Quick fix ideas

Industry expectations of further market ­turbulence in 2008 are playing a dominant role in shaping the investment outlook for the year ahead. European banks are placing their best bets on those financial instruments that ­traditionally thrive on market volatility. Short-sellers, mostly hedge funds, are starting to emerge as the ­winners of the credit crisis.

A number of private banks are recommending that investors increase their allocation to these alternative instruments, often preferring the fund of funds format. “We believe the high degree of volatility will continue in 2008 and therefore we prefer to recommend less directional products,” says Paolo Molesini, chief executive officer at Intesa Sanpaolo Private Banking in Milan.

“Hedge funds of funds, which we have employed ­successfully in the past few years, can have an important role in this strategy,” says Mr Molesini.

The Italian bank recommends that its high net-worth investors allocate up to 25 per cent of their portfolios to hedge funds. Mr Molesini is confident that investors’ ­positive experience, alongside the ongoing financial ­education process in this alternative asset class area (which the bank initiated four years ago), will make it ­possible to reach the objective.

“Those investors who today perhaps allocate 10 per cent of their assets to hedge funds will be more inclined to increase their exposure to 20-25 per cent, which is what we recommend in 2008, having seen returns of 6-­9 per cent in the past few years,” says Mr Molesini.

Within the funds of funds range, those that will gain more importance are the multi-arbitrage and event-driven ­strategies, according to Mr Molesini, while the long-short strategies will probably be underweight.

Flexible products, which typically have the freedom to swing their asset allocation between equities and cash from zero to 100 per cent, could also be a winning opportunity for the year to come. When the market is unpredictable, these products are generally more efficient, says Mr Molesini.

Sector funds

A great emphasis is also placed on sector or thematic ­products, reflecting a new viewpoint that the traditional ­portfolio construction linked to stock market indices is not satisfactory anymore to guarantee good returns to investors.

“I think the world is moving on and you have got far more of a global aspect to the way that companies and countries interact with each other,” explains Paul Gaston, head of sales at the UK arm of Swiss house Pictet Asset ­Management. Although this does not exclude a portfolio ­construction on currency or geographical asset allocation lines, continues Mr Gaston, there should be investments in the portfolios focused on thematic ideas that add extra alpha to the overall result and diversify some of the risks away.

One of the investment ideas worth considering this year are premium brands, according to Pictet, which is well known in the marketplace for its large offering of thematic funds, most notably the water fund, now closed to new ­investments. These are brands of superior quality, such as Louis ­Vuitton, Porsche, BMW or Rolex, focusing on so-called ­“aspirational” goods, says Mr Gaston.

Increasing wealth in the world, the new purchasing power in China and India, as well as social changes such as the ­continuous rise in tourism and the increased dominance of female spending power, are all favourable long-term trends.

“The rise of the middle class in countries such as China and India means a lot more spending power,” explains Mr Gaston. “Tourism is a key driver for spending on luxury goods, as around 40 per cent of luxury goods are bought while ­travelling. The ­average Chinese tourist spends over twice as much on luxury goods as an American or a European tourist,” explains Mr Gaston.

And with statistics predicting there will be 20 million ­Chinese tourists ­travelling outside China by 2010, rising to 100 million by 2020, the explosion in purchases of these ­luxury goods is going to be staggering, says Mr Gaston.

Thematic funds such as this one may also be considered defensive stocks in hard times. The returns of these ­organisations that have brand names would be less affected, because their underlying wealthy clients tend not to be affected as much by small- or short-term market ­fluctuations as other groups, explains Mr Gaston. “The cost of buying a Rolls Royce in Moscow is about 30 per cent more than the cost of buying exactly the same Rolls Royce in ­London. But all Muscovites buy the Rolls Royce in Moscow,” and the ­reason is just pure ­ostentation, believes Mr Gaston.

Pictet launched a premium brands, Luxembourg-domiciled fund over a year ago. The product has gathered ?1.4bn in assets, of which ?450m was sourced from Europe and a large part, over ?700m, from Japan, where the company runs a Japanese version, in addition to a segregated ­mandate for Nomura.

Companies making products characterised by strong brands and incorporating in them the concept of “status symbol” are indeed one of the six investment ideas that Intesa Sanpaolo Private Banking sees as appealing for the year ahead.

‘The cost of buying a Rolls Royce in Moscow is about 30 per cent more than the cost of buying exactly the same car in London. But all Muscovites buy the Rolls Royce in Moscow’ - Paul Gaston, Pictet

However, the Italian CEO highlights the role of contrarian strategies in the selection process of investment ideas. “If a market goes down a great deal but the market multiples improve, then it is time to enter,” says Mr Molesini.

Indeed, the luxury sector has been decisively penalised during 2007, says Mr Molesini, mainly because of the ­exposure of European companies’ sales to the US dollar and the yen, ­having these two currencies strongly ­depreciated versus the euro. However, given the positive expectations that the dollar will revaluate in the medium term and that the majority of the ­companies in the sector have favourable price-to-earnings and price-to-performance ratios, this is a good moment to enter the market, he says.

Performance turnaround

For the same concept of a contrarian game, the financial ­sector is also another attractive investment idea for 2008. “We think there can be opportunities in financial securities, exactly because of their very bad ­performance in 2007. The market has probably penalised them more than was fair,” says Mr Molesini.

The other appealing sectors identified by Intesa Sanpaolo are utilities, ­telecoms, renewable energies and investment in Asian infrastructure – the latter playing on the theme of the strong structural growth trend of the Chinese and Indian economies.

These ideas, which should occupy the satellite part of an investor’s portfolio, are better incorporated in funds, as they offer diversification. But it is also worth aiming at investing directly in stocks, says Mr Molesini, especially in cases of ­significant wealth. And while ETFs (exchange traded funds) are cheaper than funds, for some markets such as the ­financial, they are not suitable at all, says Mr Molesini: “The financial sector is very diversified, an insurance company being very different from a commercial bank, for example. In this sector, I want to seize segment opportunities, but an ETF just shoots into the crowd.”

Passive behaviour

Head of private investments at Spain’s BBVA, Enrique Marazuela, also sees investment in the banking sector as a good investment idea but believes in the value of ETFs. “For us the best way of getting exposure to the banking ­sector is an ETF. We don’t know what the exact credit quality is at the moment. This is the reason why every stock is vulnerable, keeping in mind there is the risk that there may be some ­hidden losses. With an ETF, being a ­passive way of investing, you bet on the behaviour of the whole industry, rather than the behaviour of a single stock of a single company.”

Mr Marazuela concedes that ETFs currently represent a very small proportion of a private investor’s portfolio, but he thinks they will gain importance in the future. “Generally, ­private banking investors think they can find more value searching for alpha, but this is going to change in the future,” he says, playing down the role that banks have in recommending actively managed products, which offer higher margins, over indexed investing.

“This has much to do with the clients’ learning process,” he adds. “In the future, clients will understand that a part of the portfolio must be linked to the market and an ETF is the best product for getting exposure to beta, without any bias; another part of the portfolio will be dedicated to the search for alpha through mutual funds or pure investment ideas.”

‘The financial sector is very diversified, an insurance company being very different from a commercial bank, for example. In this sector, I want to seize segment opportunities, but an ETF just shoots into the crowd’ - Paolo Molesini, Intesa Sanpaolo

Doubts about economic growth and risks of inflation drive the Spanish bank’s recommendation to include a higher ­proportion of short-term investments in its high net-worth clients’ portfolios. “With the volatility and uncertainty that we have, short-term investments of three-to-six months are attractive.” Bank deposits also could be good investments for 2008, says Mr Marazuela.

Mr Marazuela states that multi-manager, multi-strategy hedge funds of funds, with an emphasis on those tracking volatility, will also be on their list of most promising ­investments for the year, recommending their clients to increase hedge fund exposure to 10 per cent, at the expense of real estate and private equity.

The tax and interest rate environment in Spain does not favour the distribution of traditionally very conservative and safe haven-type funds, such as those investing in money markets, adds Jaime Perez Maura, fund selection director at Allfunds Bank in Madrid. And Spanish banks will recommend that clients invest in deposits instead.

Balanced funds

The investments in Allfunds bank’s platform reflect largely a client portfolio and the current split in terms of asset classes will not undergo a dramatic change over the year, anticipates Mr Maura. But there are a few relevant ­exceptions. In ­particular, the fixed income side is moving towards high-quality credit. “It is not a very good ­environment for fixed income,” says Mr Maura, “but if ­people want to be invested in fixed income, they should do it through funds and have exposure to high-quality issuers. If they want to have enhanced performance, they should do it through duration and not through credit.”

‘In the future clients will understand that a part of the portfolio must be linked to the market and an ETF is the best product for getting exposure to beta, without any bias’ - Enrique Marazuela, BBVA

Also expected is a growing trend to switch from pure fixed income to balanced funds. “Balanced funds having exposure to high-dividend equity stocks, combined with very low-risk high-grade bonds, are also very interesting,” says Mr Maura. “This combination is very attractive for clients because, ­usually, dividend stocks tend to be less volatile than a high-growth stock, for example.”

Tax reform impact

In Central Europe, German banks are preparing themselves for the much discussed tax reform, whose main effect will be the introduction, from January 1, 2009, of a flat rate of 25 per cent on capital gains from funds, which under the present legislation are taxable at the investors’ marginal tax rate, but tax-exempted if held for more than a year.

Clearly, this is a big opportunity for German banks to encourage investors to buy funds before the deadline. This could turn out as an un-hoped for panacea for the German funds industry, considering the huge fund outflows that have hit the country, especially in 2007, more than in the rest of Europe, apart from Italy.

In fact, the money coming from these sales will most probably be sticky, as investors will be interested in keeping their money in the fund for over a year minimum and ­supposedly for several years, in order to avoid the new tax policy that will be applied to funds bought from 2009.

‘It is not a very good environment for fixed income, but if people want to be invested in fixed income, they should do it through funds and have exposure to high-quality issuers’ - Jaime Perez Maura, Allfunds

“Private investors in Germany will use the year of 2008 to prepare their portfolios for this new situation by investing in equity or umbrella funds,” anticipates Ralf Kleber, head of department, product management, funds and securities at Deutsche Postbank. These types of fund, which can change their exposure to equities and bonds, give investors the ­possibility to avoid paying taxes on capital gains, he says.

Postbank, whose clientele falls within the mass affluent category, has launched three new umbrella funds, ranging from a conservative to an aggressive profile, which invest only in ETFs, as opposed to mutual funds, and are ­quantitatively managed, explains Mr Kleber.

Etf advantage

The allocation to fixed income, equity and cash can be changed very fast and it is computer-generated. Using ETFs has a great advantage over mutual funds when it comes to cost, adds Mr Kleber, stating that back-testing ­conducted at Postbank in past years has also proved that, over the long term, umbrella funds using a quantitative model of investing in ETFs, give better yields and better results in terms of “value at risk” measures.

In the aggressive type of fund, there is also the possibility of investing in asset classes different from the ­traditional, such as commodities, and to invest in emerging markets, other than in Europe.

With these innovative funds, the ­German bank hopes to move its investors, the large majority of whom are still invested in savings accounts or very conservative funds, to balanced or more growth-aggressive products. “We would have launched these ­products anyway,” says Mr Kleber, “but the flat-rate tax gave us another reason to launch it; it will be of help, especially in 2008.

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‘Private investors in Germany will use the year of 2008 to prepare their portfolios for this new situation, by investing in equity or umbrella funds’ - Ralf Kleber, Deutsche Postbank

The first step to securing higher returns for investors involves abandoning the traditional US-centric method of ­portfolio ­construction, according to Patrick Wierinckx, ­business ­development manager at KBC private banking in ­Brussels. This is in line with the core satellite construction ­methodology implemented at the ­Belgian private bank, where a client ­portfolio includes the best investment ideas and styles, taking into account a “risk budget” measured by Value at Risk (the maximum amount of money a client may lose in a one-month horizon with a 95 per cent ­confidence level). This way, the portfolio will not be tied to relative risk constraints of a capital weighted benchmark, says Mr Wierinckx.

In this context, KBC came up with three key strategic ­recommendations, which reflect three major investment themes to be implemented in the core part of a portfolio.

The first one is increasing allocation to emerging markets, such as Asia, Eastern Europe and Latin America, to 15 per cent. “Emerging markets contribute more to global ­economic growth than is reflected by their market cap share in ­traditional indices,” says Mr Wierinckx.

Another major strategic theme is that of natural resources, to which KBC advises its high net-worth clients to allocate 5 per cent of their portfolio. Again, in ­traditional portfolio construction, these sectors are ­typically underweighted.

Open-ended funds

KBC offers a broad range of open-ended funds in this area, both from KBC AM, including the well-known KBC ­Ecofund Water, which is successfully distributed to third ­parties, especially in Asia, and from Black Rock Merrill Lynch, which is one of the bank’s selected partners.

KBC also launched different ­structured products on ­natural resources, mainly through funds or life insurance contracts on commodities, both hard and soft. In Belgium, using the same option structure within a fund, as opposed to a note, is more tax-efficient, explains Mr Wierinckx.

On the other hand, the shorter lead time of a structured note, in addition to being subject to less stringent ­regulation, allows a better timing of the product launch.

‘Emerging markets contribute more to global ­economic growth than is reflected by their market cap share in ­traditional indices’ - Patrick Wierinckx, KBC

A third theme is that of behavioural finance. “We advise our clients to complement their traditional top-down ­managed funds with funds with a different style, one of our favourites being inspired by behavioural finance,” says Mr Wierinckx.

The fund offering in this area from KBC Asset ­Management includes the range of buy-back funds investing in companies with buy-back programmes (of their own ­equities), which aim at capitalising on the inside information revealed through that move.

High-dividend funds are also a good investment in this area, as they take advantage of the anomaly that investors ­typically prefer high-dividend stocks. “People have a bias towards the big financials and the big utilities companies, and the common factor in it is that they pay high dividends. Therefore, investors are prepared to pay a price for it that sometimes is higher than it is rational. So there is a sort of ­behavioural bias towards high ­dividends,” says Mr Wierinckx.

Not really fallen

The KBC equity fund fallen angels and the KBC equity fund quant global are also included in the range. The first product aims at picking stocks fallen out of grace, taking advantage of the fact that the markets often exaggerate in both senses.

The second is run purely on a ­quantitative basis – to ban every ­emotional bias. This KBC offering is complemented by JPMorgan funds on this theme.

Some of these ideas are also made available through structured funds with capital guarantees. A particular fund developed for KBC private ­banking invests in the Buy Back and High Dividend Funds and other value funds, combined with cash and bonds.

“The allocation is flexible to ­guarantee a maximum loss of 10 per cent on a one-year horizon,” explains Mr Wierinckx. “Every quarter, in case of a positive evolution, this bottom level is increased to 90 per cent of the attained value.

“These strategic themes are seen as open ideas, but if investors want a specific pay-off structure, we would use structured versions on the basis of the same themes,” says Mr Wierinckx.

Six of the best from italy

Intesa Sanpaolo has identified the following themes for private clients in 2008:

• Brands – investing in firms manufacturing luxury goods, which become ­status symbols for wealthy customers
• Financial stocks may have suffered recently, but taking a contrarian view, they could make gains in 2008
• Utilities, such as water and electricity companies, previously seen as
• strong defensive stocks
• Telecoms, where regulatory changes in Europe are set to create
• opportunities
• Renewable energy is one of the big investment stories
• Asian infrastructure investments, based on strong Chinese and Indian growth