern derivative techniques
make it possible to tailor risk to an extent
Investors scared of drawdowns can hedge fat-
tail risk Fixing a return is not possible (except
for a very low return) tailoring a level of risk
may be easier This concept has spawned the
development of risk parity funds and a boom in
multi-asset absolute return funds
A continuing shift from active to passive
Academic evidence strongly suggests that
active equity fund managers in aggregate
underperform their benchmarks That has
pushed investors over the past decade from
active to passive funds especially ETFs ndash a
trend we expect to continue It is also forcing
a rethink of the role of hedge funds which
have grown so large that in aggregate they no
longer seem to be able to produce superior
performance either
In the following sections we describe in detail the
10 trends we have identified and analyse their
implications for asset prices
13
Multi Asset Strategy Global September 2012
abc
hellipin credit and dividends With cash yielding zero and top-quality
government bonds little more than 15 it is
unsurprising that investors are scrambling to pick
up yield Indeed one could even say that the
market has become obsessed with income
1 Cumulative net flows to bond funds worldwide by type
-100
-50
0
50
100
150
200
250
300
07 08 09 10 11 12
USD
bn
Gov tCreditOther
Source EPFR (ldquoOtherrdquo includes muni funds MBS funds total return bonds and funds able to invest in a mix of bond types)
Look at flows into bond mutual funds recently It
is well known that these have been very healthy
totalling USD580bn over the past three years
according to EPFR But for the past 12 months at
least bonds flows have been predominantly into
credit funds (for example corporate high yield or
EM bond funds) with even a small net outflow
from government bond funds (Chart 1)
The sort of funds selling well is clear from the list
of the largest fund launches year-to-date The top
20 new US-based funds ranked by assets under
management now (Table 2 overleaf) include 10
bond funds two asset allocation funds and only
eight with an equity focus (remember this is for
the heavily equity-centric US market) Three of
the best-selling funds include the word ldquoincomerdquo
in their names
Credit is in a sweet spot Interest rates at which
corporates can issue are at historic lows But at
the same time spreads over US Treasuries are
quite high making the bonds attractive for
investors too
In the US for example BBB-rated five-year
corporate bonds currently yield only about 28 ndash
the lowest for decades ndash but that represents a spread
over Treasuries of around 200bp well above the
average of 130bp from the 2003-7 period (Chart 3)
The same is true in emerging markets The HSBC
Asian Dollar Bond Index (Chart 4) currently has a
record low yield of 37 but the spread over
Treasuries is a still attractive 300bp
This is why lots of bonds have been issued this
year August for example with over USD120bn
of issuance according to Dealogic was the highest
August on record and more than double the
USD58bn average for August Sub investment
The search for yield
With risk-free rates so low investors are desperate for income
Credit is in a sweet spot with issuers enjoying record low
borrowing costs but investors finding decent spreads
We think dividend yield stocks remain attractive too
14
Multi Asset Strategy Global September 2012
abc
grade issuance in August totalled USD27bn up
from USD13bn the same month in 2011
3 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
Source Bloomberg
Investors are clearly now having to take more risk
to get yield Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield One
example is bonds from riskier emerging markets
Ten-year paper from the Philippines a BB-rated
issuer now yields only 25 Investors have been
buying bonds from countries such as Gabon
Belarus Nigeria and Vietnam But five-year
bonds even from Gabon (BB-rated) now yield
only 38 You have to stretch to Belarus (B-) to
get a decent yield just over 10
4 HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source HSBC
This could all go very wrong Credit spreads are
supposed to compensate investors for the
probability of default At the investment grade
part of the credit spectrum defaults are rare but at
the sub-investment grade end they are less so At
present the combination of low rates on high
quality government bonds and relatively wider
credit spreads combined with very low default
rates places credit in a sweet spot compared to
some other assets classes However in an
2 Largest mutual funds launched in the US this year
Ticker Name Manager Inception date
Asset class Objective AUM (USDbn)
TGIRX US Intl Value Fund Thornburg 512012 Equity International Equity 265 OIBIX US Intl Bond Fund Oppenheimer 1272012 Debt International Debt 126 WAPRX US Core Plus Fund Western Asset 512012 Debt GovtCorp Intermediate 96 OSIIX US Global Strategic Income Fund Oppenheimer 1272012 Debt GovernmentCorporate 86 OGLIX US Global Fund Oppenheimer 1272012 Equity Global Equity 83 PSTQX US Short Term Corp Bond Fnd Pridential 322012 Debt CorporatePreferred-Inv Grade 80 AEMSX US Emerging Markets Fund Aberdeen 2272012 Equity Emerging Market-Equity 75 OIGIX US Intl Growth Fund Oppenheimer 4272012 Equity International Equity 62 MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6152012 Equity Growth-Mid Cap 60 MSFKX US Total Return Fund MFS 612012 Asset Allocation Balanced 58 PEFAX US EM Fundamental IndexPLUS Pimco 5312012 Debt Index Fund-Debt 54 CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund Columbia 4202012 Debt GovernmentCorporate 47
OBBCX US Mortgage Backed Securities Fund JP Morgan 722012 Debt Asset Backed Securities 41 JQLAX US Life Aggressive Fund John Hancock 312012 Asset Allocation Flexible Portfolio 37 OEIIX US Equity Income Fund Oppenheimer 4272012 Equity Value-Large Cap 33 MIDLX US Intl New Discovery Fund MFS 612012 Equity International Equity 32 JIPPX US Strategic Income Opportunities Fund John Hancock 312012 Debt Global Debt 31 WABRX US Core Bond Fund Western Asset 512012 Debt GovtCorp Intermediate 30 MFBKX US Bond Fund MFS 612012 Debt GovernmentCorporate 28 JDVPX US Disciplined Value Fund John Hancock 2292012 Equity Value-Large Cap 28
Source Bloomberg
15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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4
Multi Asset Strategy Global September 2012
abc
6 Illiquidity premium estimate by asset class
0
100
200
300
400
500
Equity Corporate
bonds
Gov ernment
bonds
Cov ered
bondsbp
Harvesting the illiquidity premium Most
investors have a strong preference for
liquidity But some ndash notably pension funds
and insurers ndash donrsquot always need it and may
be overpaying for it Amid the desperate
search for income they may see the attraction
of the extra yield available in illiquid assets
(Chart 6) such as infrastructure real estate
finance and ldquoprivate debtrdquo (structured like
private equity but providing debt financing)
Page 34 Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
7 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Where will the money come from Defined
benefit pensions are dwindling (Chart 7) The
growth areas for investment management
companies in the next few years will be
personal pensions Asian high net worth
individuals and sovereign wealth funds But
each of these will demand more sophisticated
products and solution-based services Page 36
Source OECD
8 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
The challenge of ESG Plan sponsors
particularly public pension funds in Europe
are increasingly focusing on environmental
social and governance issues So far most
fund managers pay only lip-service to this
But momentum is building (Chart 8) and
companies with superior ESG policies and
disclosure might start to outperform After
all who wants to buy a company with poor
corporate governance which pollutes or treats
its staff badly Page 42 Source US SIF Eurosif (definitions differ slightly)
5
Multi Asset Strategy Global September 2012
abc
Implications for asset prices
The search for yield should be positive for credit and for high dividend yield stocks both of which remain
attractive in our view Equities in general may struggle for a few more years as global economic growth
remains low but the basic concept that equities have a risk premium ndash and therefore generate greater
returns in the long run ndash will not disappear If investors become more willing to buy illiquid assets to
boost yield the pricing of long-term loans commercial real estate and infrastructure finance should be
positively affected The development of multi-asset funds should aid the development and liquidity of
more esoteric asset classes and derivatives products We believe the further growth of passive funds and
ETFs will keep inter-market and intra-market correlations high
6
Multi Asset Strategy Global September 2012
abc
Introduction an unusual world 7 Cyclical or evolutionary 7
The search for yield 13 hellipin credit and dividends 13
The death ndash or rebirth ndash of equities 17 Problem is volatility not return 17
Risk-minimising strategies 20 Tailoring risk not return 20
The growth of multi-asset 22 GARS and all its friends 22
The shift to passive 24 Itrsquos hard to beat an index 24
The relentless rise of ETFs 28 Attractive ndash but problems too 28
The decline of the hedge fund 31 Is there any alpha left 31
Harvesting the illiquidity premium 34 Do you really need liquidity 34
Where will the money come from 36 The sources of growth 36
The challenge of ESG 42 Unavoidable momentum 42
Disclosure appendix 46
Disclaimer 48
Contents
7
Multi Asset Strategy Global September 2012
abc
Cyclical or evolutionary We are in a very unusual investment world
Interest rates are at historical lows equities more
volatile than normal different assets classes
abnormally correlated (the ldquorisk on-risk offrdquo
phenomenon) and demographics are altering
savings patterns in rich countries
These developments have already caused a big
shift in investment flows over the past five years
Investors have
Sold equities and bought bonds in huge
volumes in the US since end-2007 bond
mutual funds have seen inflows of USD920bn
and equity funds outflows of USD430bn
Loaded up on risk-free assets But the supply
of these has shrunk (according to the BIS
AAA-rated government paper now totals only
USD12trn compared to USD26trn in early
2011 ndash Chart 1) This has pushed down their
nominal yields to below zero in some cases
Increasingly understood that active equity
fund managers in aggregate underperform
benchmarks (even before fees) and so moved
heavily into index funds and ETFs
Searched for new ways other than equities to
achieve a decent return without too much risk
This has led to the development of absolute
return (or diversified beta) funds and risk-
minimising strategies
1 Credit risk of pool of government debt
0
5
10
15
20
25
30
35
40
01 02 03 04 05 06 07 08 09 10 11
AA to below AA+AA+ to below AAAAAA
Source BIS (Ratings used are the simple averages of the long-term foreign currency sovereign ratings from Fitch Moodyrsquos and SampP)
Is this a permanent structural change or will we
eventually go back to the old normal Probably a
bit of both The side-effects of the 2007-9 Global
Financial Crisis will eventually wear off (though
Introduction an unusual world
Low rates high volatility high correlation ndash the world has changed
Fund managers are struggling to cope how to find returns without
too much risk and provide solutions to investors with new needs
We indentify three threads the search for income tailoring risk
and the continuing shift from active to passive
Garry Evans Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6916 garryevanshsbccomhk
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registered qualified pursuant to FINRA regulations
8
Multi Asset Strategy Global September 2012
abc
this may take a few more years) with interest
rates volatility and correlations returning to their
historical norms
But there has been some evolution too Investorsrsquo
behaviour is likely to have changed permanently
Investors will increasingly question whether
hedge funds can generate alpha and whether
they deserve fees of 2 and 20 even if
they can
Retail investors will demand access to the sort
of absolute return strategies that hedge
funds previously specialised in ndash and at a
reasonable cost
There will be more demand for solutions
whether liability-matched investments for a
defined benefit (DB) pension fund that is
winding down or a ldquoto-and-throughrdquo
personal pension plan for an individual due
to retire in five years who wants to fix
post-retirement income
Interest in buying stocks in companies with a
strong ESG (environmental social and
governance) record will increase This is not
idealistic green talk ndash after all who wants to
own a company with poor corporate
governance or which treats its staff badly
Many of these themes are fairly obvious and have
been under way for a number of years But how
the fund management industry will be affected by
them is not yet at all obvious Like any business
an investment management firm has to pick a
strategy should it rush into all these new areas
(ETFs absolute return funds pension solutions
ESG) or should it decide to focus Is it better to
be a large global investment house or a focused
boutique ndash or hedge onersquos bets by becoming a
multi-boutique umbrella organisation
These trends will affect asset prices too If
investors abandon equities for a generation PE
multiples would contract further as they did in the
1970s or after the Great Depression Further
growth in ETFs and index products could push
correlations up further A rise in demand for
alternative assets (infrastructure financing
distressed debt derivative structures) could shift
the prices of these assets As banks in Europe
deleverage infrastructure lending leasing and
other forms of long-term finance could pass to
institutional investors in a form of
disintermediation which could bring down
borrowing costs
2 Demographic trends of population aged 35-54 in DM 3 Demographic trends of population aged 35-54 in EM
20
22
24
26
28
30
1990 2000 2010 2020 2030 2040 2050
Dev eloped markets
20212223242526272829
1990 2010 2030 2050
Emerging
Source HSBC UN Population Division NB MSCI World markets Source HSBC UN Population Division
9
Multi Asset Strategy Global September 2012
abc
Why this matters
This is a topic that HSBCrsquos strategy team has
tackled before We believe that understanding the
deep underlying trends in investment are
important for asset allocation It is too easy to get
caught up in the day-to-day vicissitudes of the
economic cycle Thinking about long-term
drivers such as demographics changes in wealth
or market micro-dynamics can help improve
investment decision-making
Earlier this year for example we published a
report (Who will buy by Daniel Grosvenor 3
February 2012) which argued that demand for
equities is likely to remain structurally weak due
to prolonged risk aversion regulatory changes and
deteriorating demographics In particular ageing
populations in the developed world (Chart 2) will
tend to own fewer equities This the report
argued could keep DM valuations depressed but
EM should be immune (partly because of its
better demographics ndash Chart 3)
We also described the growing importance of
emerging markets investors in Asia buys Asia by
Herald van der Linde and Devendra Joshi June
2012 Asian equity markets have traditionally been
dominated by foreign investors or speculative local
individuals But this is changing as Asians diversify
their wealth into financial assets and pension
systems develop across the region
Our colleagues in quantitative strategy have also
looked at the risk on-risk off phenomenon (their
latest report is Risk On ndash Risk Off Fixing a
broken investment process by Stacy Williams
Daniel Fenn and Mark McDonald April 2012)
They suggest ways in which fund managers can
adapt their investment process to cope with the
phenomenon and take advantage of it
For this present report we met with CEOs chief
investment officers and senior business managers
at almost 20 investment firms in the US and
Europe These ranged from niche long-only equity
specialists to opportunistic macro hedge funds
from major ETF providers to large global multi-
asset investment managers Naturally most of the
senior managers had a bias based on what they
specialised in equity houses tend to believe that
actively managed equity will come back and
passive specialists argue that in future everything
will be indexed
But our conversations gave us a good idea of the
sort of concerns investment managers have when
they are being candid Bond houses worry about
how to cope with the crash in bond prices that we
believe is inevitable in the future Active
managers worry whether itrsquos too late to enter the
index ETF business ndash or whether they should try
to structure their active funds as ETFs Many
managers are struggling to create innovative
products ndash risk-hedged funds absolute return
strategies pension-friendly structures ndash in a world
where their revenues have stagnated and so RampD
budgets have been cut
The global investment industry today
Before we try to draw out some threads from the
10 trends in investment management we have
identified some background
4 Assets under management (USDtrn end-2010)
Insurance
funds 246
Pension
funds 299
HFs 18
SWFs 42
ETFs 13
Mutual
funds 247
PE 26
Source TheCityUK estimates
How big is the global investment industry
Conventional assets (pension funds mutual funds
10
Multi Asset Strategy Global September 2012
abc
and insurance) total about USD80trn split
roughly evenly between the three (Chart 4) The
AUM of these institutions has doubled since
2000 Hedge funds manage around USD2trn and
private equity funds a little more than that Add to
this sovereign wealth funds which in their pure
form have assets of about USD5trn include FX
reserve managers and other sovereign institutions
(such as national pensions or development funds)
and the total reaches about USD20trn ETFs
comprise another USD15trn or so Private wealth
is harder to figure out various estimates put it at
between USD26trn and USD120trn At the top
end of estimates the total amount of money
available for investment firms to manage exceeds
USD200trn ndash almost 3x global GDP
The US is still the largest source of funds with
USD35trn out of the USD79trn in conventional
assets globally (Chart 5) That is 224 of US GDP
The UK though much smaller in absolute terms at
USD65trn is the biggest in proportion to GDP with
conventional funds representing 257 of GDP
(although some of that comes from money
domiciled in the UK but not from UK nationals)
5 Source of conventional assets by country (USDtrn)
05
10152025303540
US
UK
Japa
n
Fran
ce
Ger
man
y NL
Switz
Oth
er
Pension funds Insurance assets Mutual funds
Source TheCityUK estimates based on OECD Investment Company SwissRe and UBS data (Figures are for domestically sourced funds regardless of where they are managed No reliable comparisons are available for total funds under management buy country)
hellipand the chances of it growing
There is no reason to suppose that the rate of
growth of institutional assets will slow over the
coming years Over the past decade conventional
assets have grown at a compound annual rate of
71 While it is likely in our view that global
economic growth will be lacklustre in coming
years as the after-effects of the Global Financial
Crisis are worked off this does not mean that
global savings will be stagnant Indeed quite the
opposite Households and companies are likely to
increase their savings as they stay risk averse (and
governments are likely to reduce fiscal deficits
albeit slowly)
The IMF projects that US and UK gross national
savings which have already improved modestly
since 2009 (to 129 of GDP from 115 in the
case of the US) will continue to increase over the
next five years with the US reaching 178 by 2017
(Chart 6) China meanwhile is unlikely to reduce its
savings rate much despite efforts to get households
to spend Australia has already made some headway
in raising its savings rate since its bubble in the early
2000s Japan is the only major economy where the
ratio may fall as retirees start to eat into their
savings All this suggests that the savings glut which
drove the fall in interest rates and strong equity
performance in 2003-7 will not disappear
6 Gross national savings rate selected countries ( of GDP)
0
10
20
30
40
50
60
80 85 90 95 00 05 10 15
UK US AU CH JP
F
Source IMF
And at the same time as savings grow companies in
the developed world are unlikely to need to raise
much money for the next few years Corporate cash
holdings are at record highs especially in the US
and companies are being cautious about capex
11
Multi Asset Strategy Global September 2012
abc
Dividend payout ratios are very low (31 in the US
last year for instance) This suggests that large listed
companies at least will not need to raise much
capital either debt or equity for the next few years ndash
although capital-hungry emerging markets
companies of course will
As countries get richer they tend to increase the
amount of institutional assets under management
and increase the amount invested in equities and
bonds (rather than placed in bank deposits) as
shown in Charts 7 and 8
7 Increasing wealth brings growth in institutional assets
0102030405060708090
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in institutional assets
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
8 hellipamid withdrawals from bank deposits
0
10
20
30
40
50
60
70
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in bank deposits
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
This suggests that as long as emerging markets
continue to develop (which in most cases we think
likely) then not only should the pool of potential
savings grow but the proportion of the pool
available for international investment institutions
to manage should grow even faster Not that this
will be without challenges how do London or
New York-based investment managers get access
to wealth held in China or India which is still
highly restricted in where it can invest and mostly
off limits to them
Indeed a well-read report by the McKinsey
Global Institute The emerging equity gap Growth
and stability in the new investors landscape
December 2011 argued that the growth of
international securities ownership by emerging
market investors will be essential if the role of
equities in the global financial system is not to be
reduced in the coming decades In particular
emerging market investors will need to triple their
allocation to equities if companies in these
countries are not to be starved of equity capital
Common threads
In this report we highlight the 10 trends that we
think will drive the investment management industry
over the next few years Understanding these trends
ndash and considering their implications ndash will be
important both for investment institutions in
planning their strategies and for investors interested
in the impact of these trends on asset prices
12
Multi Asset Strategy Global September 2012
abc
Inevitably there are some overlaps between the
10 trends Broadly we see three threads running
between them
The search for income With interest rates so
low investors are desperate to generate
income This has triggered demand for credit
and high dividend yield equities which we
expect to continue It is also forcing investors
to consider whether they are overpaying for
liquidity and to look at harvesting a premium
for investing in illiquid instruments such as
infrastructure and ldquoprivate debtrdquo funds
Tailoring risk Modern derivative techniques
make it possible to tailor risk to an extent
Investors scared of drawdowns can hedge fat-
tail risk Fixing a return is not possible (except
for a very low return) tailoring a level of risk
may be easier This concept has spawned the
development of risk parity funds and a boom in
multi-asset absolute return funds
A continuing shift from active to passive
Academic evidence strongly suggests that
active equity fund managers in aggregate
underperform their benchmarks That has
pushed investors over the past decade from
active to passive funds especially ETFs ndash a
trend we expect to continue It is also forcing
a rethink of the role of hedge funds which
have grown so large that in aggregate they no
longer seem to be able to produce superior
performance either
In the following sections we describe in detail the
10 trends we have identified and analyse their
implications for asset prices
13
Multi Asset Strategy Global September 2012
abc
hellipin credit and dividends With cash yielding zero and top-quality
government bonds little more than 15 it is
unsurprising that investors are scrambling to pick
up yield Indeed one could even say that the
market has become obsessed with income
1 Cumulative net flows to bond funds worldwide by type
-100
-50
0
50
100
150
200
250
300
07 08 09 10 11 12
USD
bn
Gov tCreditOther
Source EPFR (ldquoOtherrdquo includes muni funds MBS funds total return bonds and funds able to invest in a mix of bond types)
Look at flows into bond mutual funds recently It
is well known that these have been very healthy
totalling USD580bn over the past three years
according to EPFR But for the past 12 months at
least bonds flows have been predominantly into
credit funds (for example corporate high yield or
EM bond funds) with even a small net outflow
from government bond funds (Chart 1)
The sort of funds selling well is clear from the list
of the largest fund launches year-to-date The top
20 new US-based funds ranked by assets under
management now (Table 2 overleaf) include 10
bond funds two asset allocation funds and only
eight with an equity focus (remember this is for
the heavily equity-centric US market) Three of
the best-selling funds include the word ldquoincomerdquo
in their names
Credit is in a sweet spot Interest rates at which
corporates can issue are at historic lows But at
the same time spreads over US Treasuries are
quite high making the bonds attractive for
investors too
In the US for example BBB-rated five-year
corporate bonds currently yield only about 28 ndash
the lowest for decades ndash but that represents a spread
over Treasuries of around 200bp well above the
average of 130bp from the 2003-7 period (Chart 3)
The same is true in emerging markets The HSBC
Asian Dollar Bond Index (Chart 4) currently has a
record low yield of 37 but the spread over
Treasuries is a still attractive 300bp
This is why lots of bonds have been issued this
year August for example with over USD120bn
of issuance according to Dealogic was the highest
August on record and more than double the
USD58bn average for August Sub investment
The search for yield
With risk-free rates so low investors are desperate for income
Credit is in a sweet spot with issuers enjoying record low
borrowing costs but investors finding decent spreads
We think dividend yield stocks remain attractive too
14
Multi Asset Strategy Global September 2012
abc
grade issuance in August totalled USD27bn up
from USD13bn the same month in 2011
3 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
Source Bloomberg
Investors are clearly now having to take more risk
to get yield Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield One
example is bonds from riskier emerging markets
Ten-year paper from the Philippines a BB-rated
issuer now yields only 25 Investors have been
buying bonds from countries such as Gabon
Belarus Nigeria and Vietnam But five-year
bonds even from Gabon (BB-rated) now yield
only 38 You have to stretch to Belarus (B-) to
get a decent yield just over 10
4 HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source HSBC
This could all go very wrong Credit spreads are
supposed to compensate investors for the
probability of default At the investment grade
part of the credit spectrum defaults are rare but at
the sub-investment grade end they are less so At
present the combination of low rates on high
quality government bonds and relatively wider
credit spreads combined with very low default
rates places credit in a sweet spot compared to
some other assets classes However in an
2 Largest mutual funds launched in the US this year
Ticker Name Manager Inception date
Asset class Objective AUM (USDbn)
TGIRX US Intl Value Fund Thornburg 512012 Equity International Equity 265 OIBIX US Intl Bond Fund Oppenheimer 1272012 Debt International Debt 126 WAPRX US Core Plus Fund Western Asset 512012 Debt GovtCorp Intermediate 96 OSIIX US Global Strategic Income Fund Oppenheimer 1272012 Debt GovernmentCorporate 86 OGLIX US Global Fund Oppenheimer 1272012 Equity Global Equity 83 PSTQX US Short Term Corp Bond Fnd Pridential 322012 Debt CorporatePreferred-Inv Grade 80 AEMSX US Emerging Markets Fund Aberdeen 2272012 Equity Emerging Market-Equity 75 OIGIX US Intl Growth Fund Oppenheimer 4272012 Equity International Equity 62 MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6152012 Equity Growth-Mid Cap 60 MSFKX US Total Return Fund MFS 612012 Asset Allocation Balanced 58 PEFAX US EM Fundamental IndexPLUS Pimco 5312012 Debt Index Fund-Debt 54 CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund Columbia 4202012 Debt GovernmentCorporate 47
OBBCX US Mortgage Backed Securities Fund JP Morgan 722012 Debt Asset Backed Securities 41 JQLAX US Life Aggressive Fund John Hancock 312012 Asset Allocation Flexible Portfolio 37 OEIIX US Equity Income Fund Oppenheimer 4272012 Equity Value-Large Cap 33 MIDLX US Intl New Discovery Fund MFS 612012 Equity International Equity 32 JIPPX US Strategic Income Opportunities Fund John Hancock 312012 Debt Global Debt 31 WABRX US Core Bond Fund Western Asset 512012 Debt GovtCorp Intermediate 30 MFBKX US Bond Fund MFS 612012 Debt GovernmentCorporate 28 JDVPX US Disciplined Value Fund John Hancock 2292012 Equity Value-Large Cap 28
Source Bloomberg
15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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5
Multi Asset Strategy Global September 2012
abc
Implications for asset prices
The search for yield should be positive for credit and for high dividend yield stocks both of which remain
attractive in our view Equities in general may struggle for a few more years as global economic growth
remains low but the basic concept that equities have a risk premium ndash and therefore generate greater
returns in the long run ndash will not disappear If investors become more willing to buy illiquid assets to
boost yield the pricing of long-term loans commercial real estate and infrastructure finance should be
positively affected The development of multi-asset funds should aid the development and liquidity of
more esoteric asset classes and derivatives products We believe the further growth of passive funds and
ETFs will keep inter-market and intra-market correlations high
6
Multi Asset Strategy Global September 2012
abc
Introduction an unusual world 7 Cyclical or evolutionary 7
The search for yield 13 hellipin credit and dividends 13
The death ndash or rebirth ndash of equities 17 Problem is volatility not return 17
Risk-minimising strategies 20 Tailoring risk not return 20
The growth of multi-asset 22 GARS and all its friends 22
The shift to passive 24 Itrsquos hard to beat an index 24
The relentless rise of ETFs 28 Attractive ndash but problems too 28
The decline of the hedge fund 31 Is there any alpha left 31
Harvesting the illiquidity premium 34 Do you really need liquidity 34
Where will the money come from 36 The sources of growth 36
The challenge of ESG 42 Unavoidable momentum 42
Disclosure appendix 46
Disclaimer 48
Contents
7
Multi Asset Strategy Global September 2012
abc
Cyclical or evolutionary We are in a very unusual investment world
Interest rates are at historical lows equities more
volatile than normal different assets classes
abnormally correlated (the ldquorisk on-risk offrdquo
phenomenon) and demographics are altering
savings patterns in rich countries
These developments have already caused a big
shift in investment flows over the past five years
Investors have
Sold equities and bought bonds in huge
volumes in the US since end-2007 bond
mutual funds have seen inflows of USD920bn
and equity funds outflows of USD430bn
Loaded up on risk-free assets But the supply
of these has shrunk (according to the BIS
AAA-rated government paper now totals only
USD12trn compared to USD26trn in early
2011 ndash Chart 1) This has pushed down their
nominal yields to below zero in some cases
Increasingly understood that active equity
fund managers in aggregate underperform
benchmarks (even before fees) and so moved
heavily into index funds and ETFs
Searched for new ways other than equities to
achieve a decent return without too much risk
This has led to the development of absolute
return (or diversified beta) funds and risk-
minimising strategies
1 Credit risk of pool of government debt
0
5
10
15
20
25
30
35
40
01 02 03 04 05 06 07 08 09 10 11
AA to below AA+AA+ to below AAAAAA
Source BIS (Ratings used are the simple averages of the long-term foreign currency sovereign ratings from Fitch Moodyrsquos and SampP)
Is this a permanent structural change or will we
eventually go back to the old normal Probably a
bit of both The side-effects of the 2007-9 Global
Financial Crisis will eventually wear off (though
Introduction an unusual world
Low rates high volatility high correlation ndash the world has changed
Fund managers are struggling to cope how to find returns without
too much risk and provide solutions to investors with new needs
We indentify three threads the search for income tailoring risk
and the continuing shift from active to passive
Garry Evans Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6916 garryevanshsbccomhk
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registered qualified pursuant to FINRA regulations
8
Multi Asset Strategy Global September 2012
abc
this may take a few more years) with interest
rates volatility and correlations returning to their
historical norms
But there has been some evolution too Investorsrsquo
behaviour is likely to have changed permanently
Investors will increasingly question whether
hedge funds can generate alpha and whether
they deserve fees of 2 and 20 even if
they can
Retail investors will demand access to the sort
of absolute return strategies that hedge
funds previously specialised in ndash and at a
reasonable cost
There will be more demand for solutions
whether liability-matched investments for a
defined benefit (DB) pension fund that is
winding down or a ldquoto-and-throughrdquo
personal pension plan for an individual due
to retire in five years who wants to fix
post-retirement income
Interest in buying stocks in companies with a
strong ESG (environmental social and
governance) record will increase This is not
idealistic green talk ndash after all who wants to
own a company with poor corporate
governance or which treats its staff badly
Many of these themes are fairly obvious and have
been under way for a number of years But how
the fund management industry will be affected by
them is not yet at all obvious Like any business
an investment management firm has to pick a
strategy should it rush into all these new areas
(ETFs absolute return funds pension solutions
ESG) or should it decide to focus Is it better to
be a large global investment house or a focused
boutique ndash or hedge onersquos bets by becoming a
multi-boutique umbrella organisation
These trends will affect asset prices too If
investors abandon equities for a generation PE
multiples would contract further as they did in the
1970s or after the Great Depression Further
growth in ETFs and index products could push
correlations up further A rise in demand for
alternative assets (infrastructure financing
distressed debt derivative structures) could shift
the prices of these assets As banks in Europe
deleverage infrastructure lending leasing and
other forms of long-term finance could pass to
institutional investors in a form of
disintermediation which could bring down
borrowing costs
2 Demographic trends of population aged 35-54 in DM 3 Demographic trends of population aged 35-54 in EM
20
22
24
26
28
30
1990 2000 2010 2020 2030 2040 2050
Dev eloped markets
20212223242526272829
1990 2010 2030 2050
Emerging
Source HSBC UN Population Division NB MSCI World markets Source HSBC UN Population Division
9
Multi Asset Strategy Global September 2012
abc
Why this matters
This is a topic that HSBCrsquos strategy team has
tackled before We believe that understanding the
deep underlying trends in investment are
important for asset allocation It is too easy to get
caught up in the day-to-day vicissitudes of the
economic cycle Thinking about long-term
drivers such as demographics changes in wealth
or market micro-dynamics can help improve
investment decision-making
Earlier this year for example we published a
report (Who will buy by Daniel Grosvenor 3
February 2012) which argued that demand for
equities is likely to remain structurally weak due
to prolonged risk aversion regulatory changes and
deteriorating demographics In particular ageing
populations in the developed world (Chart 2) will
tend to own fewer equities This the report
argued could keep DM valuations depressed but
EM should be immune (partly because of its
better demographics ndash Chart 3)
We also described the growing importance of
emerging markets investors in Asia buys Asia by
Herald van der Linde and Devendra Joshi June
2012 Asian equity markets have traditionally been
dominated by foreign investors or speculative local
individuals But this is changing as Asians diversify
their wealth into financial assets and pension
systems develop across the region
Our colleagues in quantitative strategy have also
looked at the risk on-risk off phenomenon (their
latest report is Risk On ndash Risk Off Fixing a
broken investment process by Stacy Williams
Daniel Fenn and Mark McDonald April 2012)
They suggest ways in which fund managers can
adapt their investment process to cope with the
phenomenon and take advantage of it
For this present report we met with CEOs chief
investment officers and senior business managers
at almost 20 investment firms in the US and
Europe These ranged from niche long-only equity
specialists to opportunistic macro hedge funds
from major ETF providers to large global multi-
asset investment managers Naturally most of the
senior managers had a bias based on what they
specialised in equity houses tend to believe that
actively managed equity will come back and
passive specialists argue that in future everything
will be indexed
But our conversations gave us a good idea of the
sort of concerns investment managers have when
they are being candid Bond houses worry about
how to cope with the crash in bond prices that we
believe is inevitable in the future Active
managers worry whether itrsquos too late to enter the
index ETF business ndash or whether they should try
to structure their active funds as ETFs Many
managers are struggling to create innovative
products ndash risk-hedged funds absolute return
strategies pension-friendly structures ndash in a world
where their revenues have stagnated and so RampD
budgets have been cut
The global investment industry today
Before we try to draw out some threads from the
10 trends in investment management we have
identified some background
4 Assets under management (USDtrn end-2010)
Insurance
funds 246
Pension
funds 299
HFs 18
SWFs 42
ETFs 13
Mutual
funds 247
PE 26
Source TheCityUK estimates
How big is the global investment industry
Conventional assets (pension funds mutual funds
10
Multi Asset Strategy Global September 2012
abc
and insurance) total about USD80trn split
roughly evenly between the three (Chart 4) The
AUM of these institutions has doubled since
2000 Hedge funds manage around USD2trn and
private equity funds a little more than that Add to
this sovereign wealth funds which in their pure
form have assets of about USD5trn include FX
reserve managers and other sovereign institutions
(such as national pensions or development funds)
and the total reaches about USD20trn ETFs
comprise another USD15trn or so Private wealth
is harder to figure out various estimates put it at
between USD26trn and USD120trn At the top
end of estimates the total amount of money
available for investment firms to manage exceeds
USD200trn ndash almost 3x global GDP
The US is still the largest source of funds with
USD35trn out of the USD79trn in conventional
assets globally (Chart 5) That is 224 of US GDP
The UK though much smaller in absolute terms at
USD65trn is the biggest in proportion to GDP with
conventional funds representing 257 of GDP
(although some of that comes from money
domiciled in the UK but not from UK nationals)
5 Source of conventional assets by country (USDtrn)
05
10152025303540
US
UK
Japa
n
Fran
ce
Ger
man
y NL
Switz
Oth
er
Pension funds Insurance assets Mutual funds
Source TheCityUK estimates based on OECD Investment Company SwissRe and UBS data (Figures are for domestically sourced funds regardless of where they are managed No reliable comparisons are available for total funds under management buy country)
hellipand the chances of it growing
There is no reason to suppose that the rate of
growth of institutional assets will slow over the
coming years Over the past decade conventional
assets have grown at a compound annual rate of
71 While it is likely in our view that global
economic growth will be lacklustre in coming
years as the after-effects of the Global Financial
Crisis are worked off this does not mean that
global savings will be stagnant Indeed quite the
opposite Households and companies are likely to
increase their savings as they stay risk averse (and
governments are likely to reduce fiscal deficits
albeit slowly)
The IMF projects that US and UK gross national
savings which have already improved modestly
since 2009 (to 129 of GDP from 115 in the
case of the US) will continue to increase over the
next five years with the US reaching 178 by 2017
(Chart 6) China meanwhile is unlikely to reduce its
savings rate much despite efforts to get households
to spend Australia has already made some headway
in raising its savings rate since its bubble in the early
2000s Japan is the only major economy where the
ratio may fall as retirees start to eat into their
savings All this suggests that the savings glut which
drove the fall in interest rates and strong equity
performance in 2003-7 will not disappear
6 Gross national savings rate selected countries ( of GDP)
0
10
20
30
40
50
60
80 85 90 95 00 05 10 15
UK US AU CH JP
F
Source IMF
And at the same time as savings grow companies in
the developed world are unlikely to need to raise
much money for the next few years Corporate cash
holdings are at record highs especially in the US
and companies are being cautious about capex
11
Multi Asset Strategy Global September 2012
abc
Dividend payout ratios are very low (31 in the US
last year for instance) This suggests that large listed
companies at least will not need to raise much
capital either debt or equity for the next few years ndash
although capital-hungry emerging markets
companies of course will
As countries get richer they tend to increase the
amount of institutional assets under management
and increase the amount invested in equities and
bonds (rather than placed in bank deposits) as
shown in Charts 7 and 8
7 Increasing wealth brings growth in institutional assets
0102030405060708090
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in institutional assets
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
8 hellipamid withdrawals from bank deposits
0
10
20
30
40
50
60
70
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in bank deposits
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
This suggests that as long as emerging markets
continue to develop (which in most cases we think
likely) then not only should the pool of potential
savings grow but the proportion of the pool
available for international investment institutions
to manage should grow even faster Not that this
will be without challenges how do London or
New York-based investment managers get access
to wealth held in China or India which is still
highly restricted in where it can invest and mostly
off limits to them
Indeed a well-read report by the McKinsey
Global Institute The emerging equity gap Growth
and stability in the new investors landscape
December 2011 argued that the growth of
international securities ownership by emerging
market investors will be essential if the role of
equities in the global financial system is not to be
reduced in the coming decades In particular
emerging market investors will need to triple their
allocation to equities if companies in these
countries are not to be starved of equity capital
Common threads
In this report we highlight the 10 trends that we
think will drive the investment management industry
over the next few years Understanding these trends
ndash and considering their implications ndash will be
important both for investment institutions in
planning their strategies and for investors interested
in the impact of these trends on asset prices
12
Multi Asset Strategy Global September 2012
abc
Inevitably there are some overlaps between the
10 trends Broadly we see three threads running
between them
The search for income With interest rates so
low investors are desperate to generate
income This has triggered demand for credit
and high dividend yield equities which we
expect to continue It is also forcing investors
to consider whether they are overpaying for
liquidity and to look at harvesting a premium
for investing in illiquid instruments such as
infrastructure and ldquoprivate debtrdquo funds
Tailoring risk Modern derivative techniques
make it possible to tailor risk to an extent
Investors scared of drawdowns can hedge fat-
tail risk Fixing a return is not possible (except
for a very low return) tailoring a level of risk
may be easier This concept has spawned the
development of risk parity funds and a boom in
multi-asset absolute return funds
A continuing shift from active to passive
Academic evidence strongly suggests that
active equity fund managers in aggregate
underperform their benchmarks That has
pushed investors over the past decade from
active to passive funds especially ETFs ndash a
trend we expect to continue It is also forcing
a rethink of the role of hedge funds which
have grown so large that in aggregate they no
longer seem to be able to produce superior
performance either
In the following sections we describe in detail the
10 trends we have identified and analyse their
implications for asset prices
13
Multi Asset Strategy Global September 2012
abc
hellipin credit and dividends With cash yielding zero and top-quality
government bonds little more than 15 it is
unsurprising that investors are scrambling to pick
up yield Indeed one could even say that the
market has become obsessed with income
1 Cumulative net flows to bond funds worldwide by type
-100
-50
0
50
100
150
200
250
300
07 08 09 10 11 12
USD
bn
Gov tCreditOther
Source EPFR (ldquoOtherrdquo includes muni funds MBS funds total return bonds and funds able to invest in a mix of bond types)
Look at flows into bond mutual funds recently It
is well known that these have been very healthy
totalling USD580bn over the past three years
according to EPFR But for the past 12 months at
least bonds flows have been predominantly into
credit funds (for example corporate high yield or
EM bond funds) with even a small net outflow
from government bond funds (Chart 1)
The sort of funds selling well is clear from the list
of the largest fund launches year-to-date The top
20 new US-based funds ranked by assets under
management now (Table 2 overleaf) include 10
bond funds two asset allocation funds and only
eight with an equity focus (remember this is for
the heavily equity-centric US market) Three of
the best-selling funds include the word ldquoincomerdquo
in their names
Credit is in a sweet spot Interest rates at which
corporates can issue are at historic lows But at
the same time spreads over US Treasuries are
quite high making the bonds attractive for
investors too
In the US for example BBB-rated five-year
corporate bonds currently yield only about 28 ndash
the lowest for decades ndash but that represents a spread
over Treasuries of around 200bp well above the
average of 130bp from the 2003-7 period (Chart 3)
The same is true in emerging markets The HSBC
Asian Dollar Bond Index (Chart 4) currently has a
record low yield of 37 but the spread over
Treasuries is a still attractive 300bp
This is why lots of bonds have been issued this
year August for example with over USD120bn
of issuance according to Dealogic was the highest
August on record and more than double the
USD58bn average for August Sub investment
The search for yield
With risk-free rates so low investors are desperate for income
Credit is in a sweet spot with issuers enjoying record low
borrowing costs but investors finding decent spreads
We think dividend yield stocks remain attractive too
14
Multi Asset Strategy Global September 2012
abc
grade issuance in August totalled USD27bn up
from USD13bn the same month in 2011
3 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
Source Bloomberg
Investors are clearly now having to take more risk
to get yield Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield One
example is bonds from riskier emerging markets
Ten-year paper from the Philippines a BB-rated
issuer now yields only 25 Investors have been
buying bonds from countries such as Gabon
Belarus Nigeria and Vietnam But five-year
bonds even from Gabon (BB-rated) now yield
only 38 You have to stretch to Belarus (B-) to
get a decent yield just over 10
4 HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source HSBC
This could all go very wrong Credit spreads are
supposed to compensate investors for the
probability of default At the investment grade
part of the credit spectrum defaults are rare but at
the sub-investment grade end they are less so At
present the combination of low rates on high
quality government bonds and relatively wider
credit spreads combined with very low default
rates places credit in a sweet spot compared to
some other assets classes However in an
2 Largest mutual funds launched in the US this year
Ticker Name Manager Inception date
Asset class Objective AUM (USDbn)
TGIRX US Intl Value Fund Thornburg 512012 Equity International Equity 265 OIBIX US Intl Bond Fund Oppenheimer 1272012 Debt International Debt 126 WAPRX US Core Plus Fund Western Asset 512012 Debt GovtCorp Intermediate 96 OSIIX US Global Strategic Income Fund Oppenheimer 1272012 Debt GovernmentCorporate 86 OGLIX US Global Fund Oppenheimer 1272012 Equity Global Equity 83 PSTQX US Short Term Corp Bond Fnd Pridential 322012 Debt CorporatePreferred-Inv Grade 80 AEMSX US Emerging Markets Fund Aberdeen 2272012 Equity Emerging Market-Equity 75 OIGIX US Intl Growth Fund Oppenheimer 4272012 Equity International Equity 62 MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6152012 Equity Growth-Mid Cap 60 MSFKX US Total Return Fund MFS 612012 Asset Allocation Balanced 58 PEFAX US EM Fundamental IndexPLUS Pimco 5312012 Debt Index Fund-Debt 54 CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund Columbia 4202012 Debt GovernmentCorporate 47
OBBCX US Mortgage Backed Securities Fund JP Morgan 722012 Debt Asset Backed Securities 41 JQLAX US Life Aggressive Fund John Hancock 312012 Asset Allocation Flexible Portfolio 37 OEIIX US Equity Income Fund Oppenheimer 4272012 Equity Value-Large Cap 33 MIDLX US Intl New Discovery Fund MFS 612012 Equity International Equity 32 JIPPX US Strategic Income Opportunities Fund John Hancock 312012 Debt Global Debt 31 WABRX US Core Bond Fund Western Asset 512012 Debt GovtCorp Intermediate 30 MFBKX US Bond Fund MFS 612012 Debt GovernmentCorporate 28 JDVPX US Disciplined Value Fund John Hancock 2292012 Equity Value-Large Cap 28
Source Bloomberg
15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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6
Multi Asset Strategy Global September 2012
abc
Introduction an unusual world 7 Cyclical or evolutionary 7
The search for yield 13 hellipin credit and dividends 13
The death ndash or rebirth ndash of equities 17 Problem is volatility not return 17
Risk-minimising strategies 20 Tailoring risk not return 20
The growth of multi-asset 22 GARS and all its friends 22
The shift to passive 24 Itrsquos hard to beat an index 24
The relentless rise of ETFs 28 Attractive ndash but problems too 28
The decline of the hedge fund 31 Is there any alpha left 31
Harvesting the illiquidity premium 34 Do you really need liquidity 34
Where will the money come from 36 The sources of growth 36
The challenge of ESG 42 Unavoidable momentum 42
Disclosure appendix 46
Disclaimer 48
Contents
7
Multi Asset Strategy Global September 2012
abc
Cyclical or evolutionary We are in a very unusual investment world
Interest rates are at historical lows equities more
volatile than normal different assets classes
abnormally correlated (the ldquorisk on-risk offrdquo
phenomenon) and demographics are altering
savings patterns in rich countries
These developments have already caused a big
shift in investment flows over the past five years
Investors have
Sold equities and bought bonds in huge
volumes in the US since end-2007 bond
mutual funds have seen inflows of USD920bn
and equity funds outflows of USD430bn
Loaded up on risk-free assets But the supply
of these has shrunk (according to the BIS
AAA-rated government paper now totals only
USD12trn compared to USD26trn in early
2011 ndash Chart 1) This has pushed down their
nominal yields to below zero in some cases
Increasingly understood that active equity
fund managers in aggregate underperform
benchmarks (even before fees) and so moved
heavily into index funds and ETFs
Searched for new ways other than equities to
achieve a decent return without too much risk
This has led to the development of absolute
return (or diversified beta) funds and risk-
minimising strategies
1 Credit risk of pool of government debt
0
5
10
15
20
25
30
35
40
01 02 03 04 05 06 07 08 09 10 11
AA to below AA+AA+ to below AAAAAA
Source BIS (Ratings used are the simple averages of the long-term foreign currency sovereign ratings from Fitch Moodyrsquos and SampP)
Is this a permanent structural change or will we
eventually go back to the old normal Probably a
bit of both The side-effects of the 2007-9 Global
Financial Crisis will eventually wear off (though
Introduction an unusual world
Low rates high volatility high correlation ndash the world has changed
Fund managers are struggling to cope how to find returns without
too much risk and provide solutions to investors with new needs
We indentify three threads the search for income tailoring risk
and the continuing shift from active to passive
Garry Evans Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6916 garryevanshsbccomhk
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registered qualified pursuant to FINRA regulations
8
Multi Asset Strategy Global September 2012
abc
this may take a few more years) with interest
rates volatility and correlations returning to their
historical norms
But there has been some evolution too Investorsrsquo
behaviour is likely to have changed permanently
Investors will increasingly question whether
hedge funds can generate alpha and whether
they deserve fees of 2 and 20 even if
they can
Retail investors will demand access to the sort
of absolute return strategies that hedge
funds previously specialised in ndash and at a
reasonable cost
There will be more demand for solutions
whether liability-matched investments for a
defined benefit (DB) pension fund that is
winding down or a ldquoto-and-throughrdquo
personal pension plan for an individual due
to retire in five years who wants to fix
post-retirement income
Interest in buying stocks in companies with a
strong ESG (environmental social and
governance) record will increase This is not
idealistic green talk ndash after all who wants to
own a company with poor corporate
governance or which treats its staff badly
Many of these themes are fairly obvious and have
been under way for a number of years But how
the fund management industry will be affected by
them is not yet at all obvious Like any business
an investment management firm has to pick a
strategy should it rush into all these new areas
(ETFs absolute return funds pension solutions
ESG) or should it decide to focus Is it better to
be a large global investment house or a focused
boutique ndash or hedge onersquos bets by becoming a
multi-boutique umbrella organisation
These trends will affect asset prices too If
investors abandon equities for a generation PE
multiples would contract further as they did in the
1970s or after the Great Depression Further
growth in ETFs and index products could push
correlations up further A rise in demand for
alternative assets (infrastructure financing
distressed debt derivative structures) could shift
the prices of these assets As banks in Europe
deleverage infrastructure lending leasing and
other forms of long-term finance could pass to
institutional investors in a form of
disintermediation which could bring down
borrowing costs
2 Demographic trends of population aged 35-54 in DM 3 Demographic trends of population aged 35-54 in EM
20
22
24
26
28
30
1990 2000 2010 2020 2030 2040 2050
Dev eloped markets
20212223242526272829
1990 2010 2030 2050
Emerging
Source HSBC UN Population Division NB MSCI World markets Source HSBC UN Population Division
9
Multi Asset Strategy Global September 2012
abc
Why this matters
This is a topic that HSBCrsquos strategy team has
tackled before We believe that understanding the
deep underlying trends in investment are
important for asset allocation It is too easy to get
caught up in the day-to-day vicissitudes of the
economic cycle Thinking about long-term
drivers such as demographics changes in wealth
or market micro-dynamics can help improve
investment decision-making
Earlier this year for example we published a
report (Who will buy by Daniel Grosvenor 3
February 2012) which argued that demand for
equities is likely to remain structurally weak due
to prolonged risk aversion regulatory changes and
deteriorating demographics In particular ageing
populations in the developed world (Chart 2) will
tend to own fewer equities This the report
argued could keep DM valuations depressed but
EM should be immune (partly because of its
better demographics ndash Chart 3)
We also described the growing importance of
emerging markets investors in Asia buys Asia by
Herald van der Linde and Devendra Joshi June
2012 Asian equity markets have traditionally been
dominated by foreign investors or speculative local
individuals But this is changing as Asians diversify
their wealth into financial assets and pension
systems develop across the region
Our colleagues in quantitative strategy have also
looked at the risk on-risk off phenomenon (their
latest report is Risk On ndash Risk Off Fixing a
broken investment process by Stacy Williams
Daniel Fenn and Mark McDonald April 2012)
They suggest ways in which fund managers can
adapt their investment process to cope with the
phenomenon and take advantage of it
For this present report we met with CEOs chief
investment officers and senior business managers
at almost 20 investment firms in the US and
Europe These ranged from niche long-only equity
specialists to opportunistic macro hedge funds
from major ETF providers to large global multi-
asset investment managers Naturally most of the
senior managers had a bias based on what they
specialised in equity houses tend to believe that
actively managed equity will come back and
passive specialists argue that in future everything
will be indexed
But our conversations gave us a good idea of the
sort of concerns investment managers have when
they are being candid Bond houses worry about
how to cope with the crash in bond prices that we
believe is inevitable in the future Active
managers worry whether itrsquos too late to enter the
index ETF business ndash or whether they should try
to structure their active funds as ETFs Many
managers are struggling to create innovative
products ndash risk-hedged funds absolute return
strategies pension-friendly structures ndash in a world
where their revenues have stagnated and so RampD
budgets have been cut
The global investment industry today
Before we try to draw out some threads from the
10 trends in investment management we have
identified some background
4 Assets under management (USDtrn end-2010)
Insurance
funds 246
Pension
funds 299
HFs 18
SWFs 42
ETFs 13
Mutual
funds 247
PE 26
Source TheCityUK estimates
How big is the global investment industry
Conventional assets (pension funds mutual funds
10
Multi Asset Strategy Global September 2012
abc
and insurance) total about USD80trn split
roughly evenly between the three (Chart 4) The
AUM of these institutions has doubled since
2000 Hedge funds manage around USD2trn and
private equity funds a little more than that Add to
this sovereign wealth funds which in their pure
form have assets of about USD5trn include FX
reserve managers and other sovereign institutions
(such as national pensions or development funds)
and the total reaches about USD20trn ETFs
comprise another USD15trn or so Private wealth
is harder to figure out various estimates put it at
between USD26trn and USD120trn At the top
end of estimates the total amount of money
available for investment firms to manage exceeds
USD200trn ndash almost 3x global GDP
The US is still the largest source of funds with
USD35trn out of the USD79trn in conventional
assets globally (Chart 5) That is 224 of US GDP
The UK though much smaller in absolute terms at
USD65trn is the biggest in proportion to GDP with
conventional funds representing 257 of GDP
(although some of that comes from money
domiciled in the UK but not from UK nationals)
5 Source of conventional assets by country (USDtrn)
05
10152025303540
US
UK
Japa
n
Fran
ce
Ger
man
y NL
Switz
Oth
er
Pension funds Insurance assets Mutual funds
Source TheCityUK estimates based on OECD Investment Company SwissRe and UBS data (Figures are for domestically sourced funds regardless of where they are managed No reliable comparisons are available for total funds under management buy country)
hellipand the chances of it growing
There is no reason to suppose that the rate of
growth of institutional assets will slow over the
coming years Over the past decade conventional
assets have grown at a compound annual rate of
71 While it is likely in our view that global
economic growth will be lacklustre in coming
years as the after-effects of the Global Financial
Crisis are worked off this does not mean that
global savings will be stagnant Indeed quite the
opposite Households and companies are likely to
increase their savings as they stay risk averse (and
governments are likely to reduce fiscal deficits
albeit slowly)
The IMF projects that US and UK gross national
savings which have already improved modestly
since 2009 (to 129 of GDP from 115 in the
case of the US) will continue to increase over the
next five years with the US reaching 178 by 2017
(Chart 6) China meanwhile is unlikely to reduce its
savings rate much despite efforts to get households
to spend Australia has already made some headway
in raising its savings rate since its bubble in the early
2000s Japan is the only major economy where the
ratio may fall as retirees start to eat into their
savings All this suggests that the savings glut which
drove the fall in interest rates and strong equity
performance in 2003-7 will not disappear
6 Gross national savings rate selected countries ( of GDP)
0
10
20
30
40
50
60
80 85 90 95 00 05 10 15
UK US AU CH JP
F
Source IMF
And at the same time as savings grow companies in
the developed world are unlikely to need to raise
much money for the next few years Corporate cash
holdings are at record highs especially in the US
and companies are being cautious about capex
11
Multi Asset Strategy Global September 2012
abc
Dividend payout ratios are very low (31 in the US
last year for instance) This suggests that large listed
companies at least will not need to raise much
capital either debt or equity for the next few years ndash
although capital-hungry emerging markets
companies of course will
As countries get richer they tend to increase the
amount of institutional assets under management
and increase the amount invested in equities and
bonds (rather than placed in bank deposits) as
shown in Charts 7 and 8
7 Increasing wealth brings growth in institutional assets
0102030405060708090
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in institutional assets
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
8 hellipamid withdrawals from bank deposits
0
10
20
30
40
50
60
70
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in bank deposits
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
This suggests that as long as emerging markets
continue to develop (which in most cases we think
likely) then not only should the pool of potential
savings grow but the proportion of the pool
available for international investment institutions
to manage should grow even faster Not that this
will be without challenges how do London or
New York-based investment managers get access
to wealth held in China or India which is still
highly restricted in where it can invest and mostly
off limits to them
Indeed a well-read report by the McKinsey
Global Institute The emerging equity gap Growth
and stability in the new investors landscape
December 2011 argued that the growth of
international securities ownership by emerging
market investors will be essential if the role of
equities in the global financial system is not to be
reduced in the coming decades In particular
emerging market investors will need to triple their
allocation to equities if companies in these
countries are not to be starved of equity capital
Common threads
In this report we highlight the 10 trends that we
think will drive the investment management industry
over the next few years Understanding these trends
ndash and considering their implications ndash will be
important both for investment institutions in
planning their strategies and for investors interested
in the impact of these trends on asset prices
12
Multi Asset Strategy Global September 2012
abc
Inevitably there are some overlaps between the
10 trends Broadly we see three threads running
between them
The search for income With interest rates so
low investors are desperate to generate
income This has triggered demand for credit
and high dividend yield equities which we
expect to continue It is also forcing investors
to consider whether they are overpaying for
liquidity and to look at harvesting a premium
for investing in illiquid instruments such as
infrastructure and ldquoprivate debtrdquo funds
Tailoring risk Modern derivative techniques
make it possible to tailor risk to an extent
Investors scared of drawdowns can hedge fat-
tail risk Fixing a return is not possible (except
for a very low return) tailoring a level of risk
may be easier This concept has spawned the
development of risk parity funds and a boom in
multi-asset absolute return funds
A continuing shift from active to passive
Academic evidence strongly suggests that
active equity fund managers in aggregate
underperform their benchmarks That has
pushed investors over the past decade from
active to passive funds especially ETFs ndash a
trend we expect to continue It is also forcing
a rethink of the role of hedge funds which
have grown so large that in aggregate they no
longer seem to be able to produce superior
performance either
In the following sections we describe in detail the
10 trends we have identified and analyse their
implications for asset prices
13
Multi Asset Strategy Global September 2012
abc
hellipin credit and dividends With cash yielding zero and top-quality
government bonds little more than 15 it is
unsurprising that investors are scrambling to pick
up yield Indeed one could even say that the
market has become obsessed with income
1 Cumulative net flows to bond funds worldwide by type
-100
-50
0
50
100
150
200
250
300
07 08 09 10 11 12
USD
bn
Gov tCreditOther
Source EPFR (ldquoOtherrdquo includes muni funds MBS funds total return bonds and funds able to invest in a mix of bond types)
Look at flows into bond mutual funds recently It
is well known that these have been very healthy
totalling USD580bn over the past three years
according to EPFR But for the past 12 months at
least bonds flows have been predominantly into
credit funds (for example corporate high yield or
EM bond funds) with even a small net outflow
from government bond funds (Chart 1)
The sort of funds selling well is clear from the list
of the largest fund launches year-to-date The top
20 new US-based funds ranked by assets under
management now (Table 2 overleaf) include 10
bond funds two asset allocation funds and only
eight with an equity focus (remember this is for
the heavily equity-centric US market) Three of
the best-selling funds include the word ldquoincomerdquo
in their names
Credit is in a sweet spot Interest rates at which
corporates can issue are at historic lows But at
the same time spreads over US Treasuries are
quite high making the bonds attractive for
investors too
In the US for example BBB-rated five-year
corporate bonds currently yield only about 28 ndash
the lowest for decades ndash but that represents a spread
over Treasuries of around 200bp well above the
average of 130bp from the 2003-7 period (Chart 3)
The same is true in emerging markets The HSBC
Asian Dollar Bond Index (Chart 4) currently has a
record low yield of 37 but the spread over
Treasuries is a still attractive 300bp
This is why lots of bonds have been issued this
year August for example with over USD120bn
of issuance according to Dealogic was the highest
August on record and more than double the
USD58bn average for August Sub investment
The search for yield
With risk-free rates so low investors are desperate for income
Credit is in a sweet spot with issuers enjoying record low
borrowing costs but investors finding decent spreads
We think dividend yield stocks remain attractive too
14
Multi Asset Strategy Global September 2012
abc
grade issuance in August totalled USD27bn up
from USD13bn the same month in 2011
3 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
Source Bloomberg
Investors are clearly now having to take more risk
to get yield Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield One
example is bonds from riskier emerging markets
Ten-year paper from the Philippines a BB-rated
issuer now yields only 25 Investors have been
buying bonds from countries such as Gabon
Belarus Nigeria and Vietnam But five-year
bonds even from Gabon (BB-rated) now yield
only 38 You have to stretch to Belarus (B-) to
get a decent yield just over 10
4 HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source HSBC
This could all go very wrong Credit spreads are
supposed to compensate investors for the
probability of default At the investment grade
part of the credit spectrum defaults are rare but at
the sub-investment grade end they are less so At
present the combination of low rates on high
quality government bonds and relatively wider
credit spreads combined with very low default
rates places credit in a sweet spot compared to
some other assets classes However in an
2 Largest mutual funds launched in the US this year
Ticker Name Manager Inception date
Asset class Objective AUM (USDbn)
TGIRX US Intl Value Fund Thornburg 512012 Equity International Equity 265 OIBIX US Intl Bond Fund Oppenheimer 1272012 Debt International Debt 126 WAPRX US Core Plus Fund Western Asset 512012 Debt GovtCorp Intermediate 96 OSIIX US Global Strategic Income Fund Oppenheimer 1272012 Debt GovernmentCorporate 86 OGLIX US Global Fund Oppenheimer 1272012 Equity Global Equity 83 PSTQX US Short Term Corp Bond Fnd Pridential 322012 Debt CorporatePreferred-Inv Grade 80 AEMSX US Emerging Markets Fund Aberdeen 2272012 Equity Emerging Market-Equity 75 OIGIX US Intl Growth Fund Oppenheimer 4272012 Equity International Equity 62 MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6152012 Equity Growth-Mid Cap 60 MSFKX US Total Return Fund MFS 612012 Asset Allocation Balanced 58 PEFAX US EM Fundamental IndexPLUS Pimco 5312012 Debt Index Fund-Debt 54 CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund Columbia 4202012 Debt GovernmentCorporate 47
OBBCX US Mortgage Backed Securities Fund JP Morgan 722012 Debt Asset Backed Securities 41 JQLAX US Life Aggressive Fund John Hancock 312012 Asset Allocation Flexible Portfolio 37 OEIIX US Equity Income Fund Oppenheimer 4272012 Equity Value-Large Cap 33 MIDLX US Intl New Discovery Fund MFS 612012 Equity International Equity 32 JIPPX US Strategic Income Opportunities Fund John Hancock 312012 Debt Global Debt 31 WABRX US Core Bond Fund Western Asset 512012 Debt GovtCorp Intermediate 30 MFBKX US Bond Fund MFS 612012 Debt GovernmentCorporate 28 JDVPX US Disciplined Value Fund John Hancock 2292012 Equity Value-Large Cap 28
Source Bloomberg
15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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ESP 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FRA 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7
Multi Asset Strategy Global September 2012
abc
Cyclical or evolutionary We are in a very unusual investment world
Interest rates are at historical lows equities more
volatile than normal different assets classes
abnormally correlated (the ldquorisk on-risk offrdquo
phenomenon) and demographics are altering
savings patterns in rich countries
These developments have already caused a big
shift in investment flows over the past five years
Investors have
Sold equities and bought bonds in huge
volumes in the US since end-2007 bond
mutual funds have seen inflows of USD920bn
and equity funds outflows of USD430bn
Loaded up on risk-free assets But the supply
of these has shrunk (according to the BIS
AAA-rated government paper now totals only
USD12trn compared to USD26trn in early
2011 ndash Chart 1) This has pushed down their
nominal yields to below zero in some cases
Increasingly understood that active equity
fund managers in aggregate underperform
benchmarks (even before fees) and so moved
heavily into index funds and ETFs
Searched for new ways other than equities to
achieve a decent return without too much risk
This has led to the development of absolute
return (or diversified beta) funds and risk-
minimising strategies
1 Credit risk of pool of government debt
0
5
10
15
20
25
30
35
40
01 02 03 04 05 06 07 08 09 10 11
AA to below AA+AA+ to below AAAAAA
Source BIS (Ratings used are the simple averages of the long-term foreign currency sovereign ratings from Fitch Moodyrsquos and SampP)
Is this a permanent structural change or will we
eventually go back to the old normal Probably a
bit of both The side-effects of the 2007-9 Global
Financial Crisis will eventually wear off (though
Introduction an unusual world
Low rates high volatility high correlation ndash the world has changed
Fund managers are struggling to cope how to find returns without
too much risk and provide solutions to investors with new needs
We indentify three threads the search for income tailoring risk
and the continuing shift from active to passive
Garry Evans Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6916 garryevanshsbccomhk
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registered qualified pursuant to FINRA regulations
8
Multi Asset Strategy Global September 2012
abc
this may take a few more years) with interest
rates volatility and correlations returning to their
historical norms
But there has been some evolution too Investorsrsquo
behaviour is likely to have changed permanently
Investors will increasingly question whether
hedge funds can generate alpha and whether
they deserve fees of 2 and 20 even if
they can
Retail investors will demand access to the sort
of absolute return strategies that hedge
funds previously specialised in ndash and at a
reasonable cost
There will be more demand for solutions
whether liability-matched investments for a
defined benefit (DB) pension fund that is
winding down or a ldquoto-and-throughrdquo
personal pension plan for an individual due
to retire in five years who wants to fix
post-retirement income
Interest in buying stocks in companies with a
strong ESG (environmental social and
governance) record will increase This is not
idealistic green talk ndash after all who wants to
own a company with poor corporate
governance or which treats its staff badly
Many of these themes are fairly obvious and have
been under way for a number of years But how
the fund management industry will be affected by
them is not yet at all obvious Like any business
an investment management firm has to pick a
strategy should it rush into all these new areas
(ETFs absolute return funds pension solutions
ESG) or should it decide to focus Is it better to
be a large global investment house or a focused
boutique ndash or hedge onersquos bets by becoming a
multi-boutique umbrella organisation
These trends will affect asset prices too If
investors abandon equities for a generation PE
multiples would contract further as they did in the
1970s or after the Great Depression Further
growth in ETFs and index products could push
correlations up further A rise in demand for
alternative assets (infrastructure financing
distressed debt derivative structures) could shift
the prices of these assets As banks in Europe
deleverage infrastructure lending leasing and
other forms of long-term finance could pass to
institutional investors in a form of
disintermediation which could bring down
borrowing costs
2 Demographic trends of population aged 35-54 in DM 3 Demographic trends of population aged 35-54 in EM
20
22
24
26
28
30
1990 2000 2010 2020 2030 2040 2050
Dev eloped markets
20212223242526272829
1990 2010 2030 2050
Emerging
Source HSBC UN Population Division NB MSCI World markets Source HSBC UN Population Division
9
Multi Asset Strategy Global September 2012
abc
Why this matters
This is a topic that HSBCrsquos strategy team has
tackled before We believe that understanding the
deep underlying trends in investment are
important for asset allocation It is too easy to get
caught up in the day-to-day vicissitudes of the
economic cycle Thinking about long-term
drivers such as demographics changes in wealth
or market micro-dynamics can help improve
investment decision-making
Earlier this year for example we published a
report (Who will buy by Daniel Grosvenor 3
February 2012) which argued that demand for
equities is likely to remain structurally weak due
to prolonged risk aversion regulatory changes and
deteriorating demographics In particular ageing
populations in the developed world (Chart 2) will
tend to own fewer equities This the report
argued could keep DM valuations depressed but
EM should be immune (partly because of its
better demographics ndash Chart 3)
We also described the growing importance of
emerging markets investors in Asia buys Asia by
Herald van der Linde and Devendra Joshi June
2012 Asian equity markets have traditionally been
dominated by foreign investors or speculative local
individuals But this is changing as Asians diversify
their wealth into financial assets and pension
systems develop across the region
Our colleagues in quantitative strategy have also
looked at the risk on-risk off phenomenon (their
latest report is Risk On ndash Risk Off Fixing a
broken investment process by Stacy Williams
Daniel Fenn and Mark McDonald April 2012)
They suggest ways in which fund managers can
adapt their investment process to cope with the
phenomenon and take advantage of it
For this present report we met with CEOs chief
investment officers and senior business managers
at almost 20 investment firms in the US and
Europe These ranged from niche long-only equity
specialists to opportunistic macro hedge funds
from major ETF providers to large global multi-
asset investment managers Naturally most of the
senior managers had a bias based on what they
specialised in equity houses tend to believe that
actively managed equity will come back and
passive specialists argue that in future everything
will be indexed
But our conversations gave us a good idea of the
sort of concerns investment managers have when
they are being candid Bond houses worry about
how to cope with the crash in bond prices that we
believe is inevitable in the future Active
managers worry whether itrsquos too late to enter the
index ETF business ndash or whether they should try
to structure their active funds as ETFs Many
managers are struggling to create innovative
products ndash risk-hedged funds absolute return
strategies pension-friendly structures ndash in a world
where their revenues have stagnated and so RampD
budgets have been cut
The global investment industry today
Before we try to draw out some threads from the
10 trends in investment management we have
identified some background
4 Assets under management (USDtrn end-2010)
Insurance
funds 246
Pension
funds 299
HFs 18
SWFs 42
ETFs 13
Mutual
funds 247
PE 26
Source TheCityUK estimates
How big is the global investment industry
Conventional assets (pension funds mutual funds
10
Multi Asset Strategy Global September 2012
abc
and insurance) total about USD80trn split
roughly evenly between the three (Chart 4) The
AUM of these institutions has doubled since
2000 Hedge funds manage around USD2trn and
private equity funds a little more than that Add to
this sovereign wealth funds which in their pure
form have assets of about USD5trn include FX
reserve managers and other sovereign institutions
(such as national pensions or development funds)
and the total reaches about USD20trn ETFs
comprise another USD15trn or so Private wealth
is harder to figure out various estimates put it at
between USD26trn and USD120trn At the top
end of estimates the total amount of money
available for investment firms to manage exceeds
USD200trn ndash almost 3x global GDP
The US is still the largest source of funds with
USD35trn out of the USD79trn in conventional
assets globally (Chart 5) That is 224 of US GDP
The UK though much smaller in absolute terms at
USD65trn is the biggest in proportion to GDP with
conventional funds representing 257 of GDP
(although some of that comes from money
domiciled in the UK but not from UK nationals)
5 Source of conventional assets by country (USDtrn)
05
10152025303540
US
UK
Japa
n
Fran
ce
Ger
man
y NL
Switz
Oth
er
Pension funds Insurance assets Mutual funds
Source TheCityUK estimates based on OECD Investment Company SwissRe and UBS data (Figures are for domestically sourced funds regardless of where they are managed No reliable comparisons are available for total funds under management buy country)
hellipand the chances of it growing
There is no reason to suppose that the rate of
growth of institutional assets will slow over the
coming years Over the past decade conventional
assets have grown at a compound annual rate of
71 While it is likely in our view that global
economic growth will be lacklustre in coming
years as the after-effects of the Global Financial
Crisis are worked off this does not mean that
global savings will be stagnant Indeed quite the
opposite Households and companies are likely to
increase their savings as they stay risk averse (and
governments are likely to reduce fiscal deficits
albeit slowly)
The IMF projects that US and UK gross national
savings which have already improved modestly
since 2009 (to 129 of GDP from 115 in the
case of the US) will continue to increase over the
next five years with the US reaching 178 by 2017
(Chart 6) China meanwhile is unlikely to reduce its
savings rate much despite efforts to get households
to spend Australia has already made some headway
in raising its savings rate since its bubble in the early
2000s Japan is the only major economy where the
ratio may fall as retirees start to eat into their
savings All this suggests that the savings glut which
drove the fall in interest rates and strong equity
performance in 2003-7 will not disappear
6 Gross national savings rate selected countries ( of GDP)
0
10
20
30
40
50
60
80 85 90 95 00 05 10 15
UK US AU CH JP
F
Source IMF
And at the same time as savings grow companies in
the developed world are unlikely to need to raise
much money for the next few years Corporate cash
holdings are at record highs especially in the US
and companies are being cautious about capex
11
Multi Asset Strategy Global September 2012
abc
Dividend payout ratios are very low (31 in the US
last year for instance) This suggests that large listed
companies at least will not need to raise much
capital either debt or equity for the next few years ndash
although capital-hungry emerging markets
companies of course will
As countries get richer they tend to increase the
amount of institutional assets under management
and increase the amount invested in equities and
bonds (rather than placed in bank deposits) as
shown in Charts 7 and 8
7 Increasing wealth brings growth in institutional assets
0102030405060708090
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in institutional assets
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
8 hellipamid withdrawals from bank deposits
0
10
20
30
40
50
60
70
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in bank deposits
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
This suggests that as long as emerging markets
continue to develop (which in most cases we think
likely) then not only should the pool of potential
savings grow but the proportion of the pool
available for international investment institutions
to manage should grow even faster Not that this
will be without challenges how do London or
New York-based investment managers get access
to wealth held in China or India which is still
highly restricted in where it can invest and mostly
off limits to them
Indeed a well-read report by the McKinsey
Global Institute The emerging equity gap Growth
and stability in the new investors landscape
December 2011 argued that the growth of
international securities ownership by emerging
market investors will be essential if the role of
equities in the global financial system is not to be
reduced in the coming decades In particular
emerging market investors will need to triple their
allocation to equities if companies in these
countries are not to be starved of equity capital
Common threads
In this report we highlight the 10 trends that we
think will drive the investment management industry
over the next few years Understanding these trends
ndash and considering their implications ndash will be
important both for investment institutions in
planning their strategies and for investors interested
in the impact of these trends on asset prices
12
Multi Asset Strategy Global September 2012
abc
Inevitably there are some overlaps between the
10 trends Broadly we see three threads running
between them
The search for income With interest rates so
low investors are desperate to generate
income This has triggered demand for credit
and high dividend yield equities which we
expect to continue It is also forcing investors
to consider whether they are overpaying for
liquidity and to look at harvesting a premium
for investing in illiquid instruments such as
infrastructure and ldquoprivate debtrdquo funds
Tailoring risk Modern derivative techniques
make it possible to tailor risk to an extent
Investors scared of drawdowns can hedge fat-
tail risk Fixing a return is not possible (except
for a very low return) tailoring a level of risk
may be easier This concept has spawned the
development of risk parity funds and a boom in
multi-asset absolute return funds
A continuing shift from active to passive
Academic evidence strongly suggests that
active equity fund managers in aggregate
underperform their benchmarks That has
pushed investors over the past decade from
active to passive funds especially ETFs ndash a
trend we expect to continue It is also forcing
a rethink of the role of hedge funds which
have grown so large that in aggregate they no
longer seem to be able to produce superior
performance either
In the following sections we describe in detail the
10 trends we have identified and analyse their
implications for asset prices
13
Multi Asset Strategy Global September 2012
abc
hellipin credit and dividends With cash yielding zero and top-quality
government bonds little more than 15 it is
unsurprising that investors are scrambling to pick
up yield Indeed one could even say that the
market has become obsessed with income
1 Cumulative net flows to bond funds worldwide by type
-100
-50
0
50
100
150
200
250
300
07 08 09 10 11 12
USD
bn
Gov tCreditOther
Source EPFR (ldquoOtherrdquo includes muni funds MBS funds total return bonds and funds able to invest in a mix of bond types)
Look at flows into bond mutual funds recently It
is well known that these have been very healthy
totalling USD580bn over the past three years
according to EPFR But for the past 12 months at
least bonds flows have been predominantly into
credit funds (for example corporate high yield or
EM bond funds) with even a small net outflow
from government bond funds (Chart 1)
The sort of funds selling well is clear from the list
of the largest fund launches year-to-date The top
20 new US-based funds ranked by assets under
management now (Table 2 overleaf) include 10
bond funds two asset allocation funds and only
eight with an equity focus (remember this is for
the heavily equity-centric US market) Three of
the best-selling funds include the word ldquoincomerdquo
in their names
Credit is in a sweet spot Interest rates at which
corporates can issue are at historic lows But at
the same time spreads over US Treasuries are
quite high making the bonds attractive for
investors too
In the US for example BBB-rated five-year
corporate bonds currently yield only about 28 ndash
the lowest for decades ndash but that represents a spread
over Treasuries of around 200bp well above the
average of 130bp from the 2003-7 period (Chart 3)
The same is true in emerging markets The HSBC
Asian Dollar Bond Index (Chart 4) currently has a
record low yield of 37 but the spread over
Treasuries is a still attractive 300bp
This is why lots of bonds have been issued this
year August for example with over USD120bn
of issuance according to Dealogic was the highest
August on record and more than double the
USD58bn average for August Sub investment
The search for yield
With risk-free rates so low investors are desperate for income
Credit is in a sweet spot with issuers enjoying record low
borrowing costs but investors finding decent spreads
We think dividend yield stocks remain attractive too
14
Multi Asset Strategy Global September 2012
abc
grade issuance in August totalled USD27bn up
from USD13bn the same month in 2011
3 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
Source Bloomberg
Investors are clearly now having to take more risk
to get yield Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield One
example is bonds from riskier emerging markets
Ten-year paper from the Philippines a BB-rated
issuer now yields only 25 Investors have been
buying bonds from countries such as Gabon
Belarus Nigeria and Vietnam But five-year
bonds even from Gabon (BB-rated) now yield
only 38 You have to stretch to Belarus (B-) to
get a decent yield just over 10
4 HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source HSBC
This could all go very wrong Credit spreads are
supposed to compensate investors for the
probability of default At the investment grade
part of the credit spectrum defaults are rare but at
the sub-investment grade end they are less so At
present the combination of low rates on high
quality government bonds and relatively wider
credit spreads combined with very low default
rates places credit in a sweet spot compared to
some other assets classes However in an
2 Largest mutual funds launched in the US this year
Ticker Name Manager Inception date
Asset class Objective AUM (USDbn)
TGIRX US Intl Value Fund Thornburg 512012 Equity International Equity 265 OIBIX US Intl Bond Fund Oppenheimer 1272012 Debt International Debt 126 WAPRX US Core Plus Fund Western Asset 512012 Debt GovtCorp Intermediate 96 OSIIX US Global Strategic Income Fund Oppenheimer 1272012 Debt GovernmentCorporate 86 OGLIX US Global Fund Oppenheimer 1272012 Equity Global Equity 83 PSTQX US Short Term Corp Bond Fnd Pridential 322012 Debt CorporatePreferred-Inv Grade 80 AEMSX US Emerging Markets Fund Aberdeen 2272012 Equity Emerging Market-Equity 75 OIGIX US Intl Growth Fund Oppenheimer 4272012 Equity International Equity 62 MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6152012 Equity Growth-Mid Cap 60 MSFKX US Total Return Fund MFS 612012 Asset Allocation Balanced 58 PEFAX US EM Fundamental IndexPLUS Pimco 5312012 Debt Index Fund-Debt 54 CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund Columbia 4202012 Debt GovernmentCorporate 47
OBBCX US Mortgage Backed Securities Fund JP Morgan 722012 Debt Asset Backed Securities 41 JQLAX US Life Aggressive Fund John Hancock 312012 Asset Allocation Flexible Portfolio 37 OEIIX US Equity Income Fund Oppenheimer 4272012 Equity Value-Large Cap 33 MIDLX US Intl New Discovery Fund MFS 612012 Equity International Equity 32 JIPPX US Strategic Income Opportunities Fund John Hancock 312012 Debt Global Debt 31 WABRX US Core Bond Fund Western Asset 512012 Debt GovtCorp Intermediate 30 MFBKX US Bond Fund MFS 612012 Debt GovernmentCorporate 28 JDVPX US Disciplined Value Fund John Hancock 2292012 Equity Value-Large Cap 28
Source Bloomberg
15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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8
Multi Asset Strategy Global September 2012
abc
this may take a few more years) with interest
rates volatility and correlations returning to their
historical norms
But there has been some evolution too Investorsrsquo
behaviour is likely to have changed permanently
Investors will increasingly question whether
hedge funds can generate alpha and whether
they deserve fees of 2 and 20 even if
they can
Retail investors will demand access to the sort
of absolute return strategies that hedge
funds previously specialised in ndash and at a
reasonable cost
There will be more demand for solutions
whether liability-matched investments for a
defined benefit (DB) pension fund that is
winding down or a ldquoto-and-throughrdquo
personal pension plan for an individual due
to retire in five years who wants to fix
post-retirement income
Interest in buying stocks in companies with a
strong ESG (environmental social and
governance) record will increase This is not
idealistic green talk ndash after all who wants to
own a company with poor corporate
governance or which treats its staff badly
Many of these themes are fairly obvious and have
been under way for a number of years But how
the fund management industry will be affected by
them is not yet at all obvious Like any business
an investment management firm has to pick a
strategy should it rush into all these new areas
(ETFs absolute return funds pension solutions
ESG) or should it decide to focus Is it better to
be a large global investment house or a focused
boutique ndash or hedge onersquos bets by becoming a
multi-boutique umbrella organisation
These trends will affect asset prices too If
investors abandon equities for a generation PE
multiples would contract further as they did in the
1970s or after the Great Depression Further
growth in ETFs and index products could push
correlations up further A rise in demand for
alternative assets (infrastructure financing
distressed debt derivative structures) could shift
the prices of these assets As banks in Europe
deleverage infrastructure lending leasing and
other forms of long-term finance could pass to
institutional investors in a form of
disintermediation which could bring down
borrowing costs
2 Demographic trends of population aged 35-54 in DM 3 Demographic trends of population aged 35-54 in EM
20
22
24
26
28
30
1990 2000 2010 2020 2030 2040 2050
Dev eloped markets
20212223242526272829
1990 2010 2030 2050
Emerging
Source HSBC UN Population Division NB MSCI World markets Source HSBC UN Population Division
9
Multi Asset Strategy Global September 2012
abc
Why this matters
This is a topic that HSBCrsquos strategy team has
tackled before We believe that understanding the
deep underlying trends in investment are
important for asset allocation It is too easy to get
caught up in the day-to-day vicissitudes of the
economic cycle Thinking about long-term
drivers such as demographics changes in wealth
or market micro-dynamics can help improve
investment decision-making
Earlier this year for example we published a
report (Who will buy by Daniel Grosvenor 3
February 2012) which argued that demand for
equities is likely to remain structurally weak due
to prolonged risk aversion regulatory changes and
deteriorating demographics In particular ageing
populations in the developed world (Chart 2) will
tend to own fewer equities This the report
argued could keep DM valuations depressed but
EM should be immune (partly because of its
better demographics ndash Chart 3)
We also described the growing importance of
emerging markets investors in Asia buys Asia by
Herald van der Linde and Devendra Joshi June
2012 Asian equity markets have traditionally been
dominated by foreign investors or speculative local
individuals But this is changing as Asians diversify
their wealth into financial assets and pension
systems develop across the region
Our colleagues in quantitative strategy have also
looked at the risk on-risk off phenomenon (their
latest report is Risk On ndash Risk Off Fixing a
broken investment process by Stacy Williams
Daniel Fenn and Mark McDonald April 2012)
They suggest ways in which fund managers can
adapt their investment process to cope with the
phenomenon and take advantage of it
For this present report we met with CEOs chief
investment officers and senior business managers
at almost 20 investment firms in the US and
Europe These ranged from niche long-only equity
specialists to opportunistic macro hedge funds
from major ETF providers to large global multi-
asset investment managers Naturally most of the
senior managers had a bias based on what they
specialised in equity houses tend to believe that
actively managed equity will come back and
passive specialists argue that in future everything
will be indexed
But our conversations gave us a good idea of the
sort of concerns investment managers have when
they are being candid Bond houses worry about
how to cope with the crash in bond prices that we
believe is inevitable in the future Active
managers worry whether itrsquos too late to enter the
index ETF business ndash or whether they should try
to structure their active funds as ETFs Many
managers are struggling to create innovative
products ndash risk-hedged funds absolute return
strategies pension-friendly structures ndash in a world
where their revenues have stagnated and so RampD
budgets have been cut
The global investment industry today
Before we try to draw out some threads from the
10 trends in investment management we have
identified some background
4 Assets under management (USDtrn end-2010)
Insurance
funds 246
Pension
funds 299
HFs 18
SWFs 42
ETFs 13
Mutual
funds 247
PE 26
Source TheCityUK estimates
How big is the global investment industry
Conventional assets (pension funds mutual funds
10
Multi Asset Strategy Global September 2012
abc
and insurance) total about USD80trn split
roughly evenly between the three (Chart 4) The
AUM of these institutions has doubled since
2000 Hedge funds manage around USD2trn and
private equity funds a little more than that Add to
this sovereign wealth funds which in their pure
form have assets of about USD5trn include FX
reserve managers and other sovereign institutions
(such as national pensions or development funds)
and the total reaches about USD20trn ETFs
comprise another USD15trn or so Private wealth
is harder to figure out various estimates put it at
between USD26trn and USD120trn At the top
end of estimates the total amount of money
available for investment firms to manage exceeds
USD200trn ndash almost 3x global GDP
The US is still the largest source of funds with
USD35trn out of the USD79trn in conventional
assets globally (Chart 5) That is 224 of US GDP
The UK though much smaller in absolute terms at
USD65trn is the biggest in proportion to GDP with
conventional funds representing 257 of GDP
(although some of that comes from money
domiciled in the UK but not from UK nationals)
5 Source of conventional assets by country (USDtrn)
05
10152025303540
US
UK
Japa
n
Fran
ce
Ger
man
y NL
Switz
Oth
er
Pension funds Insurance assets Mutual funds
Source TheCityUK estimates based on OECD Investment Company SwissRe and UBS data (Figures are for domestically sourced funds regardless of where they are managed No reliable comparisons are available for total funds under management buy country)
hellipand the chances of it growing
There is no reason to suppose that the rate of
growth of institutional assets will slow over the
coming years Over the past decade conventional
assets have grown at a compound annual rate of
71 While it is likely in our view that global
economic growth will be lacklustre in coming
years as the after-effects of the Global Financial
Crisis are worked off this does not mean that
global savings will be stagnant Indeed quite the
opposite Households and companies are likely to
increase their savings as they stay risk averse (and
governments are likely to reduce fiscal deficits
albeit slowly)
The IMF projects that US and UK gross national
savings which have already improved modestly
since 2009 (to 129 of GDP from 115 in the
case of the US) will continue to increase over the
next five years with the US reaching 178 by 2017
(Chart 6) China meanwhile is unlikely to reduce its
savings rate much despite efforts to get households
to spend Australia has already made some headway
in raising its savings rate since its bubble in the early
2000s Japan is the only major economy where the
ratio may fall as retirees start to eat into their
savings All this suggests that the savings glut which
drove the fall in interest rates and strong equity
performance in 2003-7 will not disappear
6 Gross national savings rate selected countries ( of GDP)
0
10
20
30
40
50
60
80 85 90 95 00 05 10 15
UK US AU CH JP
F
Source IMF
And at the same time as savings grow companies in
the developed world are unlikely to need to raise
much money for the next few years Corporate cash
holdings are at record highs especially in the US
and companies are being cautious about capex
11
Multi Asset Strategy Global September 2012
abc
Dividend payout ratios are very low (31 in the US
last year for instance) This suggests that large listed
companies at least will not need to raise much
capital either debt or equity for the next few years ndash
although capital-hungry emerging markets
companies of course will
As countries get richer they tend to increase the
amount of institutional assets under management
and increase the amount invested in equities and
bonds (rather than placed in bank deposits) as
shown in Charts 7 and 8
7 Increasing wealth brings growth in institutional assets
0102030405060708090
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in institutional assets
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
8 hellipamid withdrawals from bank deposits
0
10
20
30
40
50
60
70
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in bank deposits
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
This suggests that as long as emerging markets
continue to develop (which in most cases we think
likely) then not only should the pool of potential
savings grow but the proportion of the pool
available for international investment institutions
to manage should grow even faster Not that this
will be without challenges how do London or
New York-based investment managers get access
to wealth held in China or India which is still
highly restricted in where it can invest and mostly
off limits to them
Indeed a well-read report by the McKinsey
Global Institute The emerging equity gap Growth
and stability in the new investors landscape
December 2011 argued that the growth of
international securities ownership by emerging
market investors will be essential if the role of
equities in the global financial system is not to be
reduced in the coming decades In particular
emerging market investors will need to triple their
allocation to equities if companies in these
countries are not to be starved of equity capital
Common threads
In this report we highlight the 10 trends that we
think will drive the investment management industry
over the next few years Understanding these trends
ndash and considering their implications ndash will be
important both for investment institutions in
planning their strategies and for investors interested
in the impact of these trends on asset prices
12
Multi Asset Strategy Global September 2012
abc
Inevitably there are some overlaps between the
10 trends Broadly we see three threads running
between them
The search for income With interest rates so
low investors are desperate to generate
income This has triggered demand for credit
and high dividend yield equities which we
expect to continue It is also forcing investors
to consider whether they are overpaying for
liquidity and to look at harvesting a premium
for investing in illiquid instruments such as
infrastructure and ldquoprivate debtrdquo funds
Tailoring risk Modern derivative techniques
make it possible to tailor risk to an extent
Investors scared of drawdowns can hedge fat-
tail risk Fixing a return is not possible (except
for a very low return) tailoring a level of risk
may be easier This concept has spawned the
development of risk parity funds and a boom in
multi-asset absolute return funds
A continuing shift from active to passive
Academic evidence strongly suggests that
active equity fund managers in aggregate
underperform their benchmarks That has
pushed investors over the past decade from
active to passive funds especially ETFs ndash a
trend we expect to continue It is also forcing
a rethink of the role of hedge funds which
have grown so large that in aggregate they no
longer seem to be able to produce superior
performance either
In the following sections we describe in detail the
10 trends we have identified and analyse their
implications for asset prices
13
Multi Asset Strategy Global September 2012
abc
hellipin credit and dividends With cash yielding zero and top-quality
government bonds little more than 15 it is
unsurprising that investors are scrambling to pick
up yield Indeed one could even say that the
market has become obsessed with income
1 Cumulative net flows to bond funds worldwide by type
-100
-50
0
50
100
150
200
250
300
07 08 09 10 11 12
USD
bn
Gov tCreditOther
Source EPFR (ldquoOtherrdquo includes muni funds MBS funds total return bonds and funds able to invest in a mix of bond types)
Look at flows into bond mutual funds recently It
is well known that these have been very healthy
totalling USD580bn over the past three years
according to EPFR But for the past 12 months at
least bonds flows have been predominantly into
credit funds (for example corporate high yield or
EM bond funds) with even a small net outflow
from government bond funds (Chart 1)
The sort of funds selling well is clear from the list
of the largest fund launches year-to-date The top
20 new US-based funds ranked by assets under
management now (Table 2 overleaf) include 10
bond funds two asset allocation funds and only
eight with an equity focus (remember this is for
the heavily equity-centric US market) Three of
the best-selling funds include the word ldquoincomerdquo
in their names
Credit is in a sweet spot Interest rates at which
corporates can issue are at historic lows But at
the same time spreads over US Treasuries are
quite high making the bonds attractive for
investors too
In the US for example BBB-rated five-year
corporate bonds currently yield only about 28 ndash
the lowest for decades ndash but that represents a spread
over Treasuries of around 200bp well above the
average of 130bp from the 2003-7 period (Chart 3)
The same is true in emerging markets The HSBC
Asian Dollar Bond Index (Chart 4) currently has a
record low yield of 37 but the spread over
Treasuries is a still attractive 300bp
This is why lots of bonds have been issued this
year August for example with over USD120bn
of issuance according to Dealogic was the highest
August on record and more than double the
USD58bn average for August Sub investment
The search for yield
With risk-free rates so low investors are desperate for income
Credit is in a sweet spot with issuers enjoying record low
borrowing costs but investors finding decent spreads
We think dividend yield stocks remain attractive too
14
Multi Asset Strategy Global September 2012
abc
grade issuance in August totalled USD27bn up
from USD13bn the same month in 2011
3 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
Source Bloomberg
Investors are clearly now having to take more risk
to get yield Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield One
example is bonds from riskier emerging markets
Ten-year paper from the Philippines a BB-rated
issuer now yields only 25 Investors have been
buying bonds from countries such as Gabon
Belarus Nigeria and Vietnam But five-year
bonds even from Gabon (BB-rated) now yield
only 38 You have to stretch to Belarus (B-) to
get a decent yield just over 10
4 HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source HSBC
This could all go very wrong Credit spreads are
supposed to compensate investors for the
probability of default At the investment grade
part of the credit spectrum defaults are rare but at
the sub-investment grade end they are less so At
present the combination of low rates on high
quality government bonds and relatively wider
credit spreads combined with very low default
rates places credit in a sweet spot compared to
some other assets classes However in an
2 Largest mutual funds launched in the US this year
Ticker Name Manager Inception date
Asset class Objective AUM (USDbn)
TGIRX US Intl Value Fund Thornburg 512012 Equity International Equity 265 OIBIX US Intl Bond Fund Oppenheimer 1272012 Debt International Debt 126 WAPRX US Core Plus Fund Western Asset 512012 Debt GovtCorp Intermediate 96 OSIIX US Global Strategic Income Fund Oppenheimer 1272012 Debt GovernmentCorporate 86 OGLIX US Global Fund Oppenheimer 1272012 Equity Global Equity 83 PSTQX US Short Term Corp Bond Fnd Pridential 322012 Debt CorporatePreferred-Inv Grade 80 AEMSX US Emerging Markets Fund Aberdeen 2272012 Equity Emerging Market-Equity 75 OIGIX US Intl Growth Fund Oppenheimer 4272012 Equity International Equity 62 MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6152012 Equity Growth-Mid Cap 60 MSFKX US Total Return Fund MFS 612012 Asset Allocation Balanced 58 PEFAX US EM Fundamental IndexPLUS Pimco 5312012 Debt Index Fund-Debt 54 CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund Columbia 4202012 Debt GovernmentCorporate 47
OBBCX US Mortgage Backed Securities Fund JP Morgan 722012 Debt Asset Backed Securities 41 JQLAX US Life Aggressive Fund John Hancock 312012 Asset Allocation Flexible Portfolio 37 OEIIX US Equity Income Fund Oppenheimer 4272012 Equity Value-Large Cap 33 MIDLX US Intl New Discovery Fund MFS 612012 Equity International Equity 32 JIPPX US Strategic Income Opportunities Fund John Hancock 312012 Debt Global Debt 31 WABRX US Core Bond Fund Western Asset 512012 Debt GovtCorp Intermediate 30 MFBKX US Bond Fund MFS 612012 Debt GovernmentCorporate 28 JDVPX US Disciplined Value Fund John Hancock 2292012 Equity Value-Large Cap 28
Source Bloomberg
15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign 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publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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9
Multi Asset Strategy Global September 2012
abc
Why this matters
This is a topic that HSBCrsquos strategy team has
tackled before We believe that understanding the
deep underlying trends in investment are
important for asset allocation It is too easy to get
caught up in the day-to-day vicissitudes of the
economic cycle Thinking about long-term
drivers such as demographics changes in wealth
or market micro-dynamics can help improve
investment decision-making
Earlier this year for example we published a
report (Who will buy by Daniel Grosvenor 3
February 2012) which argued that demand for
equities is likely to remain structurally weak due
to prolonged risk aversion regulatory changes and
deteriorating demographics In particular ageing
populations in the developed world (Chart 2) will
tend to own fewer equities This the report
argued could keep DM valuations depressed but
EM should be immune (partly because of its
better demographics ndash Chart 3)
We also described the growing importance of
emerging markets investors in Asia buys Asia by
Herald van der Linde and Devendra Joshi June
2012 Asian equity markets have traditionally been
dominated by foreign investors or speculative local
individuals But this is changing as Asians diversify
their wealth into financial assets and pension
systems develop across the region
Our colleagues in quantitative strategy have also
looked at the risk on-risk off phenomenon (their
latest report is Risk On ndash Risk Off Fixing a
broken investment process by Stacy Williams
Daniel Fenn and Mark McDonald April 2012)
They suggest ways in which fund managers can
adapt their investment process to cope with the
phenomenon and take advantage of it
For this present report we met with CEOs chief
investment officers and senior business managers
at almost 20 investment firms in the US and
Europe These ranged from niche long-only equity
specialists to opportunistic macro hedge funds
from major ETF providers to large global multi-
asset investment managers Naturally most of the
senior managers had a bias based on what they
specialised in equity houses tend to believe that
actively managed equity will come back and
passive specialists argue that in future everything
will be indexed
But our conversations gave us a good idea of the
sort of concerns investment managers have when
they are being candid Bond houses worry about
how to cope with the crash in bond prices that we
believe is inevitable in the future Active
managers worry whether itrsquos too late to enter the
index ETF business ndash or whether they should try
to structure their active funds as ETFs Many
managers are struggling to create innovative
products ndash risk-hedged funds absolute return
strategies pension-friendly structures ndash in a world
where their revenues have stagnated and so RampD
budgets have been cut
The global investment industry today
Before we try to draw out some threads from the
10 trends in investment management we have
identified some background
4 Assets under management (USDtrn end-2010)
Insurance
funds 246
Pension
funds 299
HFs 18
SWFs 42
ETFs 13
Mutual
funds 247
PE 26
Source TheCityUK estimates
How big is the global investment industry
Conventional assets (pension funds mutual funds
10
Multi Asset Strategy Global September 2012
abc
and insurance) total about USD80trn split
roughly evenly between the three (Chart 4) The
AUM of these institutions has doubled since
2000 Hedge funds manage around USD2trn and
private equity funds a little more than that Add to
this sovereign wealth funds which in their pure
form have assets of about USD5trn include FX
reserve managers and other sovereign institutions
(such as national pensions or development funds)
and the total reaches about USD20trn ETFs
comprise another USD15trn or so Private wealth
is harder to figure out various estimates put it at
between USD26trn and USD120trn At the top
end of estimates the total amount of money
available for investment firms to manage exceeds
USD200trn ndash almost 3x global GDP
The US is still the largest source of funds with
USD35trn out of the USD79trn in conventional
assets globally (Chart 5) That is 224 of US GDP
The UK though much smaller in absolute terms at
USD65trn is the biggest in proportion to GDP with
conventional funds representing 257 of GDP
(although some of that comes from money
domiciled in the UK but not from UK nationals)
5 Source of conventional assets by country (USDtrn)
05
10152025303540
US
UK
Japa
n
Fran
ce
Ger
man
y NL
Switz
Oth
er
Pension funds Insurance assets Mutual funds
Source TheCityUK estimates based on OECD Investment Company SwissRe and UBS data (Figures are for domestically sourced funds regardless of where they are managed No reliable comparisons are available for total funds under management buy country)
hellipand the chances of it growing
There is no reason to suppose that the rate of
growth of institutional assets will slow over the
coming years Over the past decade conventional
assets have grown at a compound annual rate of
71 While it is likely in our view that global
economic growth will be lacklustre in coming
years as the after-effects of the Global Financial
Crisis are worked off this does not mean that
global savings will be stagnant Indeed quite the
opposite Households and companies are likely to
increase their savings as they stay risk averse (and
governments are likely to reduce fiscal deficits
albeit slowly)
The IMF projects that US and UK gross national
savings which have already improved modestly
since 2009 (to 129 of GDP from 115 in the
case of the US) will continue to increase over the
next five years with the US reaching 178 by 2017
(Chart 6) China meanwhile is unlikely to reduce its
savings rate much despite efforts to get households
to spend Australia has already made some headway
in raising its savings rate since its bubble in the early
2000s Japan is the only major economy where the
ratio may fall as retirees start to eat into their
savings All this suggests that the savings glut which
drove the fall in interest rates and strong equity
performance in 2003-7 will not disappear
6 Gross national savings rate selected countries ( of GDP)
0
10
20
30
40
50
60
80 85 90 95 00 05 10 15
UK US AU CH JP
F
Source IMF
And at the same time as savings grow companies in
the developed world are unlikely to need to raise
much money for the next few years Corporate cash
holdings are at record highs especially in the US
and companies are being cautious about capex
11
Multi Asset Strategy Global September 2012
abc
Dividend payout ratios are very low (31 in the US
last year for instance) This suggests that large listed
companies at least will not need to raise much
capital either debt or equity for the next few years ndash
although capital-hungry emerging markets
companies of course will
As countries get richer they tend to increase the
amount of institutional assets under management
and increase the amount invested in equities and
bonds (rather than placed in bank deposits) as
shown in Charts 7 and 8
7 Increasing wealth brings growth in institutional assets
0102030405060708090
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in institutional assets
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
8 hellipamid withdrawals from bank deposits
0
10
20
30
40
50
60
70
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in bank deposits
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
This suggests that as long as emerging markets
continue to develop (which in most cases we think
likely) then not only should the pool of potential
savings grow but the proportion of the pool
available for international investment institutions
to manage should grow even faster Not that this
will be without challenges how do London or
New York-based investment managers get access
to wealth held in China or India which is still
highly restricted in where it can invest and mostly
off limits to them
Indeed a well-read report by the McKinsey
Global Institute The emerging equity gap Growth
and stability in the new investors landscape
December 2011 argued that the growth of
international securities ownership by emerging
market investors will be essential if the role of
equities in the global financial system is not to be
reduced in the coming decades In particular
emerging market investors will need to triple their
allocation to equities if companies in these
countries are not to be starved of equity capital
Common threads
In this report we highlight the 10 trends that we
think will drive the investment management industry
over the next few years Understanding these trends
ndash and considering their implications ndash will be
important both for investment institutions in
planning their strategies and for investors interested
in the impact of these trends on asset prices
12
Multi Asset Strategy Global September 2012
abc
Inevitably there are some overlaps between the
10 trends Broadly we see three threads running
between them
The search for income With interest rates so
low investors are desperate to generate
income This has triggered demand for credit
and high dividend yield equities which we
expect to continue It is also forcing investors
to consider whether they are overpaying for
liquidity and to look at harvesting a premium
for investing in illiquid instruments such as
infrastructure and ldquoprivate debtrdquo funds
Tailoring risk Modern derivative techniques
make it possible to tailor risk to an extent
Investors scared of drawdowns can hedge fat-
tail risk Fixing a return is not possible (except
for a very low return) tailoring a level of risk
may be easier This concept has spawned the
development of risk parity funds and a boom in
multi-asset absolute return funds
A continuing shift from active to passive
Academic evidence strongly suggests that
active equity fund managers in aggregate
underperform their benchmarks That has
pushed investors over the past decade from
active to passive funds especially ETFs ndash a
trend we expect to continue It is also forcing
a rethink of the role of hedge funds which
have grown so large that in aggregate they no
longer seem to be able to produce superior
performance either
In the following sections we describe in detail the
10 trends we have identified and analyse their
implications for asset prices
13
Multi Asset Strategy Global September 2012
abc
hellipin credit and dividends With cash yielding zero and top-quality
government bonds little more than 15 it is
unsurprising that investors are scrambling to pick
up yield Indeed one could even say that the
market has become obsessed with income
1 Cumulative net flows to bond funds worldwide by type
-100
-50
0
50
100
150
200
250
300
07 08 09 10 11 12
USD
bn
Gov tCreditOther
Source EPFR (ldquoOtherrdquo includes muni funds MBS funds total return bonds and funds able to invest in a mix of bond types)
Look at flows into bond mutual funds recently It
is well known that these have been very healthy
totalling USD580bn over the past three years
according to EPFR But for the past 12 months at
least bonds flows have been predominantly into
credit funds (for example corporate high yield or
EM bond funds) with even a small net outflow
from government bond funds (Chart 1)
The sort of funds selling well is clear from the list
of the largest fund launches year-to-date The top
20 new US-based funds ranked by assets under
management now (Table 2 overleaf) include 10
bond funds two asset allocation funds and only
eight with an equity focus (remember this is for
the heavily equity-centric US market) Three of
the best-selling funds include the word ldquoincomerdquo
in their names
Credit is in a sweet spot Interest rates at which
corporates can issue are at historic lows But at
the same time spreads over US Treasuries are
quite high making the bonds attractive for
investors too
In the US for example BBB-rated five-year
corporate bonds currently yield only about 28 ndash
the lowest for decades ndash but that represents a spread
over Treasuries of around 200bp well above the
average of 130bp from the 2003-7 period (Chart 3)
The same is true in emerging markets The HSBC
Asian Dollar Bond Index (Chart 4) currently has a
record low yield of 37 but the spread over
Treasuries is a still attractive 300bp
This is why lots of bonds have been issued this
year August for example with over USD120bn
of issuance according to Dealogic was the highest
August on record and more than double the
USD58bn average for August Sub investment
The search for yield
With risk-free rates so low investors are desperate for income
Credit is in a sweet spot with issuers enjoying record low
borrowing costs but investors finding decent spreads
We think dividend yield stocks remain attractive too
14
Multi Asset Strategy Global September 2012
abc
grade issuance in August totalled USD27bn up
from USD13bn the same month in 2011
3 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
Source Bloomberg
Investors are clearly now having to take more risk
to get yield Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield One
example is bonds from riskier emerging markets
Ten-year paper from the Philippines a BB-rated
issuer now yields only 25 Investors have been
buying bonds from countries such as Gabon
Belarus Nigeria and Vietnam But five-year
bonds even from Gabon (BB-rated) now yield
only 38 You have to stretch to Belarus (B-) to
get a decent yield just over 10
4 HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source HSBC
This could all go very wrong Credit spreads are
supposed to compensate investors for the
probability of default At the investment grade
part of the credit spectrum defaults are rare but at
the sub-investment grade end they are less so At
present the combination of low rates on high
quality government bonds and relatively wider
credit spreads combined with very low default
rates places credit in a sweet spot compared to
some other assets classes However in an
2 Largest mutual funds launched in the US this year
Ticker Name Manager Inception date
Asset class Objective AUM (USDbn)
TGIRX US Intl Value Fund Thornburg 512012 Equity International Equity 265 OIBIX US Intl Bond Fund Oppenheimer 1272012 Debt International Debt 126 WAPRX US Core Plus Fund Western Asset 512012 Debt GovtCorp Intermediate 96 OSIIX US Global Strategic Income Fund Oppenheimer 1272012 Debt GovernmentCorporate 86 OGLIX US Global Fund Oppenheimer 1272012 Equity Global Equity 83 PSTQX US Short Term Corp Bond Fnd Pridential 322012 Debt CorporatePreferred-Inv Grade 80 AEMSX US Emerging Markets Fund Aberdeen 2272012 Equity Emerging Market-Equity 75 OIGIX US Intl Growth Fund Oppenheimer 4272012 Equity International Equity 62 MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6152012 Equity Growth-Mid Cap 60 MSFKX US Total Return Fund MFS 612012 Asset Allocation Balanced 58 PEFAX US EM Fundamental IndexPLUS Pimco 5312012 Debt Index Fund-Debt 54 CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund Columbia 4202012 Debt GovernmentCorporate 47
OBBCX US Mortgage Backed Securities Fund JP Morgan 722012 Debt Asset Backed Securities 41 JQLAX US Life Aggressive Fund John Hancock 312012 Asset Allocation Flexible Portfolio 37 OEIIX US Equity Income Fund Oppenheimer 4272012 Equity Value-Large Cap 33 MIDLX US Intl New Discovery Fund MFS 612012 Equity International Equity 32 JIPPX US Strategic Income Opportunities Fund John Hancock 312012 Debt Global Debt 31 WABRX US Core Bond Fund Western Asset 512012 Debt GovtCorp Intermediate 30 MFBKX US Bond Fund MFS 612012 Debt GovernmentCorporate 28 JDVPX US Disciplined Value Fund John Hancock 2292012 Equity Value-Large Cap 28
Source Bloomberg
15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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ESP 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FRA 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10
Multi Asset Strategy Global September 2012
abc
and insurance) total about USD80trn split
roughly evenly between the three (Chart 4) The
AUM of these institutions has doubled since
2000 Hedge funds manage around USD2trn and
private equity funds a little more than that Add to
this sovereign wealth funds which in their pure
form have assets of about USD5trn include FX
reserve managers and other sovereign institutions
(such as national pensions or development funds)
and the total reaches about USD20trn ETFs
comprise another USD15trn or so Private wealth
is harder to figure out various estimates put it at
between USD26trn and USD120trn At the top
end of estimates the total amount of money
available for investment firms to manage exceeds
USD200trn ndash almost 3x global GDP
The US is still the largest source of funds with
USD35trn out of the USD79trn in conventional
assets globally (Chart 5) That is 224 of US GDP
The UK though much smaller in absolute terms at
USD65trn is the biggest in proportion to GDP with
conventional funds representing 257 of GDP
(although some of that comes from money
domiciled in the UK but not from UK nationals)
5 Source of conventional assets by country (USDtrn)
05
10152025303540
US
UK
Japa
n
Fran
ce
Ger
man
y NL
Switz
Oth
er
Pension funds Insurance assets Mutual funds
Source TheCityUK estimates based on OECD Investment Company SwissRe and UBS data (Figures are for domestically sourced funds regardless of where they are managed No reliable comparisons are available for total funds under management buy country)
hellipand the chances of it growing
There is no reason to suppose that the rate of
growth of institutional assets will slow over the
coming years Over the past decade conventional
assets have grown at a compound annual rate of
71 While it is likely in our view that global
economic growth will be lacklustre in coming
years as the after-effects of the Global Financial
Crisis are worked off this does not mean that
global savings will be stagnant Indeed quite the
opposite Households and companies are likely to
increase their savings as they stay risk averse (and
governments are likely to reduce fiscal deficits
albeit slowly)
The IMF projects that US and UK gross national
savings which have already improved modestly
since 2009 (to 129 of GDP from 115 in the
case of the US) will continue to increase over the
next five years with the US reaching 178 by 2017
(Chart 6) China meanwhile is unlikely to reduce its
savings rate much despite efforts to get households
to spend Australia has already made some headway
in raising its savings rate since its bubble in the early
2000s Japan is the only major economy where the
ratio may fall as retirees start to eat into their
savings All this suggests that the savings glut which
drove the fall in interest rates and strong equity
performance in 2003-7 will not disappear
6 Gross national savings rate selected countries ( of GDP)
0
10
20
30
40
50
60
80 85 90 95 00 05 10 15
UK US AU CH JP
F
Source IMF
And at the same time as savings grow companies in
the developed world are unlikely to need to raise
much money for the next few years Corporate cash
holdings are at record highs especially in the US
and companies are being cautious about capex
11
Multi Asset Strategy Global September 2012
abc
Dividend payout ratios are very low (31 in the US
last year for instance) This suggests that large listed
companies at least will not need to raise much
capital either debt or equity for the next few years ndash
although capital-hungry emerging markets
companies of course will
As countries get richer they tend to increase the
amount of institutional assets under management
and increase the amount invested in equities and
bonds (rather than placed in bank deposits) as
shown in Charts 7 and 8
7 Increasing wealth brings growth in institutional assets
0102030405060708090
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in institutional assets
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
8 hellipamid withdrawals from bank deposits
0
10
20
30
40
50
60
70
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in bank deposits
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
This suggests that as long as emerging markets
continue to develop (which in most cases we think
likely) then not only should the pool of potential
savings grow but the proportion of the pool
available for international investment institutions
to manage should grow even faster Not that this
will be without challenges how do London or
New York-based investment managers get access
to wealth held in China or India which is still
highly restricted in where it can invest and mostly
off limits to them
Indeed a well-read report by the McKinsey
Global Institute The emerging equity gap Growth
and stability in the new investors landscape
December 2011 argued that the growth of
international securities ownership by emerging
market investors will be essential if the role of
equities in the global financial system is not to be
reduced in the coming decades In particular
emerging market investors will need to triple their
allocation to equities if companies in these
countries are not to be starved of equity capital
Common threads
In this report we highlight the 10 trends that we
think will drive the investment management industry
over the next few years Understanding these trends
ndash and considering their implications ndash will be
important both for investment institutions in
planning their strategies and for investors interested
in the impact of these trends on asset prices
12
Multi Asset Strategy Global September 2012
abc
Inevitably there are some overlaps between the
10 trends Broadly we see three threads running
between them
The search for income With interest rates so
low investors are desperate to generate
income This has triggered demand for credit
and high dividend yield equities which we
expect to continue It is also forcing investors
to consider whether they are overpaying for
liquidity and to look at harvesting a premium
for investing in illiquid instruments such as
infrastructure and ldquoprivate debtrdquo funds
Tailoring risk Modern derivative techniques
make it possible to tailor risk to an extent
Investors scared of drawdowns can hedge fat-
tail risk Fixing a return is not possible (except
for a very low return) tailoring a level of risk
may be easier This concept has spawned the
development of risk parity funds and a boom in
multi-asset absolute return funds
A continuing shift from active to passive
Academic evidence strongly suggests that
active equity fund managers in aggregate
underperform their benchmarks That has
pushed investors over the past decade from
active to passive funds especially ETFs ndash a
trend we expect to continue It is also forcing
a rethink of the role of hedge funds which
have grown so large that in aggregate they no
longer seem to be able to produce superior
performance either
In the following sections we describe in detail the
10 trends we have identified and analyse their
implications for asset prices
13
Multi Asset Strategy Global September 2012
abc
hellipin credit and dividends With cash yielding zero and top-quality
government bonds little more than 15 it is
unsurprising that investors are scrambling to pick
up yield Indeed one could even say that the
market has become obsessed with income
1 Cumulative net flows to bond funds worldwide by type
-100
-50
0
50
100
150
200
250
300
07 08 09 10 11 12
USD
bn
Gov tCreditOther
Source EPFR (ldquoOtherrdquo includes muni funds MBS funds total return bonds and funds able to invest in a mix of bond types)
Look at flows into bond mutual funds recently It
is well known that these have been very healthy
totalling USD580bn over the past three years
according to EPFR But for the past 12 months at
least bonds flows have been predominantly into
credit funds (for example corporate high yield or
EM bond funds) with even a small net outflow
from government bond funds (Chart 1)
The sort of funds selling well is clear from the list
of the largest fund launches year-to-date The top
20 new US-based funds ranked by assets under
management now (Table 2 overleaf) include 10
bond funds two asset allocation funds and only
eight with an equity focus (remember this is for
the heavily equity-centric US market) Three of
the best-selling funds include the word ldquoincomerdquo
in their names
Credit is in a sweet spot Interest rates at which
corporates can issue are at historic lows But at
the same time spreads over US Treasuries are
quite high making the bonds attractive for
investors too
In the US for example BBB-rated five-year
corporate bonds currently yield only about 28 ndash
the lowest for decades ndash but that represents a spread
over Treasuries of around 200bp well above the
average of 130bp from the 2003-7 period (Chart 3)
The same is true in emerging markets The HSBC
Asian Dollar Bond Index (Chart 4) currently has a
record low yield of 37 but the spread over
Treasuries is a still attractive 300bp
This is why lots of bonds have been issued this
year August for example with over USD120bn
of issuance according to Dealogic was the highest
August on record and more than double the
USD58bn average for August Sub investment
The search for yield
With risk-free rates so low investors are desperate for income
Credit is in a sweet spot with issuers enjoying record low
borrowing costs but investors finding decent spreads
We think dividend yield stocks remain attractive too
14
Multi Asset Strategy Global September 2012
abc
grade issuance in August totalled USD27bn up
from USD13bn the same month in 2011
3 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
Source Bloomberg
Investors are clearly now having to take more risk
to get yield Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield One
example is bonds from riskier emerging markets
Ten-year paper from the Philippines a BB-rated
issuer now yields only 25 Investors have been
buying bonds from countries such as Gabon
Belarus Nigeria and Vietnam But five-year
bonds even from Gabon (BB-rated) now yield
only 38 You have to stretch to Belarus (B-) to
get a decent yield just over 10
4 HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source HSBC
This could all go very wrong Credit spreads are
supposed to compensate investors for the
probability of default At the investment grade
part of the credit spectrum defaults are rare but at
the sub-investment grade end they are less so At
present the combination of low rates on high
quality government bonds and relatively wider
credit spreads combined with very low default
rates places credit in a sweet spot compared to
some other assets classes However in an
2 Largest mutual funds launched in the US this year
Ticker Name Manager Inception date
Asset class Objective AUM (USDbn)
TGIRX US Intl Value Fund Thornburg 512012 Equity International Equity 265 OIBIX US Intl Bond Fund Oppenheimer 1272012 Debt International Debt 126 WAPRX US Core Plus Fund Western Asset 512012 Debt GovtCorp Intermediate 96 OSIIX US Global Strategic Income Fund Oppenheimer 1272012 Debt GovernmentCorporate 86 OGLIX US Global Fund Oppenheimer 1272012 Equity Global Equity 83 PSTQX US Short Term Corp Bond Fnd Pridential 322012 Debt CorporatePreferred-Inv Grade 80 AEMSX US Emerging Markets Fund Aberdeen 2272012 Equity Emerging Market-Equity 75 OIGIX US Intl Growth Fund Oppenheimer 4272012 Equity International Equity 62 MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6152012 Equity Growth-Mid Cap 60 MSFKX US Total Return Fund MFS 612012 Asset Allocation Balanced 58 PEFAX US EM Fundamental IndexPLUS Pimco 5312012 Debt Index Fund-Debt 54 CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund Columbia 4202012 Debt GovernmentCorporate 47
OBBCX US Mortgage Backed Securities Fund JP Morgan 722012 Debt Asset Backed Securities 41 JQLAX US Life Aggressive Fund John Hancock 312012 Asset Allocation Flexible Portfolio 37 OEIIX US Equity Income Fund Oppenheimer 4272012 Equity Value-Large Cap 33 MIDLX US Intl New Discovery Fund MFS 612012 Equity International Equity 32 JIPPX US Strategic Income Opportunities Fund John Hancock 312012 Debt Global Debt 31 WABRX US Core Bond Fund Western Asset 512012 Debt GovtCorp Intermediate 30 MFBKX US Bond Fund MFS 612012 Debt GovernmentCorporate 28 JDVPX US Disciplined Value Fund John Hancock 2292012 Equity Value-Large Cap 28
Source Bloomberg
15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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11
Multi Asset Strategy Global September 2012
abc
Dividend payout ratios are very low (31 in the US
last year for instance) This suggests that large listed
companies at least will not need to raise much
capital either debt or equity for the next few years ndash
although capital-hungry emerging markets
companies of course will
As countries get richer they tend to increase the
amount of institutional assets under management
and increase the amount invested in equities and
bonds (rather than placed in bank deposits) as
shown in Charts 7 and 8
7 Increasing wealth brings growth in institutional assets
0102030405060708090
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in institutional assets
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
8 hellipamid withdrawals from bank deposits
0
10
20
30
40
50
60
70
1970 1980 1990 2000 2010 2020
UK US Germany
of household w ealth in bank deposits
Bubble size = per capita GDP (PPP)
Source HSBC CEIC
This suggests that as long as emerging markets
continue to develop (which in most cases we think
likely) then not only should the pool of potential
savings grow but the proportion of the pool
available for international investment institutions
to manage should grow even faster Not that this
will be without challenges how do London or
New York-based investment managers get access
to wealth held in China or India which is still
highly restricted in where it can invest and mostly
off limits to them
Indeed a well-read report by the McKinsey
Global Institute The emerging equity gap Growth
and stability in the new investors landscape
December 2011 argued that the growth of
international securities ownership by emerging
market investors will be essential if the role of
equities in the global financial system is not to be
reduced in the coming decades In particular
emerging market investors will need to triple their
allocation to equities if companies in these
countries are not to be starved of equity capital
Common threads
In this report we highlight the 10 trends that we
think will drive the investment management industry
over the next few years Understanding these trends
ndash and considering their implications ndash will be
important both for investment institutions in
planning their strategies and for investors interested
in the impact of these trends on asset prices
12
Multi Asset Strategy Global September 2012
abc
Inevitably there are some overlaps between the
10 trends Broadly we see three threads running
between them
The search for income With interest rates so
low investors are desperate to generate
income This has triggered demand for credit
and high dividend yield equities which we
expect to continue It is also forcing investors
to consider whether they are overpaying for
liquidity and to look at harvesting a premium
for investing in illiquid instruments such as
infrastructure and ldquoprivate debtrdquo funds
Tailoring risk Modern derivative techniques
make it possible to tailor risk to an extent
Investors scared of drawdowns can hedge fat-
tail risk Fixing a return is not possible (except
for a very low return) tailoring a level of risk
may be easier This concept has spawned the
development of risk parity funds and a boom in
multi-asset absolute return funds
A continuing shift from active to passive
Academic evidence strongly suggests that
active equity fund managers in aggregate
underperform their benchmarks That has
pushed investors over the past decade from
active to passive funds especially ETFs ndash a
trend we expect to continue It is also forcing
a rethink of the role of hedge funds which
have grown so large that in aggregate they no
longer seem to be able to produce superior
performance either
In the following sections we describe in detail the
10 trends we have identified and analyse their
implications for asset prices
13
Multi Asset Strategy Global September 2012
abc
hellipin credit and dividends With cash yielding zero and top-quality
government bonds little more than 15 it is
unsurprising that investors are scrambling to pick
up yield Indeed one could even say that the
market has become obsessed with income
1 Cumulative net flows to bond funds worldwide by type
-100
-50
0
50
100
150
200
250
300
07 08 09 10 11 12
USD
bn
Gov tCreditOther
Source EPFR (ldquoOtherrdquo includes muni funds MBS funds total return bonds and funds able to invest in a mix of bond types)
Look at flows into bond mutual funds recently It
is well known that these have been very healthy
totalling USD580bn over the past three years
according to EPFR But for the past 12 months at
least bonds flows have been predominantly into
credit funds (for example corporate high yield or
EM bond funds) with even a small net outflow
from government bond funds (Chart 1)
The sort of funds selling well is clear from the list
of the largest fund launches year-to-date The top
20 new US-based funds ranked by assets under
management now (Table 2 overleaf) include 10
bond funds two asset allocation funds and only
eight with an equity focus (remember this is for
the heavily equity-centric US market) Three of
the best-selling funds include the word ldquoincomerdquo
in their names
Credit is in a sweet spot Interest rates at which
corporates can issue are at historic lows But at
the same time spreads over US Treasuries are
quite high making the bonds attractive for
investors too
In the US for example BBB-rated five-year
corporate bonds currently yield only about 28 ndash
the lowest for decades ndash but that represents a spread
over Treasuries of around 200bp well above the
average of 130bp from the 2003-7 period (Chart 3)
The same is true in emerging markets The HSBC
Asian Dollar Bond Index (Chart 4) currently has a
record low yield of 37 but the spread over
Treasuries is a still attractive 300bp
This is why lots of bonds have been issued this
year August for example with over USD120bn
of issuance according to Dealogic was the highest
August on record and more than double the
USD58bn average for August Sub investment
The search for yield
With risk-free rates so low investors are desperate for income
Credit is in a sweet spot with issuers enjoying record low
borrowing costs but investors finding decent spreads
We think dividend yield stocks remain attractive too
14
Multi Asset Strategy Global September 2012
abc
grade issuance in August totalled USD27bn up
from USD13bn the same month in 2011
3 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
Source Bloomberg
Investors are clearly now having to take more risk
to get yield Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield One
example is bonds from riskier emerging markets
Ten-year paper from the Philippines a BB-rated
issuer now yields only 25 Investors have been
buying bonds from countries such as Gabon
Belarus Nigeria and Vietnam But five-year
bonds even from Gabon (BB-rated) now yield
only 38 You have to stretch to Belarus (B-) to
get a decent yield just over 10
4 HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source HSBC
This could all go very wrong Credit spreads are
supposed to compensate investors for the
probability of default At the investment grade
part of the credit spectrum defaults are rare but at
the sub-investment grade end they are less so At
present the combination of low rates on high
quality government bonds and relatively wider
credit spreads combined with very low default
rates places credit in a sweet spot compared to
some other assets classes However in an
2 Largest mutual funds launched in the US this year
Ticker Name Manager Inception date
Asset class Objective AUM (USDbn)
TGIRX US Intl Value Fund Thornburg 512012 Equity International Equity 265 OIBIX US Intl Bond Fund Oppenheimer 1272012 Debt International Debt 126 WAPRX US Core Plus Fund Western Asset 512012 Debt GovtCorp Intermediate 96 OSIIX US Global Strategic Income Fund Oppenheimer 1272012 Debt GovernmentCorporate 86 OGLIX US Global Fund Oppenheimer 1272012 Equity Global Equity 83 PSTQX US Short Term Corp Bond Fnd Pridential 322012 Debt CorporatePreferred-Inv Grade 80 AEMSX US Emerging Markets Fund Aberdeen 2272012 Equity Emerging Market-Equity 75 OIGIX US Intl Growth Fund Oppenheimer 4272012 Equity International Equity 62 MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6152012 Equity Growth-Mid Cap 60 MSFKX US Total Return Fund MFS 612012 Asset Allocation Balanced 58 PEFAX US EM Fundamental IndexPLUS Pimco 5312012 Debt Index Fund-Debt 54 CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund Columbia 4202012 Debt GovernmentCorporate 47
OBBCX US Mortgage Backed Securities Fund JP Morgan 722012 Debt Asset Backed Securities 41 JQLAX US Life Aggressive Fund John Hancock 312012 Asset Allocation Flexible Portfolio 37 OEIIX US Equity Income Fund Oppenheimer 4272012 Equity Value-Large Cap 33 MIDLX US Intl New Discovery Fund MFS 612012 Equity International Equity 32 JIPPX US Strategic Income Opportunities Fund John Hancock 312012 Debt Global Debt 31 WABRX US Core Bond Fund Western Asset 512012 Debt GovtCorp Intermediate 30 MFBKX US Bond Fund MFS 612012 Debt GovernmentCorporate 28 JDVPX US Disciplined Value Fund John Hancock 2292012 Equity Value-Large Cap 28
Source Bloomberg
15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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 ESP 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FRA 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12
Multi Asset Strategy Global September 2012
abc
Inevitably there are some overlaps between the
10 trends Broadly we see three threads running
between them
The search for income With interest rates so
low investors are desperate to generate
income This has triggered demand for credit
and high dividend yield equities which we
expect to continue It is also forcing investors
to consider whether they are overpaying for
liquidity and to look at harvesting a premium
for investing in illiquid instruments such as
infrastructure and ldquoprivate debtrdquo funds
Tailoring risk Modern derivative techniques
make it possible to tailor risk to an extent
Investors scared of drawdowns can hedge fat-
tail risk Fixing a return is not possible (except
for a very low return) tailoring a level of risk
may be easier This concept has spawned the
development of risk parity funds and a boom in
multi-asset absolute return funds
A continuing shift from active to passive
Academic evidence strongly suggests that
active equity fund managers in aggregate
underperform their benchmarks That has
pushed investors over the past decade from
active to passive funds especially ETFs ndash a
trend we expect to continue It is also forcing
a rethink of the role of hedge funds which
have grown so large that in aggregate they no
longer seem to be able to produce superior
performance either
In the following sections we describe in detail the
10 trends we have identified and analyse their
implications for asset prices
13
Multi Asset Strategy Global September 2012
abc
hellipin credit and dividends With cash yielding zero and top-quality
government bonds little more than 15 it is
unsurprising that investors are scrambling to pick
up yield Indeed one could even say that the
market has become obsessed with income
1 Cumulative net flows to bond funds worldwide by type
-100
-50
0
50
100
150
200
250
300
07 08 09 10 11 12
USD
bn
Gov tCreditOther
Source EPFR (ldquoOtherrdquo includes muni funds MBS funds total return bonds and funds able to invest in a mix of bond types)
Look at flows into bond mutual funds recently It
is well known that these have been very healthy
totalling USD580bn over the past three years
according to EPFR But for the past 12 months at
least bonds flows have been predominantly into
credit funds (for example corporate high yield or
EM bond funds) with even a small net outflow
from government bond funds (Chart 1)
The sort of funds selling well is clear from the list
of the largest fund launches year-to-date The top
20 new US-based funds ranked by assets under
management now (Table 2 overleaf) include 10
bond funds two asset allocation funds and only
eight with an equity focus (remember this is for
the heavily equity-centric US market) Three of
the best-selling funds include the word ldquoincomerdquo
in their names
Credit is in a sweet spot Interest rates at which
corporates can issue are at historic lows But at
the same time spreads over US Treasuries are
quite high making the bonds attractive for
investors too
In the US for example BBB-rated five-year
corporate bonds currently yield only about 28 ndash
the lowest for decades ndash but that represents a spread
over Treasuries of around 200bp well above the
average of 130bp from the 2003-7 period (Chart 3)
The same is true in emerging markets The HSBC
Asian Dollar Bond Index (Chart 4) currently has a
record low yield of 37 but the spread over
Treasuries is a still attractive 300bp
This is why lots of bonds have been issued this
year August for example with over USD120bn
of issuance according to Dealogic was the highest
August on record and more than double the
USD58bn average for August Sub investment
The search for yield
With risk-free rates so low investors are desperate for income
Credit is in a sweet spot with issuers enjoying record low
borrowing costs but investors finding decent spreads
We think dividend yield stocks remain attractive too
14
Multi Asset Strategy Global September 2012
abc
grade issuance in August totalled USD27bn up
from USD13bn the same month in 2011
3 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
Source Bloomberg
Investors are clearly now having to take more risk
to get yield Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield One
example is bonds from riskier emerging markets
Ten-year paper from the Philippines a BB-rated
issuer now yields only 25 Investors have been
buying bonds from countries such as Gabon
Belarus Nigeria and Vietnam But five-year
bonds even from Gabon (BB-rated) now yield
only 38 You have to stretch to Belarus (B-) to
get a decent yield just over 10
4 HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source HSBC
This could all go very wrong Credit spreads are
supposed to compensate investors for the
probability of default At the investment grade
part of the credit spectrum defaults are rare but at
the sub-investment grade end they are less so At
present the combination of low rates on high
quality government bonds and relatively wider
credit spreads combined with very low default
rates places credit in a sweet spot compared to
some other assets classes However in an
2 Largest mutual funds launched in the US this year
Ticker Name Manager Inception date
Asset class Objective AUM (USDbn)
TGIRX US Intl Value Fund Thornburg 512012 Equity International Equity 265 OIBIX US Intl Bond Fund Oppenheimer 1272012 Debt International Debt 126 WAPRX US Core Plus Fund Western Asset 512012 Debt GovtCorp Intermediate 96 OSIIX US Global Strategic Income Fund Oppenheimer 1272012 Debt GovernmentCorporate 86 OGLIX US Global Fund Oppenheimer 1272012 Equity Global Equity 83 PSTQX US Short Term Corp Bond Fnd Pridential 322012 Debt CorporatePreferred-Inv Grade 80 AEMSX US Emerging Markets Fund Aberdeen 2272012 Equity Emerging Market-Equity 75 OIGIX US Intl Growth Fund Oppenheimer 4272012 Equity International Equity 62 MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6152012 Equity Growth-Mid Cap 60 MSFKX US Total Return Fund MFS 612012 Asset Allocation Balanced 58 PEFAX US EM Fundamental IndexPLUS Pimco 5312012 Debt Index Fund-Debt 54 CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund Columbia 4202012 Debt GovernmentCorporate 47
OBBCX US Mortgage Backed Securities Fund JP Morgan 722012 Debt Asset Backed Securities 41 JQLAX US Life Aggressive Fund John Hancock 312012 Asset Allocation Flexible Portfolio 37 OEIIX US Equity Income Fund Oppenheimer 4272012 Equity Value-Large Cap 33 MIDLX US Intl New Discovery Fund MFS 612012 Equity International Equity 32 JIPPX US Strategic Income Opportunities Fund John Hancock 312012 Debt Global Debt 31 WABRX US Core Bond Fund Western Asset 512012 Debt GovtCorp Intermediate 30 MFBKX US Bond Fund MFS 612012 Debt GovernmentCorporate 28 JDVPX US Disciplined Value Fund John Hancock 2292012 Equity Value-Large Cap 28
Source Bloomberg
15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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13
Multi Asset Strategy Global September 2012
abc
hellipin credit and dividends With cash yielding zero and top-quality
government bonds little more than 15 it is
unsurprising that investors are scrambling to pick
up yield Indeed one could even say that the
market has become obsessed with income
1 Cumulative net flows to bond funds worldwide by type
-100
-50
0
50
100
150
200
250
300
07 08 09 10 11 12
USD
bn
Gov tCreditOther
Source EPFR (ldquoOtherrdquo includes muni funds MBS funds total return bonds and funds able to invest in a mix of bond types)
Look at flows into bond mutual funds recently It
is well known that these have been very healthy
totalling USD580bn over the past three years
according to EPFR But for the past 12 months at
least bonds flows have been predominantly into
credit funds (for example corporate high yield or
EM bond funds) with even a small net outflow
from government bond funds (Chart 1)
The sort of funds selling well is clear from the list
of the largest fund launches year-to-date The top
20 new US-based funds ranked by assets under
management now (Table 2 overleaf) include 10
bond funds two asset allocation funds and only
eight with an equity focus (remember this is for
the heavily equity-centric US market) Three of
the best-selling funds include the word ldquoincomerdquo
in their names
Credit is in a sweet spot Interest rates at which
corporates can issue are at historic lows But at
the same time spreads over US Treasuries are
quite high making the bonds attractive for
investors too
In the US for example BBB-rated five-year
corporate bonds currently yield only about 28 ndash
the lowest for decades ndash but that represents a spread
over Treasuries of around 200bp well above the
average of 130bp from the 2003-7 period (Chart 3)
The same is true in emerging markets The HSBC
Asian Dollar Bond Index (Chart 4) currently has a
record low yield of 37 but the spread over
Treasuries is a still attractive 300bp
This is why lots of bonds have been issued this
year August for example with over USD120bn
of issuance according to Dealogic was the highest
August on record and more than double the
USD58bn average for August Sub investment
The search for yield
With risk-free rates so low investors are desperate for income
Credit is in a sweet spot with issuers enjoying record low
borrowing costs but investors finding decent spreads
We think dividend yield stocks remain attractive too
14
Multi Asset Strategy Global September 2012
abc
grade issuance in August totalled USD27bn up
from USD13bn the same month in 2011
3 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
Source Bloomberg
Investors are clearly now having to take more risk
to get yield Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield One
example is bonds from riskier emerging markets
Ten-year paper from the Philippines a BB-rated
issuer now yields only 25 Investors have been
buying bonds from countries such as Gabon
Belarus Nigeria and Vietnam But five-year
bonds even from Gabon (BB-rated) now yield
only 38 You have to stretch to Belarus (B-) to
get a decent yield just over 10
4 HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source HSBC
This could all go very wrong Credit spreads are
supposed to compensate investors for the
probability of default At the investment grade
part of the credit spectrum defaults are rare but at
the sub-investment grade end they are less so At
present the combination of low rates on high
quality government bonds and relatively wider
credit spreads combined with very low default
rates places credit in a sweet spot compared to
some other assets classes However in an
2 Largest mutual funds launched in the US this year
Ticker Name Manager Inception date
Asset class Objective AUM (USDbn)
TGIRX US Intl Value Fund Thornburg 512012 Equity International Equity 265 OIBIX US Intl Bond Fund Oppenheimer 1272012 Debt International Debt 126 WAPRX US Core Plus Fund Western Asset 512012 Debt GovtCorp Intermediate 96 OSIIX US Global Strategic Income Fund Oppenheimer 1272012 Debt GovernmentCorporate 86 OGLIX US Global Fund Oppenheimer 1272012 Equity Global Equity 83 PSTQX US Short Term Corp Bond Fnd Pridential 322012 Debt CorporatePreferred-Inv Grade 80 AEMSX US Emerging Markets Fund Aberdeen 2272012 Equity Emerging Market-Equity 75 OIGIX US Intl Growth Fund Oppenheimer 4272012 Equity International Equity 62 MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6152012 Equity Growth-Mid Cap 60 MSFKX US Total Return Fund MFS 612012 Asset Allocation Balanced 58 PEFAX US EM Fundamental IndexPLUS Pimco 5312012 Debt Index Fund-Debt 54 CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund Columbia 4202012 Debt GovernmentCorporate 47
OBBCX US Mortgage Backed Securities Fund JP Morgan 722012 Debt Asset Backed Securities 41 JQLAX US Life Aggressive Fund John Hancock 312012 Asset Allocation Flexible Portfolio 37 OEIIX US Equity Income Fund Oppenheimer 4272012 Equity Value-Large Cap 33 MIDLX US Intl New Discovery Fund MFS 612012 Equity International Equity 32 JIPPX US Strategic Income Opportunities Fund John Hancock 312012 Debt Global Debt 31 WABRX US Core Bond Fund Western Asset 512012 Debt GovtCorp Intermediate 30 MFBKX US Bond Fund MFS 612012 Debt GovernmentCorporate 28 JDVPX US Disciplined Value Fund John Hancock 2292012 Equity Value-Large Cap 28
Source Bloomberg
15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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14
Multi Asset Strategy Global September 2012
abc
grade issuance in August totalled USD27bn up
from USD13bn the same month in 2011
3 Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
YieldSpread
Source Bloomberg
Investors are clearly now having to take more risk
to get yield Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield One
example is bonds from riskier emerging markets
Ten-year paper from the Philippines a BB-rated
issuer now yields only 25 Investors have been
buying bonds from countries such as Gabon
Belarus Nigeria and Vietnam But five-year
bonds even from Gabon (BB-rated) now yield
only 38 You have to stretch to Belarus (B-) to
get a decent yield just over 10
4 HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source HSBC
This could all go very wrong Credit spreads are
supposed to compensate investors for the
probability of default At the investment grade
part of the credit spectrum defaults are rare but at
the sub-investment grade end they are less so At
present the combination of low rates on high
quality government bonds and relatively wider
credit spreads combined with very low default
rates places credit in a sweet spot compared to
some other assets classes However in an
2 Largest mutual funds launched in the US this year
Ticker Name Manager Inception date
Asset class Objective AUM (USDbn)
TGIRX US Intl Value Fund Thornburg 512012 Equity International Equity 265 OIBIX US Intl Bond Fund Oppenheimer 1272012 Debt International Debt 126 WAPRX US Core Plus Fund Western Asset 512012 Debt GovtCorp Intermediate 96 OSIIX US Global Strategic Income Fund Oppenheimer 1272012 Debt GovernmentCorporate 86 OGLIX US Global Fund Oppenheimer 1272012 Equity Global Equity 83 PSTQX US Short Term Corp Bond Fnd Pridential 322012 Debt CorporatePreferred-Inv Grade 80 AEMSX US Emerging Markets Fund Aberdeen 2272012 Equity Emerging Market-Equity 75 OIGIX US Intl Growth Fund Oppenheimer 4272012 Equity International Equity 62 MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6152012 Equity Growth-Mid Cap 60 MSFKX US Total Return Fund MFS 612012 Asset Allocation Balanced 58 PEFAX US EM Fundamental IndexPLUS Pimco 5312012 Debt Index Fund-Debt 54 CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund Columbia 4202012 Debt GovernmentCorporate 47
OBBCX US Mortgage Backed Securities Fund JP Morgan 722012 Debt Asset Backed Securities 41 JQLAX US Life Aggressive Fund John Hancock 312012 Asset Allocation Flexible Portfolio 37 OEIIX US Equity Income Fund Oppenheimer 4272012 Equity Value-Large Cap 33 MIDLX US Intl New Discovery Fund MFS 612012 Equity International Equity 32 JIPPX US Strategic Income Opportunities Fund John Hancock 312012 Debt Global Debt 31 WABRX US Core Bond Fund Western Asset 512012 Debt GovtCorp Intermediate 30 MFBKX US Bond Fund MFS 612012 Debt GovernmentCorporate 28 JDVPX US Disciplined Value Fund John Hancock 2292012 Equity Value-Large Cap 28
Source Bloomberg
15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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FRA 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15
Multi Asset Strategy Global September 2012
abc
environment of low growth rates credit quality is
at risk of deterioration and if default rates begin
to rise the credit spreads sought by investors
could widen significantly
Income from equities
The other obvious place to turn for yield is
equities With the dividend yield on global
equities currently averaging 32 the spread over
government bonds is the highest since the 1950s
Investors have been buying into this theme
enthusiastically over the past two years There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5) making it
the most popular of the themes tracked by EPFR
Oddly the theme has not been so popular in the
US Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6) Income funds comprise only 3
of outstanding US equity mutual funds (compared
to 33 for growth and aggressive growth funds)
5 Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11U
SDbn
Div idendBalancedmulti assetGoldCommodity
Source EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US The dividend
yield in the domestic market is quite low (26
compared to for example 43 in Europe) since
companies prefer buy-backs which are more tax
efficient The tax on dividends (currently 15) is
due to rise next year as part of the ldquofiscal cliffrdquo to
an investorrsquos marginal tax rate ie as high as
40 this is causing uncertainty It may be simply
that investors are just too nervous of equities to
touch even ones with good income
6 Cumulative net flows into US equity mutual funds by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
International
Grow th
Balanced
Agg grow th
Global
EM
Sector
Income
Source ICI
16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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16
Multi Asset Strategy Global September 2012
abc
Many CIOs argue that it is just too late to buy
dividend stocks since they have already
performed well We disagree The global dividend
yield has not fallen much it peaked at 44 in
early 2009 at the market trough but has been
fairly steadily around 3 for the past three years
High dividend stocks have not outperformed that
much yet either For example the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7 over the past three years
(ignoring the dividends paid) And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date
Implications for asset prices
The search for yield will continue if as we expect
risk-free government bond yields remain low for
some time to come That suggests to us that both
credit and high dividend equities will see further
inflows and therefore a contraction in bond
spreads and rise in equity prices
17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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FRA 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17
Multi Asset Strategy Global September 2012
abc
Problem is volatility not return Bill Gross Co-CIO of Pimco famously
announced this August that ldquothe cult of equity
is deadrdquo
But the truth is not that simple Indeed many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming and thinking about how to position
themselves for it
Certainly over the past few years investors have
switched massively away from equities and into
bonds Since the end of 2007 USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1)
This is not only because of the equity bear market
of 2007-9 The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation as
regulators especially in Europe pushed pension
funds and insurers to derisk their portfolios
1 Cumulative net flows into US mutual funds (USDtrn)
00
05
10
15
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity fundsBond funds
Source ICI
But have equity returns really been that bad
Many investors talk about the past 10 years as
having been a ldquostructural bear marketrdquo for
equities But the fact is that over that period the
total return from global equities (a compound
annual rate of 80) has been better than the
return from global bonds (52)
Of course the picture is a little more complicated
than that The return depends greatly on the
starting-point the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market
The death ndash or rebirth ndash of equities
Bill Gross says the cult of equity is dead
But equities have actually outperformed bonds over the past 10
years although admittedly with high volatility
A bigger risk is the bursting of the bond bubble could 2014 be
another 1994
18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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 ESP 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FRA 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ITA ltFEFF005500740069006c0069007a007a006100720065002000710075006500730074006500200069006d0070006f007300740061007a0069006f006e00690020007000650072002000630072006500610072006500200064006f00630075006d0065006e00740069002000410064006f006200650020005000440046002000700065007200200075006e00610020007300740061006d007000610020006400690020007100750061006c0069007400e00020007300750020007300740061006d00700061006e0074006900200065002000700072006f006f0066006500720020006400650073006b0074006f0070002e0020004900200064006f00630075006d0065006e007400690020005000440046002000630072006500610074006900200070006f00730073006f006e006f0020006500730073006500720065002000610070006500720074006900200063006f006e0020004100630072006f00620061007400200065002000410064006f00620065002000520065006100640065007200200035002e003000200065002000760065007200730069006f006e006900200073007500630063006500730073006900760065002egt JPN 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 SUO 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18
Multi Asset Strategy Global September 2012
abc
And equities have been particularly volatile over
the past decade or so (Chart 2) In the bull market
of 1992-9 equities produced a much smoother
annual return of 16 with volatility of 13
compared to a 6 return for bonds with a
volatility of 5 Over the past 10 years the
volatility of bonds has been pretty steady at 6
but the volatility of global equities has risen to
19 (Tables 3 and 4)
2 Total return indexes (log scale) since 1988
45
50
55
60
65
88 90 92 94 96 98 00 02 04 06 08 10 12
EquityBondCash
Source Bloomberg MSCI (Equity=MSCI ACWI TR Gross Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD Cash=3-month T-bills)
3 Compound return from different asset classes
Equity Bond Cash
1 year 98 14 02 2 years 81 52 02 5 years -09 64 11 10 years 80 67 21 20 years 71 64 35 1992-1999 16 6 5 Since 1988 72 71 43
Source Bloomberg MSCI
4 Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20 4 0 2 years 18 5 0 5 years 24 6 0 10 years 19 6 0 20 years 17 6 0 1992-1999 13 5 0 Since 1988 17 6 0
Source Bloomberg MSCI
That volatility explains a lot Retail investors and
regulators have been made very nervous by the
big swings in stock prices It will take a lot for
them to get confident in equities again Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation
as happened after the 1929 stock market crash
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section) volatility makes it hard for active or
thematic fund managers to perform well
But there are issues for bond markets too
valuations for a start The interest rates on top-
rated government bonds are at unprecedently low
levels the 10-year US Treasury yield for
example fell below 14 this summer the lowest
since at least the late 19th century (Chart 5)
5 10-year US Treasury bond yield ()
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source Robert Shiller
Meanwhile equity valuations while not
exceptionally low are certainly well below long-
run averages the forward PE on the SampP500 for
instance is currently about 125x compared to a
140-year average of 136x (Chart 6)
19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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19
Multi Asset Strategy Global September 2012
abc
6 One-year forward PE SampP500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source Robert Shiller IBES MSCI
Indeed the best way for investors to regain
confidence in equities would be if bond prices were
to crash This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing) How could bond houses stay relevant in a
rising rate environment
Indeed several we spoke to have begun to prepare
for this eventuality and started to consider how
they might enter the equity business Grossrsquos
Pimco set up four equity funds for the first time in
2010 and others are starting to address this also
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation using ETFs to execute country and
sector bets
They key question then is whether the recent
volatility in equities and the shift in investorsrsquo
preferences to bonds are structural or cyclical
The answer is that it is surely a bit of both With
the debt overhang in the developed world likely to
hold down growth for a few more years policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge But
this will not last forever
And in the meantime investors will struggle to
make decent returns from bonds at current levels
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds That might have
worked when interest rates on government bonds
were 7 and a 65-year-old could expect to live
only 10 years But it certainly doesnrsquot work with
bond yields at 15 and life expectancy of 80-85
Implications for asset prices
Our conclusion is that equities are likely to
struggle for a few more years with economic
growth in the developed world anaemic But the
basic concept that equities have a risk premium
should not disappear And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle)
The problem to solve is investorsrsquo perception that
equities are risky But there might be ways to
reduce the riskiness of equities without sacrificing
too much of their return We examine the idea of
risk-minimising strategies in the next section
20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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20
Multi Asset Strategy Global September 2012
abc
Tailoring risk not return What all investors would ideally like is a good
return with low risk Of course that is impossible
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility
The key insight here is that while it is impossible
to fix return it is possible to tailor risk to a
degree One could for example buy an equity
index together with a put option thus giving up
some income in return for a pre-determined limit
to drawdown Investors have a reduced tolerance
for drawdown after the upheaval of 2008 fund
managers can structure their offerings with the
aim of avoiding an outlier outcome
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes where the dividend stream is used to buy
downside protection) But in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular They are also
becoming more sophisticated and nuanced
There are many such structures around
The fastest growing especially in the UK are
multi-asset funds (aka diversified beta or
diversified growth) which we discuss in
detail in the next section These aim at
absolute returns in a range of assets with a
targeted level of volatility Essentially they
intend to provide a nice return but with low
correlation to equities
ldquoRisk aware equity servicesrdquo such as
longshort or market-neutral strategies
have for long been the territory of hedge
funds but are increasingly being used by
conventional fund managers
Balanced funds (with a mix of equity and
bonds typically 6040) have long been a
mainstream of retail fund management houses
But they have often produced poor returns
mainly because the vast proportion of the risk
lay in the equity portion A recent
development is risk-parity products where
risk between the asset classes is equalised for
example by leveraging the bond portion
Risk-minimising strategies
Investors want equity-style returns with bond-like volatility
Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
Strategies include diversified beta risk parity min vol call writing
21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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ESP 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FRA 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 SUO 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21
Multi Asset Strategy Global September 2012
abc
Minimum volatility equity funds focus on
low-beta stocks in an index often using a
quants model They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should These funds it is claimed can
produce at least as good performance as a
major index but with significantly reduced
volatility
Using options to target a level of risk For
example a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside This
could also be done simply and relatively
cheaply to eliminate extreme tail risk
Similarly a strategy of passive-plus with call
writing allows a fund to boost the return on
an index in return for capping the upside
Again the level of the cap can be tailored
Some funds have experimented with the idea
of hanging a coupon off an equity fund
This might look more attractive than a simple
dividend fund since the coupon as long as it
was relatively low (for example 2) could be
fixed for a period since shortfall is unlikely
Any dividend payment in excess of that
would be reinvested This hybrid of bond and
equity characteristics may be attractive to
some investors
Not that such tailored products are without
problems It may be hard to explain their
characteristics and attractiveness to retail
investors as one CIO told us ldquoYou canrsquot sell a
Sharpe ratiordquo
The products can be quite expensive too Some
highly risk-averse investors may end up giving
away too much upside to buy insurance With
implied volatility for equities still high (though
lower this year than for a while) the cost of
options protection is high The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal
But for both sophisticated retail investors with
astute advisers to guide them through the
complications and for institutions with strong risk
consciousness for example insurance companies
products that minimise ndash or at least tailor ndash risk
might be a wise investment
Implications for asset prices
If risk-minimising products grow further this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target
22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign 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publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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22
Multi Asset Strategy Global September 2012
abc
GARS and all its friends Standard Lifersquos Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK
Since its inception in 2008 it has gathered assets
of GBP117bn It aims to produce an annual
return of cash plus 5 with an investment time-
horizon of three years (and to have a positive
return over any 12-month period) by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions) Over five
years it has produced a compound annual return
of 7 putting it in the 99th percentile of its peers
(with volatility over the past year of only 5)
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US
although by all accounts GARS has started to gain
traction there
It is the leader of a growing category of multi-
asset absolute return funds known also as
diversified growth diversified beta or diversified
return funds These funds typically target Libor
plus 4 or 5 (or sometimes inflation plus say
3) with volatility lower than equities and often
targeted to be similar to US treasuries (ie 4-6)
They usually use leverage to achieve the targeted
return In a sense they are similar to hedge funds
but fees are lower (GARS charges 75bp a year
with no performance fee) and many are offered to
retail as well as institutional investors
1 GARS fund selected positions July 2012
Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v SampP volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source Standard Life public website
The track records of GARS and of many of its
later-established competitors have been
impressive But multi-asset funds have their
detractors too (and not only among houses late to
the game)
The growth of multi-asset
Funds that target Libor-plus absolute returns with bond-like
volatility and costs lower than hedge funds look attractive to us
The success of Standard Lifersquos GARS has spawned competitors
Multi-asset funds are likely to grow further even in the US where
they have yet to take off
23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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23
Multi Asset Strategy Global September 2012
abc
Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns Wonrsquot multi-asset
funds in aggregate underperform their
benchmarks just as active equity managers do
and (as we describe in the section below The
decline of the hedge fund) hedge funds may have
begun to do too That may happen eventually but
for now the asset class is still so small that it does
not yet face a zero-sum game
Other critics wonder whether multi-asset funds
are really an alpha product or simply take beta
risk with leverage In our view the answer to this
is that even if part of the return that multi-asset
funds achieve is beta timing the beta and
managing asset allocation can be forms of alpha
A final doubt is that leverage may work with
interest rates so low but what happens when the
cost of the leverage goes up
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet
Certainly most CIOs at US funds we talked to
were aware of the GARS phenomenon but few
have tried to market anything similar One
problem is that required returns in the US are too
high pension funds typically assume a return of
close to 8 Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would in the view
of most fund managers involve taking too much
risk Retail investors in the current environment
also tend to be wary of anything that isnrsquot yield
oriented Would there be a way to set up income
multi-asset funds
Implications for asset prices
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that in our view they should
continue to grow rapidly and develop more
diverse structures Eventually their flourishing
may push down returns but for now they are rare
enough that there is still plenty of alpha to be
picked up
As multi-asset funds grow they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1) Most multi-asset funds
implement their strategies through index futures
and other derivative instruments these should see
improved liquidity too
24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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24
Multi Asset Strategy Global September 2012
abc
Itrsquos hard to beat an index There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years
According to EPFR data (Chart 1) passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period)
1 Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USD
bn
Passiv e Activ e
Source EPFR
In the US according to the Investment Company
Institute inflows to passive mutual funds have
totalled USD427bn over the past 10 years bringing
the total size of such funds at the end of last year in
the US to USD11trn There have been particularly
big flows into bond funds over the past three years
(Chart 2) these now total USD242bn
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010
2 Annual flows into US indexed funds by type 1997-2011
-10
0
10
2030
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USD
bn
Domestic equity World equity Bond amp hy brid
Source ICI
This is unsurprising in our view Almost all
academic studies find that in aggregate active
funds underperform their benchmark particularly
once fees are taken into account This logically
must be so since before fees and trading costs the
average investor must by definition perform in
line with the index But the turnover of an active
fund is almost always higher than that of an index
So even before fees the average active investor
must underperform (The only question is
underperform what ndash a subject we return to
later) Index funds also typically charge lower
annual expenses for example usually 20-30bp for
The shift to passive
A third of active money has shifted to passive in the past 10 years
Passive encroachment is likely to continue since active funds
empirically underperform on average (and have higher costs)
But indexing strategies will need to get smarter which index
25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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25
Multi Asset Strategy Global September 2012
abc
an SampP500 index fund compared to 80-150bp for
a traditional actively managed US equity fund
Data from Standard amp Poors suggest that over the
past 10 years on average only 40 of large-cap
US funds and 38 of small cap funds
outperformed their benchmarks (Chart 3)
3 of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap fundsS i 3
Source Standard amp Poors (Large cap funds were compared with SampP500 small cap funds with SampP SmallCap 600)
Will the shift to passive continue In our view
almost certainly Passive funds still comprise only
164 of US equity mutual funds (up from 10
ten years ago) International equity funds run
passively in the US total only USD120bn Index
funds are still relatively small outside the US
With interest rates and expected returns from all
assets very low investors will focus more and
more on minimising expenses Going passive is
the best way to do this Sophisticated investors
such as institutions or high net worth individuals
will also increasingly separate beta and alpha
They will do this for example through so-called
8020 solutions where they have 80 of their
assets in passive market-linked beta assets and a
20 alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out) They will want to buy the beta portion as
cheaply as possible
Fans of active investment have a number of
arguments against this Many claim that while the
average investment manager may underperform
the benchmark their firm has superior investment
processes that allow it to outperform consistently
Unfortunately academic research shows little
evidence of sticky outperformance
Others argue that if an increasing portion of the
investor universe turns passive there should be
more merit in picking stocks since they would be
increasingly mispriced That is an appealing
argument but not well grounded in logic Think
of it like this if there were 98 passive investors in
an asset class and only two active managers then
after fees and trading costs the two active
investors would still in aggregate underperform
the index
Bond houses argue indexing might not make
sense for bonds Bond indexes are unlike equity
indexes in that they include many more securities
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life They are usually weighted by
the total outstanding debt of the issuers which
means highly indebted and risky borrowers
represent a large part of the index Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons Standard amp Poorrsquos
data does not bear this out though almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4)
26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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 ESP 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FRA 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ITA 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 JPN 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26
Multi Asset Strategy Global September 2012
abc
4 of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
Gen
eral
inte
rmed
iate
Gov
ernm
ent
long
fund
s
EM d
ebt
Glo
bal
inco
me
MBS H
Y
2002-2006 2007-11
Source Standard amp Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons An example is Japan in
the 1990s when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks Bank
stocks were mainly owned by Japanese corporates
for relationship reasons
But which index
This all begs the question of which index Some
perform better than others A traditional large-cap
market cap-weighted stock index such as the
SampP500 may not be the best choice That is
because empirically smaller cap stocks
outperform large caps in the long run Moreover
when using market capitalisation expensive
stocks are overweighted It is well accepted that
value stocks also outperform in the long run
(There is a possibility though that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks)
So in the US for example the SampP500 index has
risen by 50 over the past 10 years while an
equal weighted index of the same stocks has risen
by 105 (Chart 5)
A further problem is that when stocks are added
to a popular index they tend to rise on the
announcement (but before they actually join the
index) similarly deleted stocks fall before their
removal A less well-followed index with similar
characteristics might outperform
5 Performance of SampP500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source Bloomberg
Many passive investment managers understand
these reservations and have moved to index-plus
or passive-plus strategies Fundamental indexes
where stocks are weighted by sales or book value
(or even the number of employees) rather than by
price or market cap have also grown
Implications for asset prices
If we are correct to believe that passive
encroachment has years to go there are many
important implications for asset prices
6 Average correlation of MSCI country indexes with ACWI
00
02
04
06
08
10
90 92 94 96 98 00 02 04 06 08 10 12
Av erage
Source Bloomberg MSCI
Correlations between markets and between stocks
in a market have risen consistently over the past
decade The average correlation between MSCI
27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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27
Multi Asset Strategy Global September 2012
abc
country indexes and the overall MSCI All
Country World Index (Chart 6) for example has
risen from 30-40 in the early 2000s to 60-70
by 2010 ndash although they are some signs of it
declining recently perhaps as flows into equity
funds whether active or passive have stagnated
At the stock level the implied correlation between
individual stocks in the SampP500 index (Chart 7)
rose to a peak of 80 late last year from 40-50
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange)
7 Implied correlation of SampP500 stocks ()
010203040506070
8090
07 08 09 10 11 12
Implied correlation
Source Bloomberg CBOE
Further growth of passive funds is likely to push
correlations up further or at least keep them at the
current elevated level
If bond funds grow in popularity a similar rise in
correlations may happen between different bond
classes or issuers
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes or which are large but
underrepresented
28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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28
Multi Asset Strategy Global September 2012
abc
Attractive ndash but problems too Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs) There are
currently over 3200 ETFs around the world with
assets of USD15trn up from only USD105bn in
2001 (Chart 1)
1 Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1000
1200
1400
1600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
US Europe Other
Source Blackrock (end-Jun)
ETFs have a number of advantages which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover) They
can be traded intra-day giving investors a way to
take (or remove) exposure quickly to a country
sector or asset class Their liquidity means that
they are often used by institutions to execute asset
allocation changes Some participants estimate
that as much as 60 of ETFs are owned by
institutional rather than retail investors The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV) For retail investors the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use
But they also have their detractors Common
criticisms include
They are sub-optimal for long-term
investors Why would these investors want to
trade intra-day when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV This
can only encourage short-term speculation
unsuitable for most retail investors Moreover
since ETFs pay exchange fees and have a
bidoffer spread they should fundamentally
cost a little more than a similar mutual fund
The relentless rise of ETFs
ETF assets have grown to USD15trn
But there are issues are ETFs suitable for bonds Will overly
sophisticated ETFs blow up and invite regulatorsrsquo attention
Key to future growth is whether active ETFs take off
29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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FRA 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29
Multi Asset Strategy Global September 2012
abc
They are still very much a US phenomenon
US ETFs have AUM of USD11trn but
Europe only USD273bn and the rest of the
world just USD169bn Regulatory difficulties
still make it hard to set up an ETF in Europe
The range of available ETFs and their
liquidity is very limited in many countries
ETFs are best suited to equity index
products They work much less well for
bonds or other assets Equity ETFs globally
total USD12trn but fixed income ETFs have
reached only USD308bn and commodity
ETFs only USD35bn Fixed income is trickier
because of the problems inherent in bond
indexes described in the section on passive
funds above It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components
Moreover the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily ndash essential for market-
makers to create new units) means that traders
can see their positions and trade against them
A number of ETFs have backfired
spectacularly Some have failed to mirror the
returns on the underlying security or index
they claimed to match This has been
especially true of gold ETFs More
sophisticated ETFs that promised a multiple
or the inverse of the return on the underlying
have diverged dramatically The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code EEV) is one of the most notorious It
seeks double the inverse of the return on the
MSCI EM index But when the index fell
49 in the second half of 2008 ndash and so the
ETF should have risen 98 ndash the ETF
actually fell by 30 It has failed in the past
12 months too falling by 15 when MSCI
EM fell by only 8
The defenders of ETFs say that the resilience of
the industry despite these blow-ups (and others
such as the flash crash of 2010 which was
partially blamed on ETFs) demonstrates the
productrsquos fundamental attractiveness The chances
are though that regulators may clamp down
particularly on exchange-traded products (ETPs)
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities There are
USD182bn of ETPs in addition to the numbers on
ETFs quoted above
The keys for further growth
We expect ETFs to continue to grow But there
are two key questions that will determine their
rate of growth
The first is whether active ETFs can take off
These are somewhat problematical The
transparency rules mentioned earlier make it hard
to structure say a 30-stock high-alpha equity
fund as an ETF since competitors and traders
would be able to see daily changes in the fundrsquos
holdings Some investment houses notably Eaton
Vance claim they have found a way to report
daily holdings that would get round the
transparency problem But so far the Securities
and Exchange Commission hasnrsquot approved these
ETFs and indeed has been reluctant to approve
many innovative ETF structures
Perhaps the highest profile active ETF launch
recently was Pimcorsquos Total Return ETF (Code
BOND) listed in March this year In six months
it has grown AUM to USD25bn The ETF aims
to mimic the Pimco Total Return mutual fund
both are managed by Bill Gross But the two have
performed rather differently in the past six
months the ETF has risen 66 and the mutual
fund 32 One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly
30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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30
Multi Asset Strategy Global September 2012
abc
One answer may be quants funds which rather
than being managed in accordance with the
managerrsquos judgement chose stocks on the basis of
a model For example the largest ETF provider
Blackrockrsquos iShares is focusing its marketing
efforts currently on minimum volatility equity
ETFs These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index Its promoters claim that this allows
investors to keep most of the upside with
significantly lower volatility And indeed over
the past five years the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17 with volatility of 18
compared to 23
The second key question is how financial advisers
are remunerated Until recently FAs were
reluctant to recommend ETFs to their retail
investor clients even though this might have been
the wisest course since unlike mutual funds
ETFs do not pay commissions But the trend is
increasingly for FAs to charge an annual fee of 1-
2 of assets for their advice and to take nothing
from the investment products they put their clients
into This makes them more impartial In the US
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD17trn
In the UK the Retail Distribution Review which
takes effect next January will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors Similar moves are afoot in Australia
and Asia This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product
Bad news for mutual fund managers
This is good news for the ETF industry but wonrsquot
help conventional fund managers The ETF
business is largely sewn up by three providers ndash
iShares State Street and Vanguard ndash which
between them manage 68 of outstanding ETFs
Other firms have struggled with whether it makes
sense to enter the business but the only space left
for new entrants is in increasingly esoteric
products or in low-cost ETFs on plain-vanilla
stock indexes Both are hard to make profits from
and ETFs from smaller providers are often
illiquid making them unattractive to investors
Indeed some smaller providers have begun to pull
out Scottradersquos FocusShares for example
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering currently 26 funds A total of 71 ETFs
have closed in the US this year
Implications for asset prices
As with the move to indexation (described in the
previous section) the rise of ETFs raises intra-
and inter-market correlations
ETFs make it easy even for large institutional
investors to change weighting rapidly A fund that
decided to raise its weighting in Brazil for
example could buy a Brazil index ETF
immediately and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks So far this has mainly been
limited to equities But if bond ETFs and style
ETFs (min vol value high dividend yield) take
off the same effect could be seen within and
between other asset classes
31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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31
Multi Asset Strategy Global September 2012
abc
Is there any alpha left Earlier this year the assets under management of
hedge funds finally regained their previous peak
from 2007 around USD22trn But that was one
of the few pieces of good news for an industry
that has struggled in recent years In the five years
to the end of 2007 AUM grew at an annual
compound rate of 29 Since the end of 2008 the
CAGR has been only 12 (Chart 1)
1 Hedge fund assets under management
0
500
1000
1500
2000
2500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Assets (USDbn)
Source TheCityUK and HSBC estimates (end-Jul)
The reasons are not hard to find Performance has
been unimpressive in the past couple of years
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets such as 2003-7 and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2)
2 Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF indexLS equityMacro HFs
Source Bloomberg EurekaHedge
But they may struggle during the trendless risk
on-risk off type of market we have seen recently
This year for example as of end-July the average
hedge fund monitored by EurekaHedge was up
only 25 y-t-d The performance of longshort
equity funds (+19) and funds of funds (+17)
was even poorer By contrast global equities have
The decline of the hedge fund
Hedge funds have struggled in the recent trendless market
The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
Large hedge funds and ldquotraditionalrdquo fund managers are likely
to converge
32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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 ESP 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FRA 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32
Multi Asset Strategy Global September 2012
abc
risen 75 (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 24
so far this year Itrsquos not exactly worth paying two-
and-20 (a 2 management fee and 20
performance fee) for that sort of performance
Macro funds have particularly struggled in the
past couple of years They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well) with 10
growth in AUM in the four years to end-2011
(compared with a 5 decline for the hedge fund
universe as a whole) ndash see Chart 3 But this year
so far macro funds on average have returned only
11 ndash and macro funds of funds -05 Last year
too return was poor -12 There have been a
relatively small number of consensus macro
trades (for example betting on a rise in Bund
yields) that many macro funds put on but which
were unsuccessful The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks something
that is hard to do
Many macro funds take an opportunistic attitude
to investing switching from one strategy to
another as they spot profit-making trades But this
lack of a consistent investment approach has in
the view of some CIOs we spoke to turned some
institutions away from macro funds
Why should hedge funds outperform
The fundamental problem is that as with active
equity fund managers in theory hedge funds
should not be able in aggregate to out-perform
When the universe of hedge funds was small
enough there was still alpha for them to harvest
In essence they were getting their alpha from
traditional long-only fund managers But once
hedge funds became a USD1trn-plus community
they increasingly had to get their alpha from each
other Many investors believe that hedge funds are
charging alpha fees simply for beta
So the expensiveness of hedge fund fees is
increasingly an issue Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge Standard Lifersquos GARS
Fund for example has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset
above for details) More vehicles are becoming
available to allow retail investors to access alpha
hedge-fund-like UCITS in Europe dubbed
ldquoNewcitsrdquo can short and use leverage for
example These trends will inevitably put
downward pressure on hedge fund fees
3 Growth in hedge fund AUM by category of fund end-2007 to end-2011
8 12 2 13 10 5 100 6 9 2 7 11 2 13
-15
-10
-5
0
5
10
15
Mac
ro
Fixe
d in
com
e
Con
verti
ble
Arbi
trage
Mul
ti-st
rate
gy
Even
t Driv
en
Equi
ty L
ong
only
Tota
l
Sect
or s
peci
fic
Equi
ty L
ong
Bias
Mer
ger A
rbitr
age
Dis
tress
ed S
ecur
ities
Equi
ty lo
ngs
hort
Equi
ty m
arke
t neu
tral
Emer
ging
mar
kets
of total HF AUM
Change in AUM 2007-11
Source Barclay Hedge
33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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33
Multi Asset Strategy Global September 2012
abc
Hedge fund managers are responding Some
larger ones have admitted that their size makes
alpha generation hard and have returned funds to
their investors or closed to new money Moore
Capital for example returned USD2bn in July
Others have started to tailor their funds so that
they can sell them to retail investors AQR Capital
Management for instance markets a number of
retail funds with active strategies such as
momentum risk parity diversified arbitrage and
managed futures KKR best known for its private
equity business in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds which will invest in
special situations such as distressed debt in
Europe and Asia Under the 2012 JOBS Act US
hedge funds may soon be able to advertise for the
first time
Implications for asset prices
Hedge funds are in our view unlikely to shrink
never mind disappear After all the industry still
represents only about 2 of the total of USD82trn
in retail and institutional assets worldwide
But the more conventional strategies such as
longshort equity or multi-asset macro will be under
increasing pressure from traditional fund houses
which will run this money for much lower fees We
believe that large hedge funds will increasingly
converge with ldquotraditionalrdquo investment managers in
terms of style fees and remuneration There will
though be room for small hedge funds concentrated
on unusual asset classes or with a particular talent
for digging out alpha
The growing universe of investors looking at
hedge-fund-like strategies ndash including pairs
trades multi-asset arbitrage illiquid debt ndash should
aid price discovery making capital markets
increasingly efficient As long as smaller hedge
funds continue to be able to gather funds
alternative asset classes (distressed debt
foreclosed mortgages art volatility) should
become more mainstream
34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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34
Multi Asset Strategy Global September 2012
abc
Do you really need liquidity In the desperate search for yield one way of
finding it has been largely ignored up to now
being rewarded for illiquidity
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity buying assets that they
can liquidate quickly in volume if necessary
But does this make sense Pension funds or
insurance companies with liabilities that have an
average duration of 10 or 20 years do not need
much liquidity Individual investors particularly
for their pension savings should preferably have
limited ability to sell their holdings since this
would tempt them to invest speculatively or to
use the savings for purposes other than post-
retirement income
Moreover liquidity comes at a price Investors may
be overpaying for something they donrsquot need (or
need for only a portion of their portfolio) A survey
of academic research on this topic (ldquoLiquidity
Premium Literature review of theoretical and
empirical evidencerdquo September 2009) by risk
consultancy Barrie amp Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones and 40-200bp less from bonds depending on
their credit rating
1 Illiquidity premium estimate
Illiquidity premium estimate (bp)
No of studies
Equity 450 2 Government bonds 39 5 Covered bonds 18 2 Corporate bonds 50 9 AAA 11 2 AA 15 3 A 30 3 BBB 31 3 Investment grade 53 1 BB 110 2 B 173 1 CCC 420 1 Speculative grade 180 1
Source Adapted from Barrie amp Hibbert (wwwbarrhibbcomdocumentsdownloadsLiquidity_Premium_Literature_REviewpdf)
Gradually though investors are starting to look at
harvesting this illiquidity premium Many complain
however that this is an under-researched area Few
investors have a good answer to the question where
am I paid most for illiquidity
Harvesting the illiquidity premium
Most investors have a strong preference for liquidity
But some ndash notably pensions and insurers ndash donrsquot always need
liquidity and may be overpaying for it
They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and ldquoprivate debtrdquo funds
35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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35
Multi Asset Strategy Global September 2012
abc
We found fund managers actively looking at the
following asset classes with potentially attractive
returns because of their illiquidity
Private debt Everyone is familiar with the
concept of private equity where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years with
investors locked into the fund during this
period Why not apply the same concept to
debt While private placements are not new ndash
insurance companies use them for their buy-
and-hold portfolios especially in the US ndash
they look increasingly attractive in a low-
yield world since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity yield and
covenants The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity
Infrastructure investment With
governments fiscally strapped and banks
deleveraging and constrained by tighter
capital rules (especially in Europe) there
should be opportunities for institutional
investment managers to step in Such deals
could be structured as publicprivate
partnerships (PPPs) with the investors
choosing which part of the capital structure to
participate in Some of these deals could be
low-risk as long as they focused on income
generating assets with utility-like returns ndash
but at a premium because the money was
locked in
Replacement for bank lending
Creditworthy companies may also struggle to
get long-term funding because of banksrsquo
troubles Could investment institutions step in
Such deals could be structured as closed-end
funds collateralised loan obligations (CLOs)
Real estate finance Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure Obviously this is a traditional area
for insurance companies and other long-
duration investors But many fund managers
are looking at the area afresh
There are hurdles too Many investors are
restricted from buying illiquid assets This is
particularly true of defined contribution (DC)
pensions which might actually benefit from
owning some Defined benefit (DB) pensions are
able to buy illiquid securities but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down European banks have been slow to unwind
their loan books hedge funds looking to expand
exposure to corporate loans have been
disappointed by the slow speed at which such
assets have come onto the market
Illiquid assets also entail risk rather like selling
an option Essentially an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position The danger is that after illiquid
assets gain in popularity one day they will blow
up causing regulators to clamp down
Implications for asset prices
If long-dated debt funds were to take off this
could have a significant impact on the pricing of
loans commercial real estate and on the returns
available from infrastructure projects
36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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36
Multi Asset Strategy Global September 2012
abc
The sources of growth The changing needs and dynamics of different
investor groups ndash the decline of defined benefit
(DB) pensions for example or the growing
wealth of Asian high net worth individuals ndash have
major implications for the investment
management industry and offer the best sources of
growth In this section we discuss these changes
and look at how the industry is responding
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but even more importantly about matching these to
what sits on the liability side of their balance-sheets
In the past decade they have become even more
constrained than before as regulators have pushed
them to derisk Low interest rates and longer life
expectancy have made it very hard for pension
funds in particular to produce sufficient return to
match projected liabilities
The struggle of DB pensions
Over the past two decades companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk but benefits from some advantages such as
the ability to take the pension pot with them to a
new job) In the UK for example only 18 of
DB pensions are still open to new members (down
from 35 in 2006) 54 are closed to new
members but allow existing members to continue
to make contributions 26 are closed even to
contributions and 2 are being wound up
Nonetheless DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010 for example) as shown in Chart
1 That is partly because public-sector pensions
are almost all DB and because in many major
pensions markets (Japan the Netherlands
Switzerland for example) DC funds are still rare
In the US DB pensions have shrunk to 61 of the
total and in the UK 67
Where will the money come from
Defined benefit pensions are dwindling
But personal pensions Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
But each of these will demand more sophisticated products
37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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37
Multi Asset Strategy Global September 2012
abc
1 Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source OECD
The biggest issue DB pensions face is their
increasing underfunding caused mainly by recent
poor returns and the fall in interest rates A study
by pension consultant Towers Watson found that
last year pension funds in 11 major economies
had on average a 25 gap between assets and
liabilities (compared to a 4 gap 10 years ago)
And the true situation would be even worse if
pension funds used realistic return assumptions In
the US for example both public-sector and
company DB pension schemes use an assumed
return of about 7frac34 That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 37
(and even the 2002-2011 average only 60) But
auditors insist on sticking to the long-run historical
return in calculating assumed returns
Investment managers are increasingly offering
holistic ldquopensions solutionsrdquo to plan sponsors
faced with this sort of dilemma The sort of risk-
minimising return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk
In the UK at least the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume ndash wrongly in our view ndash have a better
duration match with pension liabilities) This
move was propelled by the Pensions Act of 1995
and other regulatory changes Equities have fallen
to 42 of assets from 82 in 1993 (Chart 2)
2 UK pension fundsrsquo asset allocation
0
20
40
60
80
100
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash amp short term Debt Equities
Source ONS
The US has not yet seen the same phenomenon
Equities are a smaller share of assets than before
the 2007 crash but at 63 they are still higher
than at any time in the 1974-95 period
3 US private pension fundsrsquo asset allocation
0
20
40
60
80
100
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash amp short term Debt Equities
Source Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption After all it is almost impossible to
make a 7 or 8 return from bonds This is also
pushing US DB funds into a wide range of
alternative assets The California State Teachers
Retirement System (CalSTRS) with USD152bn
in assets for example has been looking to invest
in a range of oddities including covered calls
infrastructure leases senior secured debt royalty
38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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 ESP ltFEFF005500740069006c0069006300650020006500730074006100200063006f006e0066006900670075007200610063006900f3006e0020007000610072006100200063007200650061007200200064006f00630075006d0065006e0074006f0073002000640065002000410064006f0062006500200050004400460020007000610072006100200063006f006e00730065006700750069007200200069006d0070007200650073006900f3006e002000640065002000630061006c006900640061006400200065006e00200069006d0070007200650073006f0072006100730020006400650020006500730063007200690074006f00720069006f00200079002000680065007200720061006d00690065006e00740061007300200064006500200063006f00720072006500630063006900f3006e002e002000530065002000700075006500640065006e00200061006200720069007200200064006f00630075006d0065006e0074006f00730020005000440046002000630072006500610064006f007300200063006f006e0020004100630072006f006200610074002c002000410064006f00620065002000520065006100640065007200200035002e003000200079002000760065007200730069006f006e0065007300200070006f00730074006500720069006f007200650073002egt FRA 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 ITA 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 JPN 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 KOR 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ltFEFF005500740069006c0069007a006500200065007300730061007300200063006f006e00660069006700750072006100e700f50065007300200064006500200066006f0072006d00610020006100200063007200690061007200200064006f00630075006d0065006e0074006f0073002000410064006f0062006500200050004400460020007000610072006100200069006d0070007200650073007300f5006500730020006400650020007100750061006c0069006400610064006500200065006d00200069006d00700072006500730073006f0072006100730020006400650073006b0074006f00700020006500200064006900730070006f00730069007400690076006f0073002000640065002000700072006f00760061002e0020004f007300200064006f00630075006d0065006e0074006f00730020005000440046002000630072006900610064006f007300200070006f00640065006d0020007300650072002000610062006500720074006f007300200063006f006d0020006f0020004100630072006f006200610074002000650020006f002000410064006f00620065002000520065006100640065007200200035002e0030002000650020007600650072007300f50065007300200070006f00730074006500720069006f007200650073002egt SUO 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38
Multi Asset Strategy Global September 2012
abc
streams and distressed debt to try to get high
returns outside of equities (although it still has
50 of its assets in equities)
In the end the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities The problem is that by doing so they
could face a blow-up that would make
matters worse
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but in Europe
especially have been pushed even harder by
regulators to reduce risk (meaning lower their
equity weightings)
The proportion of equities held by insurers differs
significantly from one region to another US
insurers have significantly raised their equity
holdings over recent years equities now comprise
27 of assets up from less than 10 in the early
1990s (Chart 4)
4 Life insurers equities as of total assets
0
10
20
30
40
50
60
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source Federal Reserve Bank of Japan ONS ECB
By contrast UK insurers have cut their weighting
to roughly the US level 31 last year down from
over 50 in 2000 Data for Eurozone insurers
does not go back far but latest data show they
have only 19 in equities
The new European insurance capital solvency
directive Solvency II which comes into force in
2014 will require capital to be held against asset-
side as well as insurance risks equities will carry
a higher capital requirement than other assets
Given that Solvency II has been discussed for
years it is tempting to think that insurers must
have already adapted their portfolios for this But
the lack of any decline in equity holdings in the
past five years suggests this is not the case Many
believe that the insurance companies spent the
time lobbying against the new rules not preparing
for them It seems likely then that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules However
with bond yields so low this may be exactly the
wrong time to make this move German insurers
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed
Will US regulators follow the European lead and
tighten regulation on pension fundsrsquo and insurersrsquo
equity holdings It is a risk that many US
investment institutions are aware of Probably the
ingrained equity culture in the US will see off this
risk But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision
their needs ndash and the opportunities for investment
managers ndash are developing
DC pensions are growing as we saw above In
OECD countries their assets have doubled over
the past 10 years to USD6trn But governments
knowing that many people have failed to save
enough for their retirement are increasingly
ldquonudgingrdquo workers to set up DC pensions In the
UK for example the National Employment
Savings Trust (NEST) which begins operations in
39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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ESP 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FRA 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 PTB 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 SUO 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 SVE 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 ENU (PDF settings file for CGI Printers - Produces High Definition print ready PDFs 260606 - Craig Brown) gtgt Namespace [ (Adobe) (Common) (10) ] OtherNamespaces [ ltlt AsReaderSpreads false CropImagesToFrames true ErrorControl WarnAndContinue FlattenerIgnoreSpreadOverrides false IncludeGuidesGrids false IncludeNonPrinting false IncludeSlug false Namespace [ (Adobe) (InDesign) (40) ] OmitPlacedBitmaps false OmitPlacedEPS false OmitPlacedPDF false SimulateOverprint Legacy gtgt ltlt AddBleedMarks false AddColorBars false AddCropMarks false AddPageInfo false AddRegMarks false ConvertColors NoConversion DestinationProfileName () DestinationProfileSelector NA Downsample16BitImages true FlattenerPreset ltlt PresetSelector MediumResolution gtgt FormElements false GenerateStructure true IncludeBookmarks false IncludeHyperlinks false IncludeInteractive false IncludeLayers false IncludeProfiles true MultimediaHandling UseObjectSettings Namespace [ (Adobe) (CreativeSuite) (20) ] PDFXOutputIntentProfileSelector NA PreserveEditing true UntaggedCMYKHandling LeaveUntagged UntaggedRGBHandling LeaveUntagged UseDocumentBleed false gtgt ]gtgt setdistillerparamsltlt 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39
Multi Asset Strategy Global September 2012
abc
October this year will automatically enrol all
employees without an existing company pension
(unless they opt out) Employers must contribute
1 (3 in future) and can contribute more
The attraction of DC plans to investment
managers is that since no liabilities are attached
there is much greater freedom in the types of
investment products that can be offered One of
the most popular has been target-date or
lifestyling plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50 then wind that down to 0 by the time they
retire at 65) In some countries target-date plans
represent as much as 70 of the products sold to
individual pension holders
Increasingly retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost while making sure
that their clients understand the risks
Post-retirement
With a large cohort of retirees over the next few
years investment managers also sniff a big
opportunity in post-retirement products providing
annuities or other regular income-yielding
strategies for people whose DC pensions reach
maturity In the US for example 19 million
people will turn 60 between 2011 and 2015
compared to 13 million a decade ago (Chart 5)
Increasingly investment managers are selling ldquoto-
and-throughrdquo products where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product
5 No of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976
-198
0
1981
-198
5
1986
-199
0
1991
-199
5
1996
-200
0
2001
-200
5
2006
-201
0
2011
-201
5
2016
-202
0
2021
-202
5
2026
-203
0
Source United Nations
One of the key issues here is that with bond
yields at such low levels annuities in bonds no
longer work The concept that in retirement you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter Moreover
life expectancy has improved a US male aged 60
can expect to live at least another 20 years In
1971 he would have expected to live only to 76
Increasingly fund managers are telling retirees
not to cash in all their growthy assets Could there
even be a market for longevity insurance
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it) Estimates put the total at between
USD26trn and USD120trn
What is clear though is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want
We will not run through here all the data for the
number of high net worth individuals around the
world Suffice it to say that Wealth-Xrsquos World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD258trn Of that
USD89trn is in the US and USD34trn (13) in
40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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 DEU 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 ESP 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 FRA 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 ITA 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 JPN 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ltFEFFc7740020c124c815c7440020c0acc6a9d558c5ec0020b370c2a4d06cd0d10020d504b9b0d1300020bc0f0020ad50c815ae30c5d0c11c0020ace0d488c9c8b85c0020c778c1c4d560002000410064006f0062006500200050004400460020bb38c11cb97c0020c791c131d569b2c8b2e4002e0020c774b807ac8c0020c791c131b41c00200050004400460020bb38c11cb2940020004100630072006f0062006100740020bc0f002000410064006f00620065002000520065006100640065007200200035002e00300020c774c0c1c5d0c11c0020c5f40020c2180020c788c2b5b2c8b2e4002egt NLD (Gebruik deze instellingen om Adobe PDF-documenten te maken voor kwaliteitsafdrukken op desktopprinters en proofers De gemaakte PDF-documenten kunnen worden geopend met Acrobat en Adobe Reader 50 en hoger) NOR ltFEFF004200720075006b00200064006900730073006500200069006e006e007300740069006c006c0069006e00670065006e0065002000740069006c002000e50020006f0070007000720065007400740065002000410064006f006200650020005000440046002d0064006f006b0075006d0065006e00740065007200200066006f00720020007500740073006b00720069006600740020006100760020006800f800790020006b00760061006c00690074006500740020007000e500200062006f007200640073006b0072006900760065007200200065006c006c00650072002000700072006f006f006600650072002e0020005000440046002d0064006f006b0075006d0065006e00740065006e00650020006b0061006e002000e50070006e00650073002000690020004100630072006f00620061007400200065006c006c00650072002000410064006f00620065002000520065006100640065007200200035002e003000200065006c006c00650072002000730065006e006500720065002egt PTB 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 SUO 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 SVE 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AsReaderSpreads false CropImagesToFrames true ErrorControl WarnAndContinue FlattenerIgnoreSpreadOverrides false IncludeGuidesGrids false IncludeNonPrinting false IncludeSlug false Namespace [ (Adobe) (InDesign) (40) ] OmitPlacedBitmaps false OmitPlacedEPS false OmitPlacedPDF false SimulateOverprint Legacy gtgt ltlt AddBleedMarks false AddColorBars false AddCropMarks false AddPageInfo false AddRegMarks false ConvertColors NoConversion DestinationProfileName () DestinationProfileSelector NA Downsample16BitImages true FlattenerPreset ltlt PresetSelector MediumResolution gtgt FormElements false GenerateStructure true IncludeBookmarks false IncludeHyperlinks false IncludeInteractive false IncludeLayers false IncludeProfiles true MultimediaHandling UseObjectSettings Namespace [ (Adobe) (CreativeSuite) (20) ] PDFXOutputIntentProfileSelector NA PreserveEditing true UntaggedCMYKHandling LeaveUntagged UntaggedRGBHandling LeaveUntagged UseDocumentBleed false gtgt ]gtgt setdistillerparamsltlt 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40
Multi Asset Strategy Global September 2012
abc
emerging markets (Chart 6) But over the next
five years wealth in emerging market is expected
to grow faster that that in developed countries at
an annual rate of 79 a year in Asia and 121
in Latin America according to the report At these
growth rates by 2017 emerging markets will
represent 16 of global UHNWI wealth or
USD55trn out of USD339trn
6 Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
Nor
th A
mer
ica
Euro
pe
Asia
Latin
Am
eric
a
Mid
dle
East
Oce
ania
Afric
a
USD
trn
2012 2017
Source Wealth-X World Ultra Wealth Report 2012-2013
Increasingly that wealth will be held in securities
and managed by professional fund managers The
usual pattern is that as individuals in emerging
markets first achieve wealth they typically buy
real estate and leave the rest of their money in the
bank deposit Only when their wealth grows and
they became more sophisticated do they gain the
confidence to start to buy stocks and to go to a
private bank In the US for instance almost 70
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate) the corresponding percentage in China is
22 in India 5 and Indonesia 2 (Chart 7)
Over the next few years high net worth
individuals will also demand the sort of products
institutions have previously been offered They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return They too are looking to separate
alpha from beta for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds
While this market offers juicy prospects for
investment managers it is not easy to access this
wealth Setting up private bank offices in Hong
Kong Singapore or Miami is all very well but
that misses a lot of the potential wealth The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter
Those who have done so via joint ventures have
on the whole not seen great success But given
the potential size of assets to be gathered they
will not stop trying
7 Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as total assets Financial assets as total assets
Source ldquoThe World Distribution of Household Wealthrdquo by James B Davies Susanna Sandstrom Anthony Shorrocks and Edward N Wolff University o9f Ontario New York University UNU-WIDER (2006) HSBC
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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 ESP 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FRA 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 ITA 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 JPN ltFEFF9ad854c18cea51fa529b7528002000410064006f0062006500200050004400460020658766f8306e4f5c6210306b4f7f75283057307e30593002537052376642306e753b8cea3092670059279650306b4fdd306430533068304c3067304d307e3059300230c730b930af30c830c330d730d730ea30f330bf3067306e53705237307e305f306f30d730eb30fc30d57528306b9069305730663044307e305930023053306e8a2d5b9a30674f5c62103055308c305f0020005000440046002030d530a130a430eb306f3001004100630072006f0062006100740020304a30883073002000410064006f00620065002000520065006100640065007200200035002e003000204ee5964d3067958b304f30533068304c3067304d307e30593002gt KOR ltFEFFc7740020c124c815c7440020c0acc6a9d558c5ec0020b370c2a4d06cd0d10020d504b9b0d1300020bc0f0020ad50c815ae30c5d0c11c0020ace0d488c9c8b85c0020c778c1c4d560002000410064006f0062006500200050004400460020bb38c11cb97c0020c791c131d569b2c8b2e4002e0020c774b807ac8c0020c791c131b41c00200050004400460020bb38c11cb2940020004100630072006f0062006100740020bc0f002000410064006f00620065002000520065006100640065007200200035002e00300020c774c0c1c5d0c11c0020c5f40020c2180020c788c2b5b2c8b2e4002egt NLD (Gebruik deze instellingen om Adobe PDF-documenten te maken voor kwaliteitsafdrukken op desktopprinters en proofers De gemaakte PDF-documenten kunnen worden geopend met Acrobat en Adobe Reader 50 en hoger) NOR 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 PTB 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 SUO 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 SVE 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 ENU (PDF settings file for CGI Printers - Produces High Definition print ready PDFs 260606 - Craig Brown) gtgt Namespace [ (Adobe) (Common) (10) ] OtherNamespaces [ ltlt AsReaderSpreads false CropImagesToFrames true ErrorControl WarnAndContinue FlattenerIgnoreSpreadOverrides false IncludeGuidesGrids false IncludeNonPrinting false IncludeSlug false Namespace [ (Adobe) (InDesign) (40) ] OmitPlacedBitmaps false OmitPlacedEPS false OmitPlacedPDF false SimulateOverprint Legacy gtgt ltlt AddBleedMarks false AddColorBars false AddCropMarks false AddPageInfo false AddRegMarks false ConvertColors NoConversion DestinationProfileName () DestinationProfileSelector NA Downsample16BitImages true FlattenerPreset ltlt PresetSelector MediumResolution gtgt FormElements false GenerateStructure true IncludeBookmarks false IncludeHyperlinks false IncludeInteractive false IncludeLayers false IncludeProfiles true MultimediaHandling UseObjectSettings Namespace [ (Adobe) (CreativeSuite) (20) ] PDFXOutputIntentProfileSelector NA PreserveEditing true UntaggedCMYKHandling LeaveUntagged UntaggedRGBHandling LeaveUntagged UseDocumentBleed false gtgt ]gtgt setdistillerparamsltlt HWResolution [2400 2400] PageSize [612000 792000]gtgt setpagedevice
41
Multi Asset Strategy Global September 2012
abc
Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years The total assets of sovereign funds
broadly defined have grown to an estimated
USD20trn at the end of last year up from
USD16trn only four years ago Pure SWFs
constitute only USD48trn of this but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds are increasingly
important clients for international money
managers (Chart 8)
This is a particularly attractive area since the
money is stable these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years
8 Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserv es
81
Other
sov ereign
investment
v ehicles
72
Commodity
SWFs 27Non-
commd
SWFs 21
Source TheCityUK estimates (includes development funds pension reserve funds state-owned companies reserve investment corporations)
But SWFs face similar issues to other types of
investors How do they continue to generate
returns with interest rates so low Reserve
managers ndash which traditionally bought only high-
quality liquid fixed income securities in major
currencies (such as US Treasury bonds) ndash are
more and more being forced to look at other
currencies and even at credit Some central banks
have split their reserves into a ldquoliquidity trancherdquo
and an ldquoinvestment trancherdquo with the latter aiming
to generate higher returns over the long run
Some of the pure SWFs have very adventurous
asset allocation At the conservative extreme
Chilersquos Economic and Social Stabilization Fund
has 20 of its assets in cash and 80 in bonds
(Chart 9) But a number of funds have high equity
allocations (Norwayrsquos USD525bn fund for
example 60) And several (for example
Irelandrsquos National Pensions Reserve Fund) have a
significant allocation to alternative assets Of
course we do not know the allocation of more
secretive funds such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp
9 Selected SWFs asset allocation end-2010
0
20
40
60
80
100
Chi
le
Nor
way
Can
ada
Aust
ralia NZ
Irela
nd
Chi
na
Kore
a
Cash Equities Fix ed income Alternativ e assets
Source IMF
But it is not all good news for investment
managers The more sophisticated SWFs are
bringing more funds back in-house figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against
There are also questions over how quickly SWFs
can grow in future Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers notably China These conditions may
not continue
42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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ESP 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42
Multi Asset Strategy Global September 2012
abc
Unavoidable momentum ESG (environmental social governance) and SRI
(socially responsible investment) are buzzwords
that have a lot of investment managers scratching
their heads They know that plan sponsors ndash
particularly for public pension funds in Europe ndash
increasingly take these concepts seriously but
many investment managers donrsquot quite know how
to respond
1 SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
Source US SIF Eurosif (definitions differ slightly)
On the surface assets managed under SRI
principles are big over USD8trn in Europe
(notably USD26trn in France) and around
USD3trn in the US at end-2010 (Chart 1) But the
definition of what comprises SRI is vague 76 of
the European SRI assets are ldquobroad SRIrdquo which is
defined as a simple screening of companies (for
example excluding some on ethical grounds)
integrating SRI principles into the fund managerrsquos
processes and engaging with management Most
fund managers would claim they do that ldquoCore
SRIrdquo which includes positively screening for best-
in-class companies or running an SRI thematic
fund totals USD17trn
And the SRI principles themselves ndash as defined by
the United Nationsrsquo ldquoPrinciples for Responsible
Investmentrdquo (PRI) ndash are hardly earth-shattering
(Table 2) Most prudent fund managers would
find they follow them without consciously having
an SRI focus
But there is no doubt that ESG is becoming more
important Broad SRI assets in Europe have
grown from almost zero in 2005 to USD8trn
Another estimate suggests that institutions
managing funds totalling USD30trn have signed
up to the UNrsquos PRI Public pension funds
increasingly demand ESG compliance when
putting out mandates for tender One European
investment manager told us that the firm already
pays 20 of broker commission based on ESG
service and expects this to rise to 40
The challenge of ESG
Pension plan sponsors especially in Europe are increasingly
focusing on environment social and governance issues
So far most fund managers pay only lip-service to this
But momentum is building and companies with superior ESG
policies and disclosure might start to outperform
43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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ESP 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FRA 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ltFEFF005500740069006c0069007a006500200065007300730061007300200063006f006e00660069006700750072006100e700f50065007300200064006500200066006f0072006d00610020006100200063007200690061007200200064006f00630075006d0065006e0074006f0073002000410064006f0062006500200050004400460020007000610072006100200069006d0070007200650073007300f5006500730020006400650020007100750061006c0069006400610064006500200065006d00200069006d00700072006500730073006f0072006100730020006400650073006b0074006f00700020006500200064006900730070006f00730069007400690076006f0073002000640065002000700072006f00760061002e0020004f007300200064006f00630075006d0065006e0074006f00730020005000440046002000630072006900610064006f007300200070006f00640065006d0020007300650072002000610062006500720074006f007300200063006f006d0020006f0020004100630072006f006200610074002000650020006f002000410064006f00620065002000520065006100640065007200200035002e0030002000650020007600650072007300f50065007300200070006f00730074006500720069006f007200650073002egt SUO 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43
Multi Asset Strategy Global September 2012
abc
US investment managers are more ambivalent
ESG is growing much more slowly in the US ndash
although some labour unions are pushing for it in
company pension schemes Non-US clients often
ask questions about ESG policies when offering
mandates and a number of US fund managers
have signed up for the SRI principles without
substantially changing their investment processes
More cautious ndash or perhaps more punctilious ndash
US investment managers have set up internal
committees to see what they need to do to adhere
wholeheartedly to the principles
But the momentum is building Pension
consultancy firm Mercer will include its
proprietary ESG ratings of investment managers
in client reports related to manager searches and
performance by the end of 2012 Mercer ranks
investment firms from 1 (the highest rating) to
4 based on their incorporation of ESG factors in
the generation of investment ideas construction of
portfolios and implementation of active ownership
practices Ratings are currently dismal among
equity managers worldwide only 2 score a 1
and 7 a 2 with 44 rated 3 and 47 4
Another pension consultant TowersWatson
also recently published a major report on
sustainable investment
Most investment managers take the view that ESG
is a positive force as long as it is about adding
value for example engaging with companies on
improving their policies on pay governance
environmental compliance corruption or
treatment of employees Which fund manager
after all wants to buy a company that has
problems in these areas But many especially in
the US worry that taken too far ESG can get in
the way of making good investment returns
Exclusion is a step too far for many avoiding
investment in tobacco companies or arms
manufacturers for example could damage
performance Increasingly though the trend in
ESG is towards integration and governance (and
in all asset classes not just equities) with
exclusion and environmental factors lagging
A further difficulty is that it is not easy to invest
along SRI lines using passive strategies There are
only a few SRI indexes for example Dow Jones
Sustainability World Index (W1SGI) Calvert
Social Index (CALVIN) iShares MSCI USA ESG
Index (KLD US) and MSCI World ESG Index
2 United Nationsrsquo Principles for Responsible Investment and examples of possible actions
1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools metrics and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates monitoring procedures performance indicators and incentive structures accordingly (for example ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Supportparticipate in networks and information platforms to share tools pool resources and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting engagement andor policy dialogue) Report on progress andor achievements relating to the Principles using a Comply or Explain1 approach
Source wwwunpriorg
44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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ESP 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 FRA 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 KOR ltFEFFc7740020c124c815c7440020c0acc6a9d558c5ec0020b370c2a4d06cd0d10020d504b9b0d1300020bc0f0020ad50c815ae30c5d0c11c0020ace0d488c9c8b85c0020c778c1c4d560002000410064006f0062006500200050004400460020bb38c11cb97c0020c791c131d569b2c8b2e4002e0020c774b807ac8c0020c791c131b41c00200050004400460020bb38c11cb2940020004100630072006f0062006100740020bc0f002000410064006f00620065002000520065006100640065007200200035002e00300020c774c0c1c5d0c11c0020c5f40020c2180020c788c2b5b2c8b2e4002egt NLD (Gebruik deze instellingen om Adobe PDF-documenten te maken voor kwaliteitsafdrukken op desktopprinters en proofers De gemaakte PDF-documenten kunnen worden geopend met Acrobat en Adobe Reader 50 en hoger) NOR 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 PTB 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 SUO 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44
Multi Asset Strategy Global September 2012
abc
(GSIN) There are also a number of specialist
funds such as the Domini Social Equity Fund
(DSEFX US) and managers such as Zurich-based
Sustainable Asset Management
But the performance of the SRI indexes has been
lacklustre relative to their comparable main
market indexes (Table 3) How much performance
are investors or plan sponsors willing to give up in
return for the satisfaction that their investments
are doing no harm
3 Performance of SRI indexes
Relative perf Index Compared
to 1Y 2Y 5Y
Dow Jones Sustainability World Index
MSCI ACWI -32 -58 -112
Calvert Social Index MSCI US 15 -02 19 iShares MSCI USA ESG Index
MSCI US -37 -41 na
MSCI World ESG Index MSCI World -10 -19 na
Source HSBC Bloomberg MSCI (Total gross return inUSD)
Implications for asset prices
In our view ESG is a concept that will expand
further Retail investors like the idea that they
hold only ldquohonourablerdquo companies So do
governments and other public fund sponsors
Fund management firms will increasingly adjust
their processes to take these preferences into
account Pressure will also increase on companies
to be become more transparent on their ESG
performance the Hong Kong Stock Exchange for
example recently announced that it will oblige
listed companies to make certain ESG disclosures
(or explain why they cannot) from 2015 with a
recommendation that they do so from next year
The European Union has also published proposals
for ESG disclosure by investment managers
With a recent focus on poor governance (notably
in China) we think it likely that investors will
start to focus more on ESG issues in the
investment decision-making process This may
mean that companies with strong ESG disclosure
and top-quality practices will outperform This is
certainly an area that fund managers will need to
spend more time on
45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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45
Multi Asset Strategy Global September 2012
abc
Notes
46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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FRA 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46
Multi Asset Strategy Global September 2012
abc
Disclosure appendix Analyst Certification The following analyst(s) economist(s) andor strategist(s) who is(are) primarily responsible for this report certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) andor any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report Garry Evans
Important disclosures
Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions which depend largely on individual circumstances such as the investors existing holdings risk tolerance and other considerations Given these differences HSBC has two principal aims in its equity research 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon and 2) from time to time to identify short-term investment opportunities that are derived from fundamental quantitative technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating HSBC has assigned ratings for its long-term investment opportunities as described below
This report addresses only the long-term investment opportunities of the companies referred to in the report As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at wwwhsbcnetcomresearch Details of these short-term investment opportunities can be found under the Reports section of this website
HSBC believes an investors decision to buy or sell a stock should depend on individual circumstances such as the investors existing holdings and other considerations Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations Investors should carefully read the definitions of the ratings used in each research report In addition because research reports contain more complete information concerning the analysts views investors should carefully read the entire research report and should not infer its contents from the rating In any case ratings should not be used or relied on in isolation as investment advice
Rating definitions for long-term investment opportunities
Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis
For each stock we set a required rate of return calculated from the cost of equity for that stockrsquos domestic or as appropriate regional market established by our strategy team The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon The performance horizon is 12 months For a stock to be classified as Overweight the potential return which equals the percentage difference between the current share price and the target price including the forecast dividend yield when indicated must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) For a stock to be classified as Underweight the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile) Stocks between these bands are classified as Neutral
Our ratings are re-calibrated against these bands at the time of any material change (initiation of coverage change of volatility status or change in price target) Notwithstanding this and although ratings are subject to ongoing management review expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change
47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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 ESP 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FRA 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ltFEFF004200720075006b00200064006900730073006500200069006e006e007300740069006c006c0069006e00670065006e0065002000740069006c002000e50020006f0070007000720065007400740065002000410064006f006200650020005000440046002d0064006f006b0075006d0065006e00740065007200200066006f00720020007500740073006b00720069006600740020006100760020006800f800790020006b00760061006c00690074006500740020007000e500200062006f007200640073006b0072006900760065007200200065006c006c00650072002000700072006f006f006600650072002e0020005000440046002d0064006f006b0075006d0065006e00740065006e00650020006b0061006e002000e50070006e00650073002000690020004100630072006f00620061007400200065006c006c00650072002000410064006f00620065002000520065006100640065007200200035002e003000200065006c006c00650072002000730065006e006500720065002egt PTB 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 SUO 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47
Multi Asset Strategy Global September 2012
abc
A stock will be classified as volatile if its historical volatility has exceeded 40 if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility However stocks which we do not consider volatile may in fact also behave in such a way Historical volatility is defined as the past months average of the daily 365-day moving average volatilities In order to avoid misleadingly frequent changes in rating however volatility has to move 25 percentage points past the 40 benchmark in either direction for a stocks status to change
Rating distribution for long-term investment opportunities
As of 26 September 2012 the distribution of all ratings published is as follows Overweight (Buy) 48 (27 of these provided with Investment Banking Services)
Neutral (Hold) 38 (26 of these provided with Investment Banking Services)
Underweight (Sell) 14 (22 of these provided with Investment Banking Services)
Analysts economists and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues
For disclosures in respect of any company mentioned in this report please see the most recently published report on that company available at wwwhsbcnetcomresearch
HSBC Legal Entities are listed in the Disclaimer below
Additional disclosures 1 This report is dated as at 26 September 2012 2 All market data included in this report are dated as at close 19 September 2012 unless otherwise indicated in the report 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business HSBCs analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBCs Investment Banking business Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential andor price sensitive information is handled in an appropriate manner
48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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 ESP 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FRA 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 PTB 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 SUO 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 SVE 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48
Multi Asset Strategy Global September 2012
abc
Disclaimer Legal entities as at 8 August 2012 lsquoUAErsquo HSBC Bank Middle East Limited Dubai lsquoHKrsquo The Hongkong and Shanghai Banking Corporation Limited Hong Kong lsquoTWrsquo HSBC Securities (Taiwan) Corporation Limited CA HSBC Bank Canada Toronto HSBC Bank Paris Branch HSBC France lsquoDErsquo HSBC Trinkaus amp Burkhardt AG Duumlsseldorf 000 HSBC Bank (RR) Moscow lsquoINrsquo HSBC Securities and Capital Markets (India) Private Limited Mumbai lsquoJPrsquo HSBC Securities (Japan) Limited Tokyo lsquoEGrsquo HSBC Securities Egypt SAE Cairo lsquoCNrsquo HSBC Investment Bank Asia Limited Beijing Representative Office The Hongkong and Shanghai Banking Corporation Limited Singapore Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch The Hongkong and Shanghai Banking Corporation Limited Seoul Branch HSBC Securities (South Africa) (Pty) Ltd Johannesburg HSBC Bank plc London Madrid Milan Stockholm Tel Aviv lsquoUSrsquo HSBC Securities (USA) Inc New York HSBC Yatirim Menkul Degerler AS Istanbul HSBC Meacutexico SA Institucioacuten de Banca Muacuteltiple Grupo Financiero HSBC HSBC Bank Brasil SA ndash Banco Muacuteltiplo HSBC Bank Australia Limited HSBC Bank Argentina SA HSBC Saudi Arabia Limited The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR
Issuer of report The Hongkong and Shanghai Banking Corporation Limited Level 19 1 Queenrsquos Road Central
Hong Kong SAR
Telephone +852 2843 9111 Telex 75100 CAPEL HX
Fax +852 2596 0200
Website wwwresearchhsbccom
This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (ldquoHSBCrdquo) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers it is not intended for and should not be distributed to retail customers in Hong Kong The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong If it is received by a customer of an affiliate of HSBC its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified HSBC makes no guarantee representation or warranty and accepts no responsibility or liability as to its accuracy or completeness Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice HSBC and its affiliates andor their officers directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment) HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments) may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies HSBC Securities (USA) Inc accepts responsibility for the content of this research report prepared by its non-US foreign affiliate All US persons receiving andor accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc in the United States and not with its non-US foreign affiliate the issuer of this report In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK In Singapore this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (ldquoSFArdquo) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA This publication is not a prospectus as defined in the SFA It may not be further distributed in whole or in part for any purpose The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore Recipients in Singapore should contact a Hongkong and Shanghai Banking Corporation Limited Singapore Branch representative in respect of any matters arising from or in connection with this report In Australia this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970 AFSL 301737) for the general information of its ldquowholesalerdquo customers (as defined in the Corporations Act 2001) Where distributed to retail customers this research is distributed by HSBC Bank Australia Limited (AFSL No 232595) These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law No consideration has been given to the particular investment objectives financial situation or particular needs of any recipient This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited New Zealand Branch incorporated in Hong Kong SAR In Japan this publication has been distributed by HSBC Securities (Japan) Limited It may not be further distributed in whole or in part for any purpose In Korea this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited Seoul Securities Branch (HBAP SLS) for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (ldquoFSCMArdquo) This publication is not a prospectus as defined in the FSCMA It may not be further distributed in whole or in part for any purpose HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea In Canada this document has been distributed by HSBC Bank Canada andor its affiliates Where this document contains market updatesoverviews or similar materials (collectively deemed ldquoCommentaryrdquo in Canada although other affiliate jurisdictions may term ldquoCommentaryrdquo as either ldquomacro-researchrdquo or ldquoresearchrdquo) the Commentary is not an offer to sell or a solicitation of an offer to sell or subscribe for any financial product or instrument (including without limitation any currencies securities commodities or other financial instruments) copy Copyright 2012 The Hongkong and Shanghai Banking Corporation Limited ALL RIGHTS RESERVED No part of this publication may be reproduced stored in a retrieval system or transmitted on any form or by any means electronic mechanical photocopying recording or otherwise without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited MICA (P) 038042012 MICA (P) 063042012 and MICA (P) 206012012
[343594]
Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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Employed by a non-US affiliate of HSBC Securities (USA) Inc and is not registeredqualified pursuant to FINRA regulations
By Garry Evans
We are in an unusual investment world of ultra-low interest rates swings between risk-on and
risk-off and investors demanding yield low fees and limited risk
This raises big challenges for the investment management industry We identify 10 trends that
that are shaping the industry ndash from the decline of hedge funds and the growth of multi-asset
funds to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix and with the Disclaimer which forms part of it
The 10 key trends changinginvestment managementhellipand how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevanshsbccomhk
Garry heads HSBCs equity strategy team worldwide His previous roles at HSBC include Asia Pacific Equity Strategist Head of
Pan-Asian Equity Research and Japan Strategist Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC in Tokyo in 1998 Garry is based in Hong Kong
120926_50909_Garry Evans_Glossy Covers_FNormal Cover 2011 9272012 1241 AM Page 1
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ESP 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 FRA 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 ITA ltFEFF005500740069006c0069007a007a006100720065002000710075006500730074006500200069006d0070006f007300740061007a0069006f006e00690020007000650072002000630072006500610072006500200064006f00630075006d0065006e00740069002000410064006f006200650020005000440046002000700065007200200075006e00610020007300740061006d007000610020006400690020007100750061006c0069007400e00020007300750020007300740061006d00700061006e0074006900200065002000700072006f006f0066006500720020006400650073006b0074006f0070002e0020004900200064006f00630075006d0065006e007400690020005000440046002000630072006500610074006900200070006f00730073006f006e006f0020006500730073006500720065002000610070006500720074006900200063006f006e0020004100630072006f00620061007400200065002000410064006f00620065002000520065006100640065007200200035002e003000200065002000760065007200730069006f006e006900200073007500630063006500730073006900760065002egt JPN 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 KOR ltFEFFc7740020c124c815c7440020c0acc6a9d558c5ec0020b370c2a4d06cd0d10020d504b9b0d1300020bc0f0020ad50c815ae30c5d0c11c0020ace0d488c9c8b85c0020c778c1c4d560002000410064006f0062006500200050004400460020bb38c11cb97c0020c791c131d569b2c8b2e4002e0020c774b807ac8c0020c791c131b41c00200050004400460020bb38c11cb2940020004100630072006f0062006100740020bc0f002000410064006f00620065002000520065006100640065007200200035002e00300020c774c0c1c5d0c11c0020c5f40020c2180020c788c2b5b2c8b2e4002egt NLD (Gebruik deze instellingen om Adobe PDF-documenten te maken voor kwaliteitsafdrukken op desktopprinters en proofers De gemaakte PDF-documenten kunnen worden geopend met Acrobat en Adobe Reader 50 en hoger) NOR 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 PTB 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 SUO ltFEFF004b00e40079007400e40020006e00e40069007400e4002000610073006500740075006b007300690061002c0020006b0075006e0020006c0075006f0074002000410064006f0062006500200050004400460020002d0064006f006b0075006d0065006e007400740065006a00610020006c0061006100640075006b006100730074006100200074007900f6007000f60079007400e400740075006c006f0073007400750073007400610020006a00610020007600650064006f007300740075007300740061002000760061007200740065006e002e00200020004c0075006f0064007500740020005000440046002d0064006f006b0075006d0065006e00740069007400200076006f0069006400610061006e0020006100760061007400610020004100630072006f0062006100740069006c006c00610020006a0061002000410064006f00620065002000520065006100640065007200200035002e0030003a006c006c00610020006a006100200075007500640065006d006d0069006c006c0061002egt SVE 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 ENU (PDF settings file for CGI Printers - Produces High Definition print ready PDFs 260606 - Craig Brown) gtgt Namespace [ (Adobe) (Common) (10) ] OtherNamespaces [ ltlt AsReaderSpreads false CropImagesToFrames true ErrorControl WarnAndContinue FlattenerIgnoreSpreadOverrides false IncludeGuidesGrids false IncludeNonPrinting false IncludeSlug false Namespace [ (Adobe) (InDesign) (40) ] OmitPlacedBitmaps false OmitPlacedEPS false OmitPlacedPDF false SimulateOverprint Legacy gtgt ltlt AddBleedMarks false AddColorBars false AddCropMarks false AddPageInfo false AddRegMarks false ConvertColors NoConversion DestinationProfileName () DestinationProfileSelector NA Downsample16BitImages true FlattenerPreset ltlt PresetSelector MediumResolution gtgt FormElements false GenerateStructure true IncludeBookmarks false IncludeHyperlinks false IncludeInteractive false IncludeLayers false IncludeProfiles true MultimediaHandling UseObjectSettings Namespace [ (Adobe) (CreativeSuite) (20) ] PDFXOutputIntentProfileSelector NA PreserveEditing true UntaggedCMYKHandling LeaveUntagged UntaggedRGBHandling LeaveUntagged UseDocumentBleed false gtgt ]gtgt setdistillerparamsltlt HWResolution [2400 2400] PageSize [612000 792000]gtgt setpagedevice