investment strategy webinar - aon · investment strategy webinar january 16, 2013. 2 ......
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Investment Strategy Webinar
January 16, 2013
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Presenters
Steve Cummings, President & CEOPhone: 847.442.0064Email: [email protected]
Mike Sebastian, PartnerPhone: 312.715.3352Email: [email protected]
Peter Hill, PartnerPhone: 312.715.2925Email: [email protected]
Kristen Doyle, Associate PartnerPhone: 312.715.3310Email: [email protected]
Tapan Datta, PrincipalGlobal Asset AllocationPhone: 011 + 44 020 7086 9076Email: [email protected]
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Presenters (cont’d)
Kevin Hrad, Senior ConsultantPhone: 312.715.3337Email:[email protected]
Lucinda Downing, Senior Research AnalystPhone: 001 +44 207 086 9440Email: [email protected]
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Discussion Topics
Opening Remarks Market Views: Fiscal Cliff and Diversification Opportunities Hedge Funds in 2013 Securities Lending Regulatory and Market Update Closing RemarksQ&A Session
Market Update and a focus on Emerging Market Local Currency Debt
Tapan Datta & Lucinda Downing
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Fiscal Cliff Aftermath – Tax Hikes to Pressure the Consumer
Fiscal cliff’s worst scenario avoided, but there is an aftermath…
$200 bn in tax rises coming through, which is not far from 2% of disposable income, a point of weakness in the economy over several years…
If sequester is avoided, the economy can bear it, if it is not, far worse outcomes possible.
If sequester is avoided, consumer and business spending can just offset each other.
THE INCOME STRUGGLE(Real personal disposable income, $m, constant prices)
4000
5000
6000
7000
8000
9000
10000
11000
Jan-93
Jan-95
Jan-97
Jan-99
Jan-01
Jan-03
Jan-05
Jan-07
Jan-09
Jan-11
7
Treasury Bond Yields – Less One Sided!
Some firmness in US treasury yields is appearing, and the yield curve has been steepening.
Driven by doubts about how much more balance sheet expansion by the Fed.
Inflation expectations remain contained.
Fiscal issues still showing limited impact so far…sequester impact?
TREASURY YIELDS: LONGER YIELDS FIRMER(% rise in yields since end June 2012)
-0.1
-0.05
0
0.05
0.1
0.15
0.2
0.25
0.3
1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 30Y
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Equities Versus Bonds: How Will the Equity Risk Premium Normalize?
Though equities still face lots of risks, ultra-low bond yields make equities look very attractive on a relative basis. Equity risk premiums are over 2% higher than normal.
The unusually high equity risk premium will correct either through rising bond yields, or because profit outcomes disappoint expectations.
We expect both, but the adjustment process is more likely to come from rising bond yields.
Equities should be outperforming bonds.
US EQUITY RISK PREMIUM
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
Jan 98 Jan 01 Jan 04 Jan 07 Jan 10 Jan 13ERP
Equities cheap relative to Government bonds
Equities expensive relative to government bonds
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Historical Breakdown of Total Return
Limited interest rate risk
Portfoliodiversification
Potential for capital and currency
appreciation
Yield enhancement
Local EM debtbenefits
With low yield levels in developed markets and a continuing search for yield, local emerging debt offers an attractive yield.
Our positive view on local emerging debt relative to other fixed income asset classes is based on this yield pick-up and expected currency appreciation.
Currency’s high return contribution in any one year means that it is important to get the currency direction right.
Benefits of Emerging Market Local Currency Debt
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Local Currency Emerging Debt: Character Attributes?
Local and hard currency bond yields have different return drivers:
– Domestic rates, not USLocal debt is driven more by domestic emerging market factors, whilst hard currency debt is anchored on US yields.
– Higher credit ratingThe average credit rating of local debt is higher than that of hard currency debt (BBB+ vs BB+). Over 80% of local EM debt is investment grade, compared to around 60% in hard currency.
– Shorter durationThe average duration of the local bond index currently stands at 4.9, compared to 7.5 for hard currency debt.
– More concentrationThere are just 15 countries in the JPMorgan GBI-EM Global Diversified Index compared to 55 countries in the EMBI Global Diversified Index, JPMorgan’s hard currency index.
Local debt yield = Local yield + currency exposureHard currency debt yield = US treasury yield + credit spread
Hard and Local EM Debt Yields
4
6
8
10
12
14
16
Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
Dec-10
Dec-11
%Hard Currency EM Debt Local EM Debt
Despite higher credit quality, local emerging bond yields are higher than hard currency counterparts as low US yields have dragged down ‘safer’ hard EM debt.
Country Weights:GBI-EM Global Diversified Index
Indonesia 10%
Malaysia 10%
Mexico 10%
Russia 10%
South Africa 10%
Turkey 10%
Brazil9% Chile
0%Colombia
4%
Hungary 6%
Poland 10%Philippines
1%
Thailand 7%
Peru 2%
Nigeria1%
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Summary of Medium-Term Market Views
Equities Cautious on medium-term view, but prefer to bonds We still favor large cap, but view now moderated after small cap
underperformance We are neutral on growth vs value Even with US underperforming we favour non-US markets on any rebalancing
Bonds Continue with negative views on bonds Take profits on credit – move back towards target Favor intermediate to long duration interest rate exposure, but long duration
credit exposure Prefer local to hard currency emerging market debt
Alternative Asset Classes Favor real estate, hedge funds, infrastucture and selected private equity investments
Hedge Funds in 2013
Kevin Hrad
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Hedge Funds: 2012 Performance Overview
2012 Hedge Fund Performance vs. Strategy Indices
4.7%3.4%
0.7%
4.9%
6.9%
4.1%
-2.8% -2.3% -1.6%-2.5%
-4.6%
3.0%1.7%
3.4% 3.6%
1.8%
-1.0%
3.1%1.8%
6.2%5.2%
-0.2%
8.5% 7.4%
10.0%
0.1%
2.9%2.4% 1.9%1.3%
-6.0%-4.0%-2.0%0.0%2.0%4.0%6.0%8.0%
10.0%12.0%
HFRI Fund WeightedComposite Index
HFRI Fund of FundsComposite Index
HFRI Macro Index(22.1%)
HFRI Event-DrivenIndex (24.5%)
HFRI Equity HedgeIndex (26.7%)
HFRI Relative ValueIndex (26.7%)
1Q 2012 2Q 2012 3Q 2012 4Q 2012 2012 Year
2012 Hedge Fund Performance vs. Major Market Indices
4.7%3.4%
11.9%
0.3%
-5.6%
3.0% 2.4%
6.8%
1.6%1.3% 1.8%0.2%
6.2% 5.2%
16.1%
4.2%
-2.3%-2.8%
2.1%2.9%
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
HFRI Fund Weighted CompositeIndex
HFRI Fund of Funds CompositeIndex
MSCI ACWI Barclays Agg Bond Index
1Q 2012 2Q 2012 3Q 2012 4Q 2012 2012 Year
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Have Hedge Funds Underperformed?
The risk-return chart above plots the annualized return of hedge fund and various public market indices over the past 4 years against the annualized volatility over the same period
The plots illustrate that, on a risk-adjusted basis compared to a hypothetical policy benchmark of 65% global equity / 35% U.S. bonds, direct hedge fund strategies have performed relatively well while FoHFs have been in-line
Risk/Return: Trailing 4 Years Ending 12/31/2012
Dow Jones U.S. Total Stock Market Index
MSCI All Country World ex-U.S. Index
MSCI All Country World Index
Barclays AggregateBond Index
Credit Suisse High Yield Index
HFRI Fund Weighted Composite Index
HFRI Fund of Funds Composite Index
65/35 ACWI/BC Agg
T-Bills
0%
5%
10%
15%
20%
25%
0% 5% 10% 15% 20% 25%Annualized Risk
Annu
aliz
ed R
etur
n
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Return Dispersion Across Hedge Funds
Source: HFR
2012 Risk and Return of Individual Hedge Funds Hedge fund index returns do not account for the success of individual managers
– Thousands of hedge funds report returns to various index providers (>2,200 direct hedge funds and >600 fund of hedge funds (FoHFs) included in HFR indices)
– Return dispersion across managers remains relatively high
– Larger managers generally outperformed smaller and less experienced peers and amassed the bulk of inflows during 2012
– Investors should focus on high conviction managers with characteristics indicative of future success: Broad ownership and significant co-
investment among key professionals Large and stable asset base of high
quality investors Well-resourced (front and back office) Sound philosophy and process Strong track risk-adjusted track record Fair terms, accessible, transparent Source: Deutsche Bank Markets Prime Finance,
Hedge Fund Intelligence
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2013 Industry Outlook
Hedge fund performance expectations for 2013 are difficult to forecast, however we expect returns to exceed those of traditional equity and fixed income markets on a risk-adjusted basis
Hewitt EnnisKnupp Medium Term Views:– Limited upside for stocks with earnings growth headwinds, fiscal tightening, and potential volatility– Very low bond yields with greater downside than upside risk– Hedge funds best equipped to add value amid fluid market conditions
Notable Trends
– Institutional interest in hedge funds has never been greater, and we expect this trend to continue; plan sponsors have been implementing new and expanding hedge fund portfolios across a variety of objectives
– The last couple years have been difficult for many hedge funds; with a waning outlook for incentive fees and with top performers drawing capital from weaker managers, we expect some consolidation but also an elevated number of spin-out launches
– We expect the trend of outflows from FoHFs to continue as the industry has been squeezed by competitive forces
In response, FoHF managers have been evolving to remain relevant among larger institutional investors
Likely to see further consolidation, custom solutions, and specialized strategies such as the seeders and specialty and illiquid credit funds that emerged in 2012
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2013 Strategy Outlook
Credit markets offer some of the most appealing risk/reward characteristics, and event-driven / credit opportunities are abundant– Managers have been sifting for value through settlement claims and European sovereigns, and
others see value in pockets of the RMBS market– A relatively scarce amount of M&A activity in 2012 should be surpassed in 2013; excess cash
reserves and tempered organic growth prospects suggest more strategic acquisitions– Even as credit-oriented opportunities surfaced during the course of 2012, managers have generally
remained patient to wait for an attractive entry point
Global macro managers have a brighter outlook within the political/central bank-driven environment after a year of steadily rising equity markets and dampened trading volumes; larger and more nimble managers have an advantage
Long/short equity managers were largely positioned neutrally in terms of their net and gross exposure ranges due to uncertainty regarding the fiscal cliff outcome and other macro/political factors; managers have since become fully invested along with more big picture clarity
Large, established, and globally-oriented multi-strategy managers continue to be well-positioned to take advantage of fluid opportunities; those with longer horizons and less need for liquidity are able to fill financing voids left by banks and others investors limited by capital needs and guidelines
The emergence of opportunistic fund launches that offer investors an opportunity to harness price dislocations in more illiquid market segments, mainly credit; characteristics include high single-digit / low double-digit return objectives, specialized mandates, drawdown structures
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2013 Strategy Outlook (cont’d)
Source: KKRSource: J.P. Morgan Prime Brokerage
A favorable stock-picking environment should support long/short equity managers– Stock correlations have fallen dramatically
since the elevated levels seen in 2010-2011– Secular trends in several sectors creating
opportunities– Potential to reduce volatility of long-only
equity portfolio
The search for yield should boost demand for specialized credit managers
– With spreads and yields at historical lows, opportunities exist both long and short
– Shorts focus on overvalued credit in late cycle bull market, and long positions invest in specialized markets (e.g. direct lending)
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Hedge Fund Asset Flows
Total hedge fund assets under management continue to grow steadily
AUM reached all-time highs in 2013 and is expected to increase primarily through allocations from institutional investors
While total asset flows have been positive over the past 3 years, FoHFs have experienced net outflows in each of the past 5 years
Source: HFR
Source: HFR
Hedge Fund Industry Annual Asset Flows
$-
$500,000
$1,000,000
$1,500,000
$2,000,000
$2,500,000
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Q12012
Q22012
Q32012
-$200,000-$150,000-$100,000-$50,000$0$50,000$100,000$150,000$200,000$250,000
Assets Net Flows
$ Milli
ons)
$ Millions)
Hedge Fund Asset Flows: Direct vs. FoHFs
$(250,000)
$(200,000)
$(150,000)
$(100,000)
$(50,000)
$-
$50,000
$100,000
$150,000
$200,000
$250,000
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
(YTD
)
($ M
illio
ns)
Single Strategy Hedge Funds FoHFs
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Fund of Hedge Funds Developments
FoHFs are adapting to a more difficult business environment
Institutional investors in particular have become more educated on hedge funds, and demands for higher returns and lower fees has led many to build portfolios of direct investments
A sharp rise in M&A activity
– Legacy owners using industry consolidation as an exit opportunity
Likely influenced by tax incentives and business valuations
– FoHFs struggling with organic growth are partnering with firms for greater outreach
Retail segment of U.S. and Europe is one targeted area
Institutional investors have leverage to negotiate with FoHF managers
FoHF Actions Client Activity
Strategic partnerships Customized accounts Opportunistic investments Acquisitions
Many institutional investors have elected to phase out their FoHF allocations in favor of direct mandates
FoHFs remain a popular option for others:– First time allocations– Inability to meet multiple direct fund
minimums– Limited staff resources
Securities Lending Regulatory and Market Update
Kristen Doyle
22
Securities Lending Regulatory Environment Update
Several rules and regulations that have been debated, scrutinized, and lobbied for and against since the aftermath of the 2008 financial crisis are set to begin taking effect in 2013
Certain components of the overarching financial industry reforms may directly impact the securities lending market
The regulations that HEK is following include:– Basel III– Dodd Frank: Section 165(e)– Dodd Frank: The Volcker Rule– Money market reform
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Basel III & Dodd Frank - Section165(e)
Basel III Recommendations on banking laws and regulations that create international standards
for capital requirements Basel III, which will begin to take effect this year and be phased in through 2018, calls for
higher capital requirements than Basel II– Under Basel III, banks are required to hold 4.5% of common equity (up from 2%) and
6% of Tier I capital (up from 4%)– Additional capital buffers that regulators can trigger in periods of high credit growth
Dodd Frank – Section 165(e) Dodd Frank section 165(e) is a regulation aimed at controlling credit exposures of banks
and other financial institutions Specifically, the regulation states that organizations must limit their credit exposure* to
any one company at 25% of the company’s capital Most securities lending agents have other lines of business that require taking on credit
exposure, and a limit of 25%** is believed to be unreasonable
*Defined as “the aggregate net credit exposure will include the net credit exposure between all of [an organization’s] subsidiaries and all subsidiaries of the counterparty”
**The threshold is even stricter at 10% for the six largest banks
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Basel III & Dodd Frank 165(e) Possible Impact on Securities Lending
The future of indemnification is in question Such regulations on capital and credit exposure implies an increased value on the capital
allocation process and the manner in which credit can be extended It is reasonable to question whether organizations that support securities lending
programs will deem indemnification as a worthwhile capital expenditure and/or allocation of credit exposure
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The Volcker Rule
The Volcker Rule, which is a specific section of the Dodd Frank reform act, is aimed at prohibiting banks from engaging in speculative trading
Technically, the rule went into effect in July 2012 on a “good faith effort” basis In reality, strict enforcement of the rule is yet to occur and debates among industry
participants and regulators continue
Potential Impact on Securities Lending Commingling of securities lending collateral into an unregistered pool may be prohibited Under the current form of the Rule, an unregistered pool may be deemed to engage in
speculative trading Custody lending agents that HEK regularly works with have already taken steps to
mitigate the impact from this unintended consequence Third party lending agents face less of an impact since most use separate accounts for
the investment of cash collateral or third party money market funds
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Money Market Reform
In late 2012, the Financial Stability Oversight Council (FSOC) officially proposed three options for enhancing the stability of money market funds
The following proposals may still evolve prior to adoption, but currently the options include:– Shifting from a fixed $1 net asset value to a variable net asset value– Capital buffers + redemption restrictions– Capital buffers + investment restrictions
Money market funds are used by securities lending agents as a vehicle to invest cash collateral
Any reforms to such funds may introduce administrative or operational burdens to securities lending programs
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Question & Answer
Questions may be submitted at any time during the web seminar by typing the question in the "Ask a Question" text field and clicking "Submit." Questions will be answered live as time permits during the question and answer sessions.
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Our next investment strategy update call is scheduled for Wednesday, February 20th, at 10 a.m. CST.