"A more intuitive approach where lending is based on a borrower’s ability to repay their debt"

Last year, Lombard Odier Investment Managers and ETF Securities have joined forces to launch Europe's first range of smart beta fundamental fixed income ETFs. Howie Li, Co-Head of CANVAS at ETF Securities, explains the concept of fundamental weighting and why it is attractive for institutional investors.

Together with Lombard Odier Investment Managers, ETF Securities has launched a couple of fundamentally weighted fixed income products. What distinguishes those from ”traditional” bond funds?

The fundamentally weighted fixed income ETFs’ key objective is to focus on constructing a quality-based diversified bond portfolio, which aims to deliver higher risk-adjusted returns than traditional market-cap approaches. This is done based upon a set of fundamental factors and leads to a more intuitive approach where lending is based on a borrower’s ability to repay their debt rather than on its capacity to borrow.

As an investment benchmark, traditional market cap-based bond indices are flawed as they are constructed using size and price of debt and therefore have no link to the underlying credit risk of a bond. Traditional market cap-based portfolios give a higher weighting to the most indebted issuers, regardless of their capacity to service their debt. This procyclical approach to investing can lead to real issues. Indeed, research shows that market-cap benchmarks encourage bubble creation over a business cycle as they are designed to reward leverage.

The ETF incorporates an innovative proprietary approach uses underlying fundamentals to build fixed income portfolios. To achieve this, it applies an economic allocation which takes into account a set of fundamental factors to assess issuers’ creditworthiness and reduce default risk exposure (60%). It then adds a market-based allocation which incorporates a liquidity adjustment (20%) and a yield adjustment (20%). The result is a portfolios which provide what we consider to be quality-based diversification. All this is wrapped in a UCITS compliant index calculated by Bloomberg.

Why is the concept of fundamental weighting attractive for institutional investors?

Global fixed income markets are undergoing a deep structural shift. This is being driven by:

  • Key central banks using QE as a mainstream policy tool
  • An ever-tightening regulatory environment

These developments, along with increased “herding,” imply that liquidity-induced storms are likely to become a more permanent feature of the market landscape going forward. Indeed, we saw a strong liquidity-induced accident in 2015 centred on the Bund market – this created sharp gyrations across the global fixed income spectrum.

These storms expose investors to undue credit risks at a time when rates are already extremely low due to widespread QE and low inflation (thus creating an asymmetric risk/return profile). A sustained disinflationary/deflationary environment still supports an allocation to fixed income (“the search for yield”).

However, fixed income allocations in investor portfolios can be implemented in a more prudent manner – by building market exposure that directly mitigates underlying credit risk. In our view, this can be achieved through focusing on underlying fundamentals, a process which we believe results in portfolios being much more resistant to liquidity-induced shocks.

The advantages of fundamental weighting seem clear but why should investors use the structure of a passively investing ETF instead of an active fund manager selection the bonds after a human fundamental analysis.

We believe systematic/rule-based index portfolio construction reflecting issuer’s fundamentals, coupled with optimal implementation, is an efficient way to provide market exposure. The transparency and systematic approach minimises human biases and the temptation to remain close to a flawed market-capitalisation benchmark.

In addition and against the backdrop of liquidity concerns, ETFs can enhance liquidity. Where a regular fund relies on bond brokers, ETFs have additional layers of liquidity support which is especially useful in volatile environments when markets can experience significant movements intraday.

In what markets do you see particular potential for the concept of fundamental weighting?

A fundamental approach to fixed income can apply to both corporate bonds and government bonds and can be expressed across geographies such as Global Corporate Bonds, Global Government Bonds, Emerging Market Local Currency Government Bonds, European Corporate Bonds and European Government Bonds.

To find out more about investing in Emerging Market Fixed Income, ETF Securities & Lombard Odier are hosting a webinar on 3rd March at 4pm (CET). Please click here to register for the webinar.

"Avoiding losers is more important than picking every winner"

In this ifund fundmanager interview, Sander Bus, fund manager of the Robeco High Yield Bonds, explains his investment approach towards the high yield fixed income market, what to expect from this market segement and how to avoid losers using fundamental analysis.

What is your fund all about and what differentiates it from your competitors?

  1. We have a long-term, conservative approach to high yield investing, with a structural bias to higher quality names to provide a more stable performance pattern.
  2. An experienced and stable credit team with senior portfolio managers working together for well over 10 years and career-analyst model, encouraging analysts to become high-level experts in their specialization and enabling us to capture inefficiencies in valuation, risk and reward.
  3. We are contrarian investors. We believe investors tend to exhibit herd mentality, which makes that investors crowd up for the same trades. By being contrarian we steer clear of the herd and prevent the risk of getting trapped with too many investors in untenable positions.

How do you add value for your investors?

We attempt to capture market inefficiencies through the use of a diversified set of low-correlated performance drivers:

  • Credit beta positioning. An essential element for adding value to a high yield portfolio is to determine what level of risk to run at any given moment in the market cycle. We make an assessment of the expected credit environment and change the portfolio’s risk profile (credit beta) accordingly. As a result, the portfolio is to benefit from (or to weather against) the stage of the market cycle our team is anticipating.
  • Credit issuer selection. We use a combination of fundamental analysis and a proprietary quantitative bond selection model to target mispriced bonds and instruments. The universe of eligible bonds is split in three buckets: large caps, listed small caps and private small caps. Each bucket is analyzed by the subset of research techniques that best suits the specifics of that segment of the high yield market.

How do you generate investment ideas?

We base our investment ideas on combined fundamental analysis (fundamental scores) and an assessment on relative bond valuation by the portfolio managers. Our analysts are continuously screening their sectors for opportunities. But key element for High Yield investing is that is more important to avoid the losers than to identify winners.

How is your team structured and who is responsible for the investment decisions?

Robeco’s High Yield capability is managed by the Credit team, consisting of 9 portfolio managers 17 credit analysts, 4 quantitative researchers and 5 traders. The portfolio managers (Sander Bus, Roeland Moraal and Christiaan Lever) are responsible for the management of all High Yield portfolios, whereas the analysts cover the team’s research effort. The analysts cover issuers across the rating spectrum from investment grade to high yield and are clustered around sector specializations. This allows for an efficient transfer of knowledge from the analysts to the portfolio managers in the team.

On average, the team members have an experience in the asset management industry of 16 years, of which 8 years with Robeco. In addition, the head of the team, and the lead portfolio manager for Robeco High Yield Bonds, Sander Bus, has been a team member since inception of the High Yield team in 1998. As a result, our Credit capability benefits from a team of professionals with hands-on experience over the full credit cycle.

In which market environment does your investment style work best?

Our investment style is to construct a portfolio that avoids losers. We take a long investment horizon and allocate to companies that we believe will survive throughout the cycle. Our relative performance versus the market will typically be the best during bear markets, we outperformed 450bp in 2015, but we can also deliver alpha in bullish markets like 2012-2014 where we outperformed 146bp per year on average (gross of fees).

Where do you currently see the best potential and largest risks in the market?

[mid-Feb 2016] Since the start of 2016 we have seen that the high yield markets have turned bearish and spreads have increased to very high levels. Fears of a US recession are dominating the market, and although we won’t try to predict if there will be one, we can say for sure that a potential recession is already priced into the current spreads; they are not as high as in 2008, but they are at levels which are associated with recessions. Only an ‘Armageddon situation’ has not been priced in, but that’s not what we expect. We therefore have a positive view on the market and have increased our portfolio’s exposure to a beta overweight of 1.1.We look for buying opportunities in sectors where the sentiment or management behavior is changing for the better for bondholders, such as the metals & mining sector. We remain careful to try to pick the winners and avoid the losers. We stick to our cautious, long-term fundamental approach and subsequent quality bias, however we do screen CCC’s or other high spread names that have widened beyond levels that are fundamentally justified.

  • We continue to have a preference for European HY over US HY.
  • Major overweights are in Banking, chemicals, Paper, Packaging and Automotive.
  • Major underweights: Energy (although we are currently reducing underweight), Technology, Pharmaceuticals and US fixed line and wireless.

Which aspects of responsible investing do you consider in your investment process?

One of the cornerstones of our investment philosophy is that avoiding losers is more important than picking every winner. The credit analysts perform this analysis through a structured format assessment of five different factors of which ESG is one.

We believe that in-depth ESG analysis provides deep insights into issuers, ultimately leading to a greater awareness of the negative impact of ESG factors on their economic performance and credit quality. Our prime goal in integrating ESG factors into its analysis is to strengthen the ability to assess the downside risk of our credit investments.

Each credit research report includes an interpretation of ESG-related issues, with the analysts having to weigh the importance for the determination of the fundamental score. The materiality of ESG issues will vary per investment case. In all instances, the findings are summarized in the investment thesis, clearly stating the impact on the fundamental score. 

Our ESG opinion is formed in close co-operation with RobecoSAM. Using detailed assessment questionnaires and self-assessments, RobecoSAM evaluates the ability of companies to embrace change by seizing opportunities and by managing risks that sustainability developments impose on each industry. By leveraging its comprehensive database, RobecoSAM is ideally positioned to identify companies leading and lagging their peers in terms of sustainability and thus stakeholder value creation. In addition to RobecoSAM’s research, we use specialized external research from firms like Glass Lewis (governance,voting) and Sustainalytics as inputs for determining the ESG profile. 

How do you invest your own personal assets? 

My personal savings are used for my pension so that is a long term goal (at least 20 years). High yield bonds fit perfectly in my personal investment objectives. So I invest a big part of my private wealth in the Robeco High Yield fund. The balance is invested in cash and equities.

What do you do in your leisure time? What is your preferred hobby and why?

I like to run a few times a week to stay fit; I ran my first semi-marathon in December. I also like to coach the field hockey team of my daughters and I like to visit my favorite football team Sparta Rotterdam. This is the oldest football club in The Netherlands (1888) and they are currently in the first position of the second division. 

About Robeco:
Robeco, a global asset manager, offers a mix of investment solutions within a broad range of strategies to institutional and private investors worldwide. As at 31 December 2015 the company has EUR 268 billion in assets under management, of which 47% are institutional. In 2015 Robeco had a net profit of EUR 237 million.
Robeco’s head office is located in Rotterdam, the Netherlands. The company has a strong presence in the US, Europe and Asia and a developing presence in key emerging markets such as India and Latin America.
Robeco was founded in 1929 in the Netherlands as ‘Rotterdamsch Beleggings Consortium’. Today, Robeco is the center of asset-management expertise for ORIX Corporation, Robeco’s majority shareholder based in Tokyo, Japan. The following subsidiaries and joint ventures form part of Robeco Group: Robeco Institutional Asset Management, Robeco Investment Management, Corestone Investment Management, Harbor Capital Advisors, Transtrend, RobecoSAM and Canara Robeco Asset Management Company. More information is available at www.robeco.com.

About ifund
ifund provides fund research, manager selection and asset management based on liquid investment funds. Clients include banks, asset managers, family offices, pension funds and insurance companies in Europe. ifund has signed the UN Principles for Responsible Investment and integrates sustainability criteria in fund analysis.
www.ifundservices.com, info@ifundservices.com, +41 44 286 8000

About altii
alternative investor information (altii – altii.com) is the digital marketing and online portal for all asset management strategies in the German-speaking regions (D/A/CH). altii is focusing on institutional investors and has a public and a product area. For investors the service is free of charge. The portal www.altii.de/en is supported by a targeted newsletter and through clear social media campaigns.
www.altii.com, info@altii.de, @altii_news, +49 69 57708987

Important Information
Robeco Institutional Asset Management B.V., hereafter Robeco, has a license as manager of UCITS and AIFs from the Netherlands Authority for the Financial Markets in Amsterdam. Without further explanation this presentation cannot be considered complete. It is intended to provide the professional investor with general information on Robeco’s specific capabilities, but does not constitute a recommendation or an advice to buy or sell certain securities or investment products. All rights relating to the information in this presentation are and will remain the property of Robeco. No part of this presentation may be reproduced, saved in an automated data file or published in any form or by any means, either electronically, mechanically, by photocopy, recording or in any other way, without Robeco's prior written permission. The information contained in this publication is not intended for users from other countries, such as US citizens and residents, where the offering of foreign financial services is not permitted, or where Robeco's services are not available. The prospectus and the Key Investor Information Document for the Robeco Funds can all be obtained free of charge at www.robeco.com.

Information for Swiss investors
RobecoSAM AG (previously SAM Sustainable Asset Management AG) has been authorized by the FINMA as Swiss representative of the Fund, and UBS Switzerland AG, Bahnhofstrasse 45, 8001 Zürich, postal address: Badenerstrasse 574, P.O. Box, 8098 Zurich, Switzerland as Swiss paying agent. The Prospectus, the Key Investor Information Document (KIID), the articles of association, the annual and semi-annual reports of the Fund, as well as the list of the purchases and sales which the Fund has undertaken during the financial year, may be obtained, on simple request and free of charge, at the head office of the Swiss representative RobecoSAM AG, Josefstrasse 218, CH-8005 Zurich. The value of the investments may fluctuate. Past performance is no indication of future results. The values and returns indicated here do not consider the fees and costs which may be charged when subscribing, redeeming and/or switching units. The prices used for the performance figures of the Luxembourg-based funds are the end-of-month transaction prices up to 4 August 2010. From 4 August 2010, the transaction prices will be those of the first business day of the month. Return figures versus the benchmark show the investment management result before management and/or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark. Please refer to the prospectus of the funds for further details. Performance is quoted net of investment management fees. If a total expense ratio is mentioned in this publication this is the one stated in the fund's latest annual report at closing date.

Additional Information for investors with residence or seat in Germany
This information is solely intended for professional investors or eligible counterparties in the meaning of the German Securities Trading Act. The information contained is only intended for the addressee and must not be forwarded without the prior consent of Robeco.

Co-Creation: Eine neue Dimension unserer Anlegerbeziehungen

Die Anleiherenditen sind eingebrochen, Aktienrenditen sinken: In diesem Umfeld angemessene Erträge zu erwirtschaften, stellt Institutionelle Investoren derzeit vor große Herausforderungen. Und da sich viele Asset-Klassen im Gleichschritt entwickeln und negative Marktereignisse häufiger werden, müssen Asset-Allokation-Modelle neu gedacht werden. Davon ist Fiona Frick, Chief Executive Officer bei Unigestion, überzeugt.

Für Unigestion heißt die Antwort Co-Creation: Der Schweizer Asset-Manager rückt dazu das Risiko-Management in den Mittelpunkt und nutzt diese Chance, um die Bedürfnisse seiner Kunden genau zu analysieren und mit ihnen gemeinsam passgenaue Anlagelösungen zu erarbeiten.

Statt, wie in der Vergangenheit, nur die Verwaltung eines Segments oder einer Asset-Klasse zu übernehmen und die Asset-Allokation den Investoren zu überlassen, trägt der Vermögensverwalter damit heute mehr Verantwortung. Er errichtet, zusammen mit den Investoren, ein tragfähiges Gesamtkonzept, statt ihnen nur Bausteine zu liefern.

Fiona Frick führt im links beiliegenden PDF aus, was Unigestion unter Co-Creation genau versteht und zeigt mit verschiedenen Case Studies, wie der Asset-Manager dieses Konzept für seine Kunden umsetzt. Kernpunkte der Publikation sind:

  1. Die Tage der traditionellen Asset-Management- Modelle sind gezählt. Vermögensverwalter müssen heutzutage ein umfassenderes Leistungsspektrum anbieten.
  2. Asset-Managermüssen innovative Lösungen anbieten, die passgenau auf die Anforderungen ihrer einzelnen Kunden abgestimmt werden können.
  3. Co-Creation ist das neue Modell, bei dem Asset- Manager mit ihren Kunden als vertraute Investmentpartner zusammenarbeiten, anstatt nur für sie zu arbeiten.

Liquid alternative strategies as an answer to the low interest rate environment

After many years of persistent financial repression coupled with heightened volatility in the capital markets, investors are increasingly challenging the role played by high rated government bonds as a core holding, and by equities as the main driver of returns in a portfolio. Consequently, numerous investors are looking for new sources of returns in their portfolios, which to date have been dominated by equity and interest rate risks. Liquid alternative investment strategies, which are frequently available in a UCITS-compliant mutual fund format, (and which may also be referred to as absolute return strategies), can offer a viable means of enhancing the risk/return profile of a portfolio and, in some cases, offer a bond-like, or even bond-substitute, return profile.

Please find the full report from Allianz Global Investors attached on the left. It provides insights into the advantages of liquid alternative strategies in portfolios, explains the sources of returns as well as risk premiums and advices on the construction of liquid alternatives portfolios.

Currency Strategies: A historical Review

von Ross Taylor, Director at Absolute Return Strategies.

From time to time, we share our thoughts regarding the state of world affairs; not just from a financial or technical view, but with thoughts on trends underway that will have long-term consequences for every investor.

We will admit up front that our thoughts, and the ideas presented here are expressed with a view to encouraging you to consider the currency markets as a very appropriate and vital place to allocate a portion of your assets and risk, even as we are making highs in many equity indices, and other sectors of the U.S. economy appear to be enjoying a considerable renaissance from the dark ages of 2008/2009.

There are two themes to discuss. The first is the pernicious and dangerous effects that low interest rate policies – almost globally – have had on investor and borrower alike.

The second, in so many ways linked to the first, are thoughts on just how the central banks and governments of the USA, UK, Eurozone, and Japan (this is not the de nitive list) have behaved for the past 10-12 years, what they are doing now, and what they – meaning we the people - are facing.

The Third is our rationale for asset and risk allocation to the currency markets, through professional managers.

I apologize in advance for the history lesson, which is by no means a complete account of all that happened in the post WWII world, but it may help to explain why things got to be where they are today, and some alternative ideas on investing going forward.

Low Interest Rates – ZIRP the Usurper

In modern post-war financial history, there have been two reasons for a country’s level of interest rates to fall to almost zero, or beyond. In the early 1970’s, Western Europe was awash in US dollars accumulated as a result of the tremendous economic boom that began in the wake of WWII and continued without a blink, until the late 1960’s. The dollar was fixed to the price of gold, and most currencies maintained a stable relationship following the 1948 Bretton Woods agreement. Then things changed; the US began to run up de cits, price inflation re-appeared, and all those holders of U.S. dollars began to get nervous that their holdings were in danger of losing value; a fear that proved true when in August 1971, Nixon suspended the convertibility of the dollar into gold.

Safe haven countries such as Switzerland and West Germany began to feel the heat of appreciating currency rates versus the dollar and they did what they could to discourage inflows of short-term capital by curtailing the yield on bank deposits. They even went as far as to impose negative interest rates on foreign depositors who insisted on parking their francs and marks in local banks. There are many other factors that were involved here, but suffice it to say, with the dollar no longer convertible into gold – hence the destruction of a global fixed exchange rate policy – everything changed in international finance, and in particular, a country’s rate of exchange against the dollar – and by extension against its neighbor’s – became fair game for speculators and government economic policy makers alike.

Eventually, those strong currency nations learned to live with the situation, while the weaker ones used their ability to devalue as a means of economic redress. This de nitely included the USA, when the late John Conally, Treasury Secretary in the Nixon administration, informed a group of European finance ministers concerned with importing U.S. in ation that “the dollar is our currency; and your problem”.

I’m getting a little off track but we shall return to review this form of policy shortly. Three events shaped the present state of affairs in world finances, where we are witnessing widely fluctuating growth and unemployment rates, and living from crisis to crisis – be it the banking sector or the national treasury.

The first has its roots back in the 1957 (The European Coal and Steel Community, ECSC formed in 1951 was the rst post-war attempt to unify Europe), with the creation of the European Economic Community – a French-led initiative to create a united Europe, thus creating regional political and economic stability after so much war and destruction. I think it’s fair to say that the founders also had their eyes on countering American dominance.

What started as a tariff-free trade area began experimenting with an intra-bloc currency policy, with a long-term goal of creating one currency for the members, to be followed by full fiscal and political union – a very ambitious plan, given the divergent local economies and cultures involved.

Let’s fast forward to 1992 when the Treaty of Maastricht proclaimed three things: One – there would be a single currency that would replace all the Eurozone national ones; two – there would be strict limits on in ation to be policed by creating a successor to the in ation-paranoid Bundesbank, and three – there would be fiscal discipline with regard to the ratio of government debts and deficits to each member’s GDP.

It was extremely ambitious, politically driven, and economic madness, yet as the date for currency conversion approached – January 1999, somehow all the first 12 members magically got their finances in line to qualify. In return, they got the Euro stamp of approval.

In what proved to be uncannily similar to the mortgage derivative horror years into the future, more member countries were able to borrow money at cheap rates, even going as far as using the derivatives market to hide their true fiscal position. Prior to the Euro, their interest rates and exchange rates had fluctuated wildly before converging as entry into the Euro approached.

The rating agencies waved the AAA wand and the international debt markets opened their arms and wallets to the likes of Greece, Portugal, Italy, Ireland and Spain – as if they were Germany, or France.

It was all good for several years; money was borrowed; money was spent; yet the budget targets were always met. World economic conditions were generally very positive, so meeting debt and in ation targets appeared to be relatively painless, even for the most profligate members.

Now to the U.S. and the second condition for low interest rates. Long term rates had been on a downtrend ever since Paul Volcker stepped into Arthur Burn’s shoes at the Fed and squeezed the daylights out of in ation. There were bumps in the road but up until the collapse of tech-led stocks in 2000-2001, massive corporate fraud, and the World Trade Center horror, the US had survived without too much damage.

In fact, the US remained mostly in a growth phase right up until 2008, but along the way, the then present Fed chairman Alan Greenspan had aggressively used low interest rates as a stimulative tool. In fairness, I will point out that the Japanese have pursued the same low interest rate policy in a fruitless attempt the stimulate their economy, which had been in a slump since the early 1990’s, thanks to globalization, and a collapse of most Japanese banks many years before the 2008 crisis.

Repeating what had happened in Japan many years prior, the US housing and mortgage market exploded to the upside. Mortgage rates were cheap; property prices were on an unheard of upward spiral; lending standards were loosened to the point of fraud in many cases; banks learned new techniques for offloading these mortgages that would have stayed on their books until the sale of the property.

In a relatively low interest rate environment, investors were hungry for yield, and banks were very creative in packaging, slicing, and synthesizing these loans – all with the blessing of the rating agencies, and apparently the regulators. What was safer than a home mortgage? The buyer had ‘qualified’; the mortgage was secured by the property, and property prices never fell. AAA all the way!

Banks and borrowers alike were leveraged to the hilt. No one dared say it, but a small downward blip in house prices would spell disaster. You borrow a dollar to buy something for 100 dollars; the value of that something falls to 95 bucks – you just lost 5 times your investment, all for a lousy 5 percent drop in the underlying.

Why they all got away with it, we may never know. But when it all came unraveled in 2008 and 2009, so much value was destroyed to be beyond repair. The only solution was a government bailout through the creation of trillions of dollars to save failing banks and other significant institutions, and a forced reduction in the cost of money to almost zero thanks to massive Fed purchases of US government debt.

And here we remain. No one knows what the long-term effects of all that money creation will be. It’s supposed to be massive inflation – hence the peak 300 percent run up in gold from $650 since 2007. We do know that asset bubbles are a fact of human behavior – we may very well be witnessing one right now, as stocks soar.

No one knows how the US can repay its debts; no one even knows how they will be able to service them when interest rates inevitably rise. But it doesn’t end here.

While US banks were undoubtedly the leaders in mortgage product, most European banks competed aggressively for a slice of the business. Housing prices went through the roof – pun intended – in countries like Spain and Ireland, only to crash massively. Unsurprisingly, banks had to be bailed out by their respective countries. Global GDP took a massive hit in 2009. Budget deficits were ballooning; tax receipts were down, now public debt levels ballooned.

This was the beginning of the European sovereign crisis. Those poorer, poorly managed, and heavily indebted countries within the Eurozone had to confess that they’d fudged the numbers from the very beginning. Lending between banks had almost stopped in 2008 and 2009. Now no one was going to lend money to a Greece, or a Portugal (and soon to be others) – at least not at German-style interest rates. Ironically, it was cheap money that got these countries into trouble. And now instead of dealing with too-big-to-fail companies, we faced sovereign nations in the same mess. In another twist, Eurozone banks were permitted to carry sovereign debt of any Eurozone country at par, since it was all deemed to be AAA’ish. But as these banks were forced to rapidly shrink their balance sheets, they needed solid sovereign assets, not downgraded and discounted secondary balance sheet capital. The first real crisis was in 2010 involving Greece, who got a bailout, and assurances were made that all was well. This process has been repeated in 2011, and 2012.

Once again, thanks to the authorities’ largesse, the crisis has been muted of late, although the recent Italian election impasse raises many fears. But the European Central Bank has in effect offered to buy the bonds of any Eurozone country that requests assistance with restructuring, and interest rates in these troubled Euro members are now artificially low.

The curse of low interest rates, quite apart from the damage it has done to savers, and other pension plans that rely on fixed income coupons, is thus: Careless and reckless spending, borrowing, and overreaching for dangerous assets to produce current yield. Massive financial inflation – not the kind that necessarily shows up in the Consumer Price Index, but the kind that can destroy individuals and countries alike; asset bubbles that have led to public bailouts whose eventual costs no one dares to calculate. The destruction of traditionally solid institutions that chose to ignore risk.

Currency wars – the new (but very old) economic weapon of choice.

So we get back to currencies. Most of the Eurozone is in trouble – no growth, high unemployment, massive public debt. In the past, some of the members would have devalued to stimulate growth. Now they cannot. For a European, today’s equivalents of the exchange rate are interest rates and high unemployment.

Other countries such as Japan have begun to pursue aggressive moves to depreciate their currencies in order to stimulate their economies. Yet other countries are understandably concerned by this. China, in many ways the sleeping tiger in nancial markets, has sharply criticized the use of the currency weapon – and they were looking at Japan when they said this. The Swiss were forced to put a limit on how far the euro could drop against the franc; the US always advocates a strong dollar, but everyone knows it’s still Conally time when it suits. For the Eurozone as a whole, a weaker Euro would do no harm, especially for the poorer countries whose GDP has fallen by 10-20 percent over the past few years. But weaker against who or what?

It is pretty clear that the British, who wisely decided to remain outside of the Euro currency – being that they have always been serial devaluers in troubled times, appear to be content to guide Sterling lower through hints of massive monetary creation, and are happy to tolerate higher in ation to stimulate growth. The Brits actually invented a name for when this fails – stagflation.

Global trade counts. If a country cannot export its products and services to other countries, then it cannot afford to import the vital goods that it needs to survive – food – energy – minerals – to name a few critical areas. And it will not be able to grow its economy. Globalization is starting to reverse its original trend, as global production costs converge – largely due to the destruction of Western economic prosperity insofar as wage levels are concerned, and the rapidly rising standards of living in the areas that had been the major bene ciaries of outsourcing. Many large US companies earn as much as 80 percent of their revenues from overseas sales; Japan is running a trade deficit for the first time in 40 years, largely due to the effects of the 2011 Tsunami that curtailed industrial activity and sharply increased imports of oil, as nuclear power plants were shut down.

Recent developments in U.S. energy production threaten a massive upheaval of the balance of trade between wealthy Middle East countries – who are heavy consumers of U.S, European and Asian goods and services. This same development threatens to reverse the outsourcing boom that has been so instrumental in the growth of places like China, and India. The US will have a tremendous production advantage over many other developed countries, because it has the manufacturing infrastructure and cheap energy, while the cost of transporting goods back to their home market may end up outweighing any labor cost advantage in those outsourcing nations.

Every country denies that they are engaged in currency manipulation. They all claim that monetary policy is aimed solely at stimulating the domestic economy, but just as they say all politics is local, all local economies are now global.

These are big macro themes that should be taken seriously, and given due consideration by long-term investors, while they consider the best way to profit from what appears at face value to be a series of destructive forces.

Why and How to allocate to currencies as a pure asset class

It will be clear from the all of the above that many countries are in unstable and untenable positions. It should also be clear that currency rates are one of the many weapons of global trade. What is less clear to many investors is that currency relationships fluctuate for a myriad of other reasons. These may be Central Bank reserve adjustments, an international M&A transaction, demand for equity or fixed income assets from an overseas manager, or an unexpected event – political – natural – economic - somewhere in the world.

We buy stocks to benefit from corporate profits; we buy bonds to earn interest; we buy commodity futures if we need to hedge or want to take a view on the future for that commodity – it could be gold, it could be crude, soybeans, wheat, or copper.

Currency trading is largely unknown to many investors, largely because there is no industry performance benchmark. For some, it’s a concept that cannot be processed – the very idea of buying something and shorting something else simultaneously! For them, currency trading is the province of banks and hedge funds, and for some, it’s just a cost of doing international business.

Let’s consider the premise that currency rates do two things: They tend to move in a trending fashion over long periods of time; they also fluctuate quite significantly on a daily basis.

Now this doesn’t make them different from any stock or commodity future in terms of volatility and directional outcome. What makes currency trading unique is that long/short idea that I just mentioned. You want to sell the Japanese Yen because you heard that the Japanese are attempting to lower its value? Lower its value against what? The dollar? The Euro? The Australian dollar, the Chinese Yuan, the Korean Won, Gold? Steel?

The answer right now is probably any other currency that is a major trading partner with Japan. The fact that they’ll have to pay more for steel is unfortunate, but since steel helps create value-added products that can be exported, there should be a net advantage.

But....You choose to sell the Yen against the dollar. All is going well until one day something causes the Dow to fall 500 points, for reasons that have absolutely nothing to do with Japanese economic policy. Suddenly, international investors are dumping US stocks, and US dollars are being converted back to local currencies, and one of those just happens to be the Japanese Yen. This pattern happens dozens of times a day in the currency markets. Small events, news, M&A deals, speculative flows cause a change in the ratio of the Yen to the dollar and to the Euro and the Australian and the Canadian dollar etc. etc. and sometimes for no obvious or apparent reason. Yes, tomorrow you’ll read in the WSJ that currencies rose against the dollar or some perfectly logical reason. Unfortunately, the WSJ only comes out after the market closes, and not before.

Most markets appear to act in a random way over short periods of time. A professional trader can make sense out of those moves, no matter what the instrument. The duality of currency trading may sound even more random and confusing, but think how much information – be it technical or fundamental is available to a professional currency trader.

Here’s another fact that makes currency trading unique: The foreign exchange market dwarfs every other financial market. Over $ 4 trillion are traded daily. It is a very transparent market. It is extremely hard for a single investor to influence the market; there are hedgers and speculators at work simultaneously; there are traders who add liquidity by trading every millisecond; the biggest institutions in the world are involved on a daily basis. During the 2008/2009 crash, the currency markets operated normally without major disruption (other than to shut out a few soon to be defunct players).

The reason that this market is so vast is that every international transaction needs access to the currency market. It is the highway down which all global trade and finance must travel, and it is supported by vast investor interest that seeks to profit from its fluctuations. Every news headline, every economic data point, every geo-political event leaves a footprint.

Entry into the market is simple, but there are issues to consider in doing so:

  • You can invest in a mutual fund or buy an ETF that has exposure to the currency market. These are very directional, and tend to have longer-term outcomes, while perhaps creating unwanted risk exposure to other asset classes, or counterparty risks.
  • You can open an account with your broker and attempt to trade the currency market. Recently, the growth of retail interest has been phenomenal. Unfortunately, unless you are prepared to devote your day (and night) to following events you will probably lose money. I believe that the average retail client in currency loses money 80 percent of the time – not because the market is rigged, but because there are so many dynamics to consider when making a trading decision, that only a professional can survive.
  • You may place your money with a hedge fund that actively trades currencies. There have been some recent success stories as to how certain managers cleaned up on the short yen trade. Hedge Funds however will generally not provide liquidity due to extended investor lock up periods.
  • You should consider opening a managed account which hands the trading duties to a professional trader, while keeping your assets safe in a bank or broker of your choosing. In this way, you benefit from the skills of a professional – just like any other managed investment; you retain liquidity, you have total transparency, and your core assets are protected. A good currency manager should be able to generate returns that match or exceed other traditional investments, on a net basis, especially taking into account the volatility targeted. A professionally selected grouping of currency managers is a new alternative that spreads risk and should be given serious consideration either as a standalone investment or as an overlay to another asset class such as fixed income.


We know that the world of investing is a dangerous arena, where the relationship between risk and reward has fluctuated wildly for many years now, especially in ‘safe’ traditional asset classes.

The currency market by its very nature (Long some- thing/Short something) offers a non-correlated investment to those traditional classes, because profits can be generated regardless of whether equities, bonds, or commodities are rising or falling. In recent years, protection against risk has become the theme for many. There are two ways to reduce risk: Keep your money in cash, or spread your investment allocations so as to be able to earn returns even when traditional asset classes are falling. In my view, a properly managed allocation to the currency markets does just that.

We wish all readers successful investing, and as few sleepless nights as is possible – leave those to the currency traders.

About Ross Taylor
Ross Taylor is a Member of the Board of Directors at Absolute Return Strategies, a CFTC and SEC registered company. He is responsible for the development and monitoring of FX Alpha programmes for Pension Funds, Family Offices, Wealth Managers, Insurance Companies and Private Banks. He has more than 40 years of FX market experience with leading US and European banks.

Please find more about currencies in altii's FX Special
In altii's FX special, asset managers explain in videos and texts how trading the FX markets works and what benefits investors can expect from treating currencies as an asset class. altii has updated the FX special with the latest thinking on selected curriencies and consultancies give their advice on hedging currency risks.

Cognitive technologies to ­improve portfolio diversification

By Dr. Jochen Papenbrock, Firamis / PPI AG, for the 132. Hedgework in February 2016. A cornerstone of modern finance is diversification, first formalised in the 1950s. Today, innovative financial technologies help to manage diversification and systemic risk more effectively. Please find an excerpt from the Hedgework News attached on the left.

Financial markets have become very integrated and synchronised because of instantaneous information processing, global trading activity, cross-border financial intermediaries, regulatory regimes, and benchmarking/indexation activity. Also, financial markets are characterised by complex dynamics because humans and machines are part of a huge market and information network governing investment and trading activities. In fact, financial markets are a prime example of complex systems due to their feedback loops, reflexivity and adaptivity. The ensuing systemic market dynamics can lead to cascading multiplier effects and emerging collective dynamics. As a result, the system might be rendered more fragile and vulnerable with increased severity of tail events. Approaching a systematic and more effective portfolio diversification, these complex market dynamics should not be ignored – rather, they should be embraced.

There are frameworks originating from natural and computer sciences to rationalise complexity in financial markets. For example, it is relevant to examine assets’ dependence structure as measured by their correlation. Many investment managers already analyse these structures but on a more general level, often ignoring the hidden value provided in correlation information. This hidden value resides in the interconnectedness of assets. Using correlation network approaches allows to assess the degree of interconnectedness of certain assets and to judge whether systemic shocks spread to other assets in a contagious way. Conversely, there are also assets which are relatively unaffected by network impacts. These assets are potential diversifiers. Also, the overall shape of an asset network and its changes over time characterise different market regimes and thus the current and upcoming state of market fragility.

Cognitive technologies allow for algorithmic visualisations of the results for humans to evaluate and act on them. Also, the outcomes can be further processed in ­decision support systems, portfolio construction tools and automated investment services as provided by “robo advisory” offerings. We use an ensemble of cognitive techno­logies for systematic, transparent, and intuitive integration of diversification and ­systemic risk handling into portfolio and risk management. As a result, risk-adjusted investment performance can improve because of a robust, diversified and efficient investment management. It also enables an unimpaired process of harvesting risk pre­miums. Moreover, the measurement of asset interconnectedness will improve the way we communicate about diversification levels and risk concentrations. These developments will enhance the standards of communicating portfolio risk by just volatility or value at risk.

The detected structures are automatically processed by computers, e.g. to translate into better diversification. In this process we use essential components of nature that were designed to withstand fragile and stressed environments and adapt to emerging stress quickly. Specific portfolios are automatically monitored and permanently super­vised for given risk and diversification levels as well as for specific assets that mostly contribute to portfolio fragility. Meaningful scenario analyses and stress tests can be designed that help to construct more resilient and efficient portfolios.

To investigate the usefulness of cognitive technologies for investment and risk management we have launched several research initiatives with academic and ­industry researchers alike1.  For example, we investigate the use of sector ­correlation networks in investment strategies. In fact, a dense sector correlation network characterises a healthy market whereas a wider network indicates unstable markets. As a consequence, the diameter of a sector correlation network can be exploited for equity market timing strategies. Moreover, the network approach is also useful in explaining the cross-section of equity sector returns where more peripheral sectors tend to outperform more central ones.  Consequently, one can implement a portfolio strategy that comprises the complete information content of the sector network topology conditional on a given level of risk aversion.

We have extended and generalised these approaches to other asset classes and financial instruments like ETFs and Futures. This extension is the basis for an active and dynamic investment and risk management framework for institutional overlay management strategies, product-sleeves, core-satellite models or advanced indices. Also, it is a powerful tool in wealth management and private banking as advisory intel­ligence is increased and client interactions on multiple channels can be based on these technologies. Finally, retail clients can use automated investment services at any day or night time. Investment platforms and ecosystems with empowered, self-directed and self-activated users can be designed based on our framework.

About the author
Dr. Jochen Papenbrock has more than 10 years’ experience of management and technology consulting in the financial industry. Also, he has invented, developed and operationalised several innovative financial technologies. He is Managing Consultant at PPI AG and CEO/Founder of Firamis. He earned his doctorate and degree in business engineering at the Karlsruhe Institute of Technology.

About the Firamis
Firamis is a Fintech company founded 2012 near Frankfurt, Germany, with services, consulting and automated b2b solutions for investment and risk management in financial institutions. 

About PPI
PPI AG has been working successfully for banks and insurance companies for more than 30 years and has more than 400 employees today in several locations in Europe. PPI is active in the following lines of business: ­Consulting, Software development, Business Intel­ligence, and Products. PPI is specialist for payments, risk management, compliance, core processes and digitalisation.

1 Lohre, Harald and Papenbrock, Jochen and Poonia, Muddit, The Use of ­Correlation Networks in Parametric Portfolio Policies (October 24, 2014). ­Available at SSRN
Papenbrock, Jochen; Schwendner, Peter (2013). Handling Risk On/Risk Off ­Dynamics with Correlation Regimes and Correlation Networks. Financial ­Markets and Portfolio Management, Springer US
Schwendner, Peter and Schüle, Martin and Ott, Thomas and Hillebrand, Martin, European Government Bond Dynamics and Stability Policies: Taming Contagion Risks (May 24, 2015). Journal of Network Theory in Finance 1 (4), 2015
Packham, Natalie E. and Papenbrock, Jochen and Schwendner, Peter and ­Woebbeking, Fabian, Tail-Risk Protection Trading Strategies (December 11, 2015). Available at SSRN

How to make the best of commodities: the contrarian model

Asset Allocation Research from Edith Southammakosane, Director – Multi-Asset Strategist at ETF Securities. Commodities used in a passive asset allocation strategy have been underperforming other asset classes for a fifth consecutive year in 2015. An exposure to commodities in a balanced or growth portfolio of equities and bonds can still benefit investors with a long-term investment horizon. An active strategy such as the contrarian model could have provided an effective protection against the commodities rout over the past 5 years.

Commodities in a passive strategy

While commodities have performed poorly over the past few years, by including commodities in a portfolio of bonds and equities (for example using the Bloomberg Commodity Index) could have improved returns over the past 25 years.

Commodities have historically had a low correlation with other asset classes. Driven by commodity-specific factors, they tend to provide higher return for the same level of risk when added in a standard portfolio of stocks and bonds.

Using a portfolio of stocks and bonds as the benchmark, we run a passive portfolio model under three different styles: cautious, balanced and growth. The portfolios follow a strategic asset allocation model that rebalances every quarter to the original weighting over a period of 25 years.

Our analysis shows that commodities don’t add any value in a cautious portfolio where the allocation into bonds is the highest (80%). While balanced and growth portfolios are by nature more volatile than the cautious portfolios, both substantially outperformed cautious portfolios by 20% and 23%, respectively, on average. In the balanced and growth portfolios, allocating 10% into commodities enhances the portfolio Sharpe ratio regardless of whether the commodity basket includes energy or not.

Role of commodities in a portfolio

The below chart illustrates how commodities in a passive asset allocation model have played a crucial role in enhancing the Sharpe ratio of a standard portfolio of equities and bonds between 1991 and 2005. During these years, commodities posted strong returns for a level of risk similar or lower than stocks. Between 2006 and 2010, the optimal weight of commodities fell to 1.5% and then dropped to nearly zero over the past 5 years to December 2015.

Our analysis shows that applying a strategic asset allocation model to commodities works well during periods of strong performance. The years between 2001 and 2005 for instance were ‘the golden years’ for commodities. However, during bear market periods such as that over the past five years, actively managed strategies would have provided better returns than the passive Bloomberg Commodity Index 3 Month Forward.

Examples of active strategies

An active strategy or a tactical asset allocation typically involves getting exposure to riskier securities in order to increase the potential return of a portfolio. An actively managed portfolio generally rebalances the weights based on various types of signals and could involve the introduction of short selling and leverage.

A short exposure to commodities enables investors to benefit from negative spot return and a futures curve in contango. An effective strategy is then to play the shape of the futures curve. In this strategy, investors are short commodities in contango and long commodities in backwardation. Implementing this strategy on futures contracts at the short end of the curve increases the portfolio return significantly but also its volatility compared to traditional commodity indices.

Another interesting strategy is the calendar spread which consists in getting exposure to futures contracts further out on the curve while selling near-term contracts at the same time. Short maturity futures contracts are more sensitive to price movement and roll costs than futures contracts that expire in 6 months plus. Commodity indices exposed to contracts with longer lifespan tend to enhance investors risk/return profile.

The contrarian portfolio

The contrarian model is a hybrid long only asset allocation strategy based on the contrarian reading of four indicators: inventories, positioning, roll yield and price momentum. We derived five portfolios from the model: one based on the contrarian reading of each indicator and one based on the contrarian reading of all four indicators combined. In the latter, each commodity is scored based on how each of their respective four indicators has recently evolved. The selected commodities are then equally weighted in the portfolio with the selection reassessed and rebalanced every quarter.

Over the past 15 years, the best performing contrarian portfolio is the portfolio based on the contrarian reading of the roll yield. Exposed to commodities in contango between its front and third month contracts, the portfolio has outperformed other contrarian portfolios by 32.6% on average. Its annual return over the past 15 years is on average 5 times higher than the annual return of existing commodity indices and global stocks and 4 times higher than the annual return on global bonds.

Over the past 5 years, while enhanced or optimised commodity indices are falling 12% per year on average, the momentum and roll yield portfolios have been flat. Global stocks rose 4.4% and global bonds increased by 2.4% per year over the same period.

Over both periods, the volatility of contrarian portfolios has been close to the volatility of existing commodity indices and global stocks. Combined with strong returns, the average Sharpe ratio of the contrarian portfolios is 0.78 over 15 years, 11.3% higher than the Sharpe ratio of global bonds.

All the charts and performance data in this note are based on the price of commodity front month futures contracts excluding fees. Introducing a fixed execution fee of US$1 per day per contract does not have any significant impact on each portfolio annualised return over 5 or 15 years.

To conclude, there are great benefits of taking a contrarian perspective when reading certain indicators such as roll yield. During commodity bull periods, between 2001 and 2010, each contrarian portfolio outperformed other asset class indices by far including commodity. Like existing indices, the model works best during periods of strong momentum for commodities. However, the overall model also provides an effective protection against commodity market downturns such as that over the last 5 year rout.