Day Three

Asset Allocation for reserve managers: dealing with the end of the fixed income market boom

50% of participants of the UBS Annual Reserve Management Seminar Survey changed their asset allocation over the past 12 months, and 24% said they are considering investing in illiquid asset classes to enhance returns This is not a big surprise in view of the performance of many portfolios in 2022 so far. Massimiliano Castelli, Head Global Sovereign Markets Strategy and Advice at UBS Asset Management showed the performance of sample portfolios that consist of only government bonds. Even a portfolio with short duration bonds had a negative return of 1.9% year-to-date until the end of May. The long duration portfolio lost 9% during the same period, which is the biggest loss for this portfolio type since 1973. Given the higher correlation between bonds and equities, a broader diversification is necessary to improve returns. UBS has calculated expected returns in four different scenarios:

  • Growth and inflation
  • Soft landing with transitory inflation
  • Stagflation
  • Stagnation

One of the key findings is that alternatives like real estate, commodities or hedge funds can improve the risk/reward profile of balanced portfolios and hedge against inflation.

Asset allocation and sustainability

Growth in sustainable investing is expected to continue despite the fact that portfolios applying ESG criteria have underperformed since the start of the war in Ukraine. Michele Gambera, Co-Head of Strategic Asset Allocation at UBS Asset Management, thinks that sustainable investing requires more dimensions than expected risks and returns. The additional dimensions are ESG preferences and time. He pointed out that whatever the ESG preferences are, they would reduce the investable universe and restrict the efficiency of the portfolio. Time is important in this context, because over the long-term, ESG investments are expected to outperform, as markets will price risks, such as environmental liabilities, properly.

So far, there's no scientific evidence that there is an ESG factor premium, compared to a value factor premium, for example. However, there is some evidence pointing to a size and quality factor, as many mega cap and quality companies rank high in terms of ESG.

There is good news for investors preferring index investments, that it's relatively easy to produce an index with limited exclusions and low tracking error versus a traditional index, but with a much higher ESG score.

Rising rates and Fixed Income markets

With bond yields rising, income is coming back for fixed income investments. This was one piece of good news that Uta Fehm, Fixed Income Investment Specialist at UBS Asset Management, shared with the audience. She is convinced that risk-return characteristics of fixed income have been stabilizing and will improve going forward. The main reason for this opinion was that a lot of rate hikes have already happened globally, so negative market reactions should be limited. So, bonds offering positive yields again means that investors can generate more income, which will help to offset or minimize potential market losses, created by further rate hikes. Uta Fehm mentioned the remarkable yield changes of multiple UBS strategies since the end of last year and advised investors to take a closer look at their fixed income allocations and also to stay flexible with regards to duration changes.

China Economic Outlook

China's economy is still feeling the pain of COVID-related restrictions, although some of the measures will be gradually abandoned. In his overview, Ning Zhang, China Economist at the UBS Investment Bank, mentioned that in Q2 2022 the estimated GDP growth will be just 3% year to date for 2022, compared to 8.1% in the previous year. The ongoing downturn in the property market is curbing growth substantially, because property is still the most important sector of the Chinese economy. Ning Zhang expects the market to stabilize by Q3, thanks to more policy easing. As far as currency is concerned, some fundamental support factors for the Renminbi have weakened. Capital flows from other countries to China are more volatile, and the yields of China bonds have come down. The UBS Investment Bank doesn't expect China's foreign exchange reserves to grow further, but they should stay above USD 3 trillion. The government also plans to further diversify away from the USD, and they currently have a share of 60% of total reserves.

Panel discussion: Should reserve managers further diversify into alternative asset classes?

Should currencies be considered as a separate asset class within a portfolio to enhance returns? Jonathan Davies' answer to this question is yes. The Senior Portfolio Manager, Investment Solutions at UBS Asset Management added that a long term currency strategy can be very effective to increase returns, and that the zero or very low correlation to risky assets can be a diversification benefit. However, he emphasized that having a clearly defined risk budget in managing currencies is a must.

In an investment world of high volatility and high inflation, hedge funds are "en vogue" again. But there are also structural reasons that make this asset class much more appealing to investors, as René Steiner, Head of Hedge Fund Solutions Investment Specialists at UBS Asset Management, explained. Since the financial crisis in 2008, there have been major changes in the financial industry, for example stricter capital requirements imposed on banks. As a consequence, investment banks are now purely acting as agents and serve hedge funds with higher priority without the conflict of interest from proprietary trading. Exposure to hedge funds can help investors navigate a volatile environment. Market-neutral and conservative strategies in general can substitute parts of portfolios, e.g. sub asset classes within fixed income. Other strategies can add more diversification by benefiting from the alpha opportunities in the macro and commodity space.

Many investors like real estate because they view it as a very stable element in the investment landscape. Nevertheless, real estate markets are changing as fast as society changes. Joe Azelby, Head of Real Estate and Private Markets at UBS Asset Management, asked whether shopping malls are still essential today. As the answer is no, it's clear that this will impact the retail segment of the real estate market. The same is true for office space. During the pandemic, it became obvious that the offices we were used to are no longer essential, and that existing office buildings have to be changed or upgraded to meet today's requirements. That's why the multi-manager approach in real estate is so attractive. It's all about allocating to specialized managers in areas that are - or become more essential - and vice versa.

Panel discussion: Challenges and opportunities for reserve managers

Two representatives of central banks shared their views on the current strategy. Aram Sahakyan, Head of the Global Markets Division at the Central Bank of Armenia, made the case for floating rate bonds, and he substantiated his view with data from previous cycles. While the asset allocation mainly includes floating rate bonds and short duration government bonds, the portfolio is diversified across multiple currencies. Moreover, there will be an allocation to the Renminbi soon and they'll take a closer look at the Korean Won.

The currency composition of reserves is a task the Czech National Bank is working on too. Despite being diversified more broadly compared to the Central Bank of Armenia, the Czech portfolio still suffered a loss year-to-date, as Jan Schmidt, Executive Director of Risk Management and Transaction Support pointed out.

From conversations with clients, Willem van Breugel, Head of Global Sovereign Markets at UBS Asset Management, knows that there's a lot of soul searching going on in the industry. Younger investors have never seen such a high level of inflation in their professional life, which could be a reason why conviction levels are quite low, as market volumes indicate. Do investors have to be more nimble and more tactical? There's no easy answer to his question, just advice. Once convinced of an investment case, a phased approach could be useful - but it's always helpful to have a solid framework in place.