A focus on the funds market in 2013
"If you have five high-yield bonds in the core of your portfolio, you’re playing Russian roulette with your money."
Building wealth is a dynamic process. Paul Stefansson and Ernest Chan discuss some ways in which Asian investors may grow their wealth using a core-satellite approach to manage funds in the current environment.
At UBS we use a core satellite investment framework. The core investment funds have shown a reasonable return on investment. Satellite funds normally offer relatively more exciting returns, but are riskier.
For example, Asian investors should consider building their core funds with diversified investment-grade corporate bonds and blue chip, high-quality companies. Once the core is in place, satellite funds can be added to focus on individual countries such as China, high-yield bonds, smaller companies, hedge funds, property and private equity.
Unfortunately, many investors only invest in a few individual bonds. While it’s adequate with investment-grade bonds, if you only have a few high-yield bonds or stocks then you are playing Russian roulette with your money. Most investors know that investment-grade bonds have very low default rates (i.e. 0.09% per year according to Moody’s Investor Service from 1983 to 2011) and that high-yield bonds offer great yield, but few investors know the default rate on high-yield bonds is 51-times higher (i.e. 4.67%). For owners of high-yield bonds, there is almost a one in 20 chance that you will lose 100%. Getting exposure to high-yield bonds through a bond fund is one way to actively manage the risk and generate higher returns, as a bond fund will usually hold more than a 100-plus different bonds. Stop playing Russian roulette!
Given the higher growth rates in emerging markets, especially in Asia, investors should consider investing more in emerging market bond and equity funds. The easiest way to achieve this is to invest in Asian or emerging market asset income funds that are split between bonds and stocks and yield over 5%. The bonds will protect on the downside, while the stocks will provide upside. The protection will keep you invested in bear markets. You need to stay committed to your core funds in difficult times to reap the benefits of a healthy relationship and a potential yield of over 5%!
Not all fixed income funds are created equal and therefore not all would react the same way through an interest rate cycle. Therefore, it may be ideal for an investor to build their core portfolio with funds which, when put together, can weather an interest rate cycle.
If investors are indeed worried about rising rates, they may consider choosing funds which have shorter duration or have the flexibility to generate alpha through currencies. Investors may wish to consider moving a portion of their fixed income fund holdings into asset income funds – with flexibility to allocate between bonds and equities based on their respective return potential. These asset income funds typically offer greater diversification benefits versus pure equity funds, while providing a steady income stream similar to a bond fund, and at the same time, offering upside potential via their equity exposure.
In the developed world, the global financial crisis and the subsequent fiscal deficits have raised debt to GDP about 90%. In the book, ‘This Time is Different’ by Kenneth Rogoff and Carmen Reinhart, when debt to GDP reaches 90%-plus, growth slows down by -1% per year. The developed world will have slower growth. On the monetary policy front, the US Federal Reserve and many other central banks have lowered interest rates to 0% and printed money to stimulate growth. Slow economic growth and 0% interest rates make investing challenging. If investors stay in cash, then they will have negative real returns. For example, a fixed deposit investor in Singapore earning 0.5% will have a negative real yield of -4.7% (i.e. return of 0.5% – inflation of 5.2%). That is, the investor has lost -4.7% in purchasing power. Therefore, investors who want to beat inflation may need to take on additional risk in investing in corporate bonds, high-yield bonds, and equities.
Healthcare sectors could see stable growth in the medium and long term given aging demographics around the world. For example, senior housing not only benefits from the ageing population in the US but is also indirectly influenced by the positive sentiment of the US housing market. Biotech companies are headed towards the "patent cliff," with many drug patents maturing, which could trigger more M&A activity to acquire new patents. Valuation is a bit high in this sector but good for long term investors investing on any correction or through investment funds by means of diversification.
On a regional basis, we still prefer the US market. Aggressive investors could focus on ASEAN, and maybe even Europe. ASEAN has benefited from shifting of foreign direct investment from China, while Europe has surprised investors over the last two years with equity markets going up by more than 20% per year. The crisis in Europe is diminishing and any economic improvement could trigger a nice upside surprise for investors. European high-yield bonds may also provide potential higher upside to investors given European companies’ steady cash flow and the prolonged low interest rate environment.
I believe that the ‘home bias’ that many Asian investors show – focusing mainly on their home country – constrains their ability to take advantage of opportunities. Making the safe, comfortable choice by going for investments that you know more about is a natural response, but it often means you forego other opportunities.
Unlike many Asia-based investors, I prefer to take a global approach. Currently, I think that investment opportunities in the US or Europe look at least as attractive as Asia. Limiting yourself to Asia might mean higher regional risk and forgone investment opportunities in relatively inexpensive developed markets. Investors may thus wish to at least look globally.
In my portfolio, I have a core fund position in investment-grade bonds, high-yield bonds and US mortgage backed securities. The majority of my long-term core equity positions are in private equity and blue-chip companies (I have held these equity positions for more than 10 years). Finally, I have satellite funds in US property and European banks. In my opinion, that’s a healthy combination.
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