Strategic allocation

Burkhard Varnholt, one of the best-known investors in Swiss private banking, is hitting the headlines again. Three years ago, as head of a 130-strong Zurich-based financial products team for Credit Suisse, he sent an e-mail update to the bank's army of client advisers. Most of his recommendations for 2006 centred around emerging market economies, and the demand their rising middle classes would generate for luxury goods such as German sports cars, Swiss watches and Italian designer clothes. To benefit from these trends, Mr Varnholt recommended actively managed thematic funds for private clients, including the Clariden Luxury Goods fund, and the Merrill Lynch New Energy fund. While the Clariden fund performed respectably, investors in the Blackrock/Merrrill Lynch fund enjoyed more than 60 per cent returns over the first two years. And even if they did not heed warnings and stayed invested for the whole of 2008, they would still be nearly 30 per cent up. For 2009 and beyond, Mr Varnholt’s predictions are even more dramatic. In his new role as chief investment officer of Basel-based Bank Sarasin, he summarises the most important drivers for investors during the global economic crisis in just two words: “asset allocation”. Investors must be open-minded and contrarian, but if they make their decisions rapidly and decisively, Mr Varnholt believes they can benefit from “once-in-a-generation” investment opportunities. He has picked out investments including Chinese A-shares, sustainable water companies involved in desalination, treatment, metering and irrigation, rare materials such as platinum, and wheat grain and fertilizer companies. He also favours currently unfashionable currencies including sterling, and all Asian currencies, bar the Hong Kong dollar. His optimism for Asia comes against a background of grim economic numbers for China, Taiwan, South Korea and Japan. The contrarian in Mr Varnholt, and the fact that the region has a history of overcoming economic crises means he is tipping it to bounce back. “Regions are like individuals,” says Mr Varnholt. “They have track records that suggest future performance.” To hedge against potential policy and economic failures, he recommends private clients take a 10 per cent allocation to gold, which can also hedge against reflation and US dollar devaluation. Among key Swiss banks, nobody doubts Mr Varnholt’s assumption that the crisis has thrown up huge opportunities. The shared belief is that top-down shouts must be the loudest, before funds and other products are chosen to fill the allocated parking spaces. Balancing long and short terms UBS, the world’s largest and best-known wealth manager has totally redrawn its allocation models for discretionary clients under Michael Strobaek, global head of Investment Solutions, and member of the group’s managing board. The move is in part a response to huge outflows from clients who are losing faith with major private banking groups. The notions of currency risk, following wild swings during 2008, and home bias to a country or region versus global diversification are today’s key building blocks. “If there was one thing we learned out of the tech boom and bust, it was that nobody cared a whole lot about long-term strategic asset allocation, they just wanted to get into the most important asset class, which was equities during the boom years,” says Mr Strobaek. But once clients have seen a bear market, they realise they need to diversify risks and that equity is not the only long-term asset class. The new thinking is that yes, clients are concerned about long-term allocations, but they also expect their bankers to take bigger and broader shorter-term tactical bets. These elements are taken into account in the newly launched UBS Managed Wealth Portfolios, which blend third party and UBS funds. The key, dramatic change, compared to discretionary wealth management even last year, is the extensive use of exchange traded funds (ETFs) for asset allocation. The rise of passive investments With the realisation that most active managers have failed to effectively manage core, long-only equities, UBS expects passive investments, such as ETFs, to account for up to 50 per cent of the typical portfolio. “The very traditional country and regional space will increasingly be inhabited by passive instruments,” confirms Mr Strobaek at UBS. But he expects more niche strategies to also get a strong look-in. “In the fund business, clients are increasingly looking for themes, which give access to specialists. Eco efficiency, infrastructure investment and emerging market themes are all very important.” For these thematic plays, he believes it may be a good time for well-regulated, transparent mutual funds to regain some of their lost ground. These products are believed to include funds focussing on European companies paying growing and sustainable dividends, such as ING Invest Europe High Dividend; and socially responsible energy plays such as Sarasin New Power. Default hedge fund allocations will remain at 15 to 20 per cent. “We are still strong believers in the role of hedge funds in a portfolio context,” confirms Mr Strobaek. “They are being harshly portrayed for a lot of things they haven’t done.” Structured products will continue to be used regularly, particularly to minimise currency risk of a portfolio, as part of large cash allocations. But they are not seen as a separate asset class, deserving its own percentage allocation, by private banking departments. The view from product-generating investment banks is a very different one. According to Société Générale Corporate & Investment Banking, most large wealth managers have a separate allocation to structured products, accounting for approximately 30 per cent of a typical portfolio. “Right now, every major private bank has a bucket allocated to structured products and derivatives,” says Emmanuel Naïm, head of equity structured products at SGCIB. “The sizes we are asking for in these trades are not small, so they are mainly dedicated to big private banks.” A E25m minimum investment means the tranche can be split between large numbers of private clients and managed through a collective fund approach. Between 2002 and 2008, Mr Naïm says most structures sold were of the reverse convertible type, which generated significant income for investors by betting that markets will not actually rise. “The problem has never been with the quality of a product,” says Mr Naïm. “But with the concentration of those types of products in a portfolio.” With many competitors having pulled back from issuing equity structured products, SGCIB should have some clear space to deliver new themes including an arbitrage on the difference between the low level of equity dividends currently being paid out and the future levels expected by market analysts. There are also long-term plans to work on a global asset allocation approach with private banks, where the wealth manager shares details of model portfolios with the investment bank, which tries to match allocations with products, but this has not yet been fully developed at SGCIB. Smaller Swiss private banks such as Lombard Odier, Pictet and Vontobel, aim to use their in-house fund products to populate the satellite sections of private client portfolios in third party banks with exactly the type of high conviction, thematic investment vehicles described by UBS. “SRI and clean tech may be a belief system, but on a mid-term basis, it has the potential to add value as a theme in itself, and it cannot be easily replicated passively,” claims Zeno Staub, CEO of Vontobel Asset Management. Describing Vontobel’s Global Trends fund, he outlines his investment philosophy. “I don’t say ‘give me a 180 basis points fee and I will buy Siemens, ABB and GE and call it global technology investments. We have thorough analysis of major companies in the MSCI World index, which have a key part of their value chains linked with these trends,” says Mr Staub. “I don’t buy Toyota because they make the Lexus, but buy the company which makes the key components to make it drive,” he explains. This same approach has been taken across other ‘trend’ industries, including wind energy and waste management. Patrick Odier, senior partner at Lombard Odier, responsible for mutual funds, identifies sustainability, clean technology and healthcare as key areas of expertise for his research teams. He believes the thematic approach to selecting assets also helps attract younger investors to private banks. “This will help serve our customers in the private client sector in particular,” states Mr Odier. “It will attract bigger families and entrepreneurs who are interested in what is going on in the world and what will happen tomorrow, rather than simply looking at the diversification of their portfolio. Clients want convictions and a view of the world. They come to us for this specialisation,” he adds.Yet Mr Odier is under no illusion that funds are currently the hot ticket, noting widespread outflows from institutions across Europe, including his own and the industrial-size wealth managers such as UBS making large scale moves into passive ETFs. “There is a reduced demand for building portfolios with mutual funds and very well financed research shows the value-added of some of these strategies is very low,” admits Mr Odier. “There is an increased demand for ETFs and passive solutions. A low-cost, low-risk core is combined with other areas – the thematic approach for instance.” He also believes private banks offering investments such as convertibles and private equity can play an important part in satellite portfolios of wealthy individuals. “We have benefited from the general destabilisation of worldwide financial markets as clients see firms like ours as being a safe harbour,” says Mr Odier. A sign of panic But Amin Rajan, chief executive of asset management consultancy Create-Research believes the new emphasis on asset allocation is a sign of panic from many banks, who failed to set up proper portfolios in the first place, because they enjoyed the captive attention of wealthy families. “The likes of UBS were talking about core-satellite models five years ago, but they didn’t look at it. In wealth management, there is always a big gap between talking and implementing. They present it as if it is signed, sealed and delivered.” Professor Rajan believes large allocations should still be made to equities, but that many investors have lost faith in this asset class, after the institutions lost their money in a series of crises. “Look at equities on a price/earnings basis, and you can see that a lot of stocks are heavily undervalued. But banks have disappointed investors who held equities in the past,” he says. “Clients want simplicity, and a huge part of that will be a move back to equities, both global and local. They don’t want long-term lock-ups where the value is judged by managers, custodians and prime brokers,” believes Professor Rajan.

Burkhard Varnholt - Bank Sarasin