Global Perspectives, Issue 3: Multi Asset Investing

AUG 2014 ISSUE THREE

MULTI ASSET INVESTING ACTIVATING MORE SOURCES OF RETURN Q&A Investing across global markets MULTI ASSETS Emerging popularity MULTI ASSETS Managing risk to enhance returns EMERGING MARKETS Emerging market assets and risk premia CREDIT RISK Liability driven investing in South Africa 1

Global Perspectives

A part of the FirstRand Group

Workers adjust the valves of oil pipes at West Qurna oilfield in Iraq’s southern province of Basra. Image: Corbis Cover image: A Fulani man uses his headscarf to clean solar panels.

Image: Giacomo Pirozzi/Panos

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Global Perspectives

Contents 04 Welcome

Activating more sources of return CEO of Ashburton Investments Boshoff Grobler looks back on the first year’s achievements.

05 Multi Assets

Investing across global markets Focus on multi asset investing on a global basis.

09 Multi Assets

Emerging popularity of multi asset funds How to mitigate risk in multi asset investing.

12 Multi Assets

Managing risk to enhance returns Why multi asset fund investments have become so popular in the South African investment landscape.

16 Emerging Markets

“We have created significant momentum in distributing our product to a wider audience, including the institutional market.” p04 Boshoff Grobler,

Emerging market assets and risk premia The importance of evaluating equity risk premiums.

20 Credit Risk

Liability driven investing in South Africa Banking on higher returns?

24 Product Development

Our perspective on changes New launches and global regulatory changes.

CEO, Ashburton Investments.

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WELCOME

A view of the downtown skyline, Johannesburg, South Africa. Image: Getty Images

Activating more sources of return We are currently celebrating the end of our first full year as Ashburton Investments, the FirstRand Group’s new generation investment manager. Our ambition, simply put, is to provide global investors with access to more sources of return, broader investment capabilities and more ways of managing their risks.

BOSHOFF GROBLER,

CEO Ashburton Investments.

It has been an extremely busy year for us and our clients, with multiple product and platform launches, but we believe also a successful one for Ashburton Investments.

Since launch, assets under management have risen by 8% to top $10.9bn as at the end of June and we have created significant momentum in distributing our product to a wider audience, including the institutional market.

More importantly, we have achieved an important milestone in that some 41% of our assets under management is now comprised of nontraditional assets such as inflation-linked bonds, private equity, as well as unlisted corporate credit and longer-dated loans, including renewable energy investments.

By virtue of our unique position within a major banking group, we are

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Global Perspectives

ideally placed to channel these nontraditional assets from FirstRand deal originators to institutional investors, who may not be well placed to access such investments themselves.

This is a core focus of the business as we believe that the benefits of the consistent returns available on these types of assets provide a valuable diversifier away from more volatile, traditional asset classes such as listed equities. This plays to the institutional and retirement fund market in particular, where the challenge more often than not lies in correctly aligning the underlying risk profiles of portfolios to promised future returns or generating sufficient yield to meet long-term liabilities.

Over the past few months, global asset prices have generally risen but their path has been erratic at times, clouded by politics, interest rate speculation and weather related economic issues out of the US. In this uncertain world, it is

perhaps appropriate both in terms of timing and content that this edition of Global Perspectives is focused on multi asset investing and the harnessing of wider sources of returns and risk management techniques.

Ashburton Investments, of course, has a rich legacy in multi asset investing through its international arm based in Jersey, and the strategic direction of the business continues to amplify that core skills set both internationally and in Africa. As an example of this, much of what we do in this space is focused on risk management, to the extent that asset protection strategies are viewed very much as a source of additional risk-adjusted return rather than just a temporary view on volatile markets.

It has been a meaningful twelve months for Ashburton Investments. We look forward to ensuring that our investors continue to share in our success. /

Multi Assets

Investing across global markets Head of Asset Allocation, Tristan Hanson, shares some insights on our approach to multi asset investing.

TRISTAN HANSON,

Head of Asset Allocation, Ashburton Investments.

Q: Over the long-run, asset allocation is probably the biggest driver of returns for multi asset investors. How do you go about forming expectations of future returns for the various asset classes?

Strategic asset allocation plays a major role in determining long-run returns for multi asset funds, although one should not underestimate the impact shorter-run, tactical decisions can have.

Circular fields on the Orange River used to irrigate large areas in the Karoo Desert, Gariepdam, Free State Province, South Africa. Image: Corbis

There are various ways of forming expectations of returns. Long-run historical returns can provide a guide. But a better method would also consider starting point valuations, since buying an asset at an elevated or depressed price is likely to lead to lower or higher future returns respectively over the long-run. Moreover, macroeconomic regimes are not static; the direction of inflation, interest rates and profit margins are among the factors that vary significantly from one decade to the next, with considerable implications for investment returns across asset classes.

We therefore place a lot of emphasis on valuations and the macro environment when assessing potential future returns.

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Multi Assets

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0.2%

The process is necessarily both quantitative and qualitative, since macro forecasting involves making judgements.

Naturally, it is essential that such judgement calls are based on high quality analysis and debated rigorously within the team. Equally, if not more important than a point forecast is to consider the distribution of potential future returns, since the future will always hold surprises and we need to be cognisant of risks to our central view scenario.

the current yield-tomaturity on ten year inflation-protected government bonds in the US

At Ashburton Investments we have dedicated multi asset specialists with considerable experience in Jersey, London and South Africa investing across asset classes in all regions, both in cash and derivatives markets. We also draw on expertise across the various fund teams to form our views for individual asset classes.

Q: For someone thinking about

investing today, what are your thoughts on potential long-run returns of the major asset classes?

Firstly, it is important to be clear about time horizon. Loosely speaking, we consider the short term to be anything less than a year, the medium term one to five years, and the long-run anything over five years (although we understand investors’ perspectives on this issue vary). Secondly, one must distinguish between nominal and real (after-inflation) returns. We should focus on the latter, since this is what investors should really care about when deciding to spend or invest their wealth.

Government bonds have historically paid a risk premium over treasury bills and, on a time frame of longer than five years,

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Global Perspectives

Figure 1. Global real returns (USD) (various periods, 1900-2013) 6

5.4

5.2

5

5.3

4.1

4

%

Figure 1 provides some details of longrun historical real returns from bonds and equities. Relative to the very long-run history (1900-2013), we would expect lower returns on Treasury Bills (3 months) than the historic average because interest rates are so low currently and unlikely to rise rapidly, in our view. As the economic effects of the various financial crises of recent years dissipate, we expect global interest rates to rise into positive territory on an inflation adjusted basis, but this may take some time.

The Reichstag Dome, Berlin, Germany.

Image: Gallery Stock

3 1.8

2 1

0.9

1.7 0.9

0 -0.4

-1 1900 – 2013 Treasury Bills

1964 – 2013 Bonds

2003 – 2013 Equities

Source: Credit Suisse Global Investment Returns Yearbook, 2014

Multi Assets

“We believe global equities can deliver longrun returns close to the historic average.”

we would expect the same again.

However, on an initial investment today the real return from developed market government bonds is likely to be low on a five to ten year investment horizon.

For example, the current yield to maturity on ten year inflation-protected government bonds in the US, UK and Germany is 0.2%, -0.3% and -0.2% respectively (note that UK bonds are linked to the domestic retail price index which tends to be higher than the consumer price index).

For equities, the outlook appears more positive. On a global basis, equity valuations are not especially high relative to history, largely because of low valuations in emerging markets and a secular de-rating in Japan. Cyclicallyadjusted valuations in Europe are also low.

However, US profits are above trend and valuation multiples above the long-run average so this poses a risk to long term returns, given that the US is the world’s largest market. Putting it all together, we believe global equities can deliver long-run returns close to the historic average.

Q: How do you move from a forecast of returns to constructing a portfolio?

Well, expected returns is one element – we also need to think about correlations and risk. The starting point for constructing a portfolio is to decide what the investment objective is, including over what time horizon. Risk should be defined with that objective in mind, as should risk tolerance.

Then the analysis that contributes to forming forecasts of returns, risk and correlation can be used to construct a suitable portfolio. The goal of maximising returns needs to be considered in the context of a risk budget.

Building a portfolio of individual assets requires analysis of how one asset price moves in relation to another and how far an asset price might fall in an adverse scenario. These relationships are not stable and vary according to macroeconomic conditions and valuations.

For example, for much of the 1970s and 1980s government bonds and equities were positively correlated: as long as

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Multi Assets

The China headquarters of AstraZeneca in Shanghai, China. Image: Getty Images

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inflation expectations and real interest rates were falling, both performed well.

However, since the late 1990s bonds and equities have been negatively correlated.

This is because in the earlier period, real interest rates were high and inflation was the perceived macro risk. In more recent times, low growth or deflation has been the greater risk, so when bonds are doing well because such fears are elevated, there are worries over profits growth and equities underperform as a result. Conversely, bonds have performed very well during periods of significant equity weakness.

Again, while quantitative analysis is essential, judgments are also necessary in order to determine the type of regime we are likely to experience going forwards.

Acknowledging this, it is helpful to determine ‘flags’ to signal whether our original assumptions are on track or if the

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Global Perspectives

world is moving to a different highway requiring a different assumption set.

In summary, the portfolio construction process requires the combination of expected returns analysis with risk management.

Q: Are your short term views aligned with your long term views currently?

In broad terms, yes, although we anticipate real returns on cash to be negative in developed markets for at least another year. Similarly, government bonds are likely to generate negative real returns over the next year. Within fixed income, we continue to expect outperformance from corporate bonds, although we acknowledge spreads have tightened a lot. Over the next year, our base case scenario is that global equities will deliver returns in line with the long-run average, which would mean reasonably

strong relative outperformance. However, equity returns are more volatile and we have to recognise there is a wide range of possible outcomes.

Q: Volatility is low across most asset classes and currencies currently. How does this affect multi asset portfolio construction at Ashburton Investments?

Volatility is low so we have to be wary that it might increase. This could arise from a number of possible catalysts. Where we think volatility is underpriced, we may look to take advantage by using options, either to buy cheap protection or to capture possible upside.

Q: What do you think is the most undervalued asset currently?

Patience. /

MULTI ASSETS

Emerging popularity of multi asset funds The appeal of a diversified portfolio of assets became apparent after the financial crisis of 2007/2008.

Tony Cadle,

Fund Manager, Ashburton Investments.

Climbers in the Italian Dolomites. Image: Corbis

Multi asset funds (often called balanced funds in South Africa) gained in popularity as investment vehicles after Dr Harry Markowitz (1952) published a seminal work on the nature of investments and investment markets. This body of ideas became known as Modern Portfolio Theory and established the value of combining diverse assets to maximise risk-adjusted returns. It transformed the way the vast majority of asset management companies and investment advisors conducted business with investors.

The importance of multi asset funds in the South African investment landscape is illustrated by recent data released by Association for Savings and Investing in South Africa (ASISA). At the end of March 2014 the local unit trust industry held investments totalling R1.5trn.

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MULTI ASSETS

Figure 1. South African Unit Trust Funds and multi asset fund composition Unit Trust Funds

47% 47% 47% 28% 28% 28% 22% 22% 22% 3% 3%

Multi asset funds

Multiasset assetfunds funds Multi Multi asset funds Interestbearing bearingfunds funds Interest Interest bearing funds Equityfunds funds Equity Equity funds Realestate estatefunds funds Real Real estate funds

45% High equity 45% High equity 45% High equity 26% Low equity 26% Low equity 26% Low equity 16%Income Income 16% 16% Income Flexible 7% 7%7% Flexible Flexible 6% equity Medium equity 6%6%Medium Medium equity

Source: Association for Savings and Investment South Africa (March 2014 Local Fund Statistics)

> Of this, R1.4trn (91%) comprised South African funds and R655.9trn or 47% of these funds were multi asset funds (Figure 1), up from just 25% at the end of 2010. Furthermore, these funds received 75% of domestic mutual fund net inflows over the three-year period to the end of March 2014.

This rise in popularity of multi asset investments in South Africa is partially ascribed to the financial crisis of 2007/2008 when equity markets lost a significant percentage of their market capitalisation and the appeal of a diversified portfolio of financial assets became readily apparent.

Modern Portfolio Theory advocates that the returns of all asset classes are not perfectly correlated, that is, do not move in lock-step and often move in opposite directions. An excellent example of the inverse correlation of different asset classes was illustrated through the performance of the South African equity and bond markets between May 2008 and November 2008. Over this time period the FTSE/JSE All Share Index declined by 46.4% and, in contrast, the All Bond Index recorded a positive return of 11.7%.

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Global Perspectives

Multi asset funds, in order to mitigate risk, hold a variety of investment instruments across various asset classes. Each exhibits unique financial properties compared to other asset classes and these differences are measurable in different economic conditions, which is critical in portfolio construction. Fund managers aspire to hold a variety of asset classes with varying correlations which, when combined, can provide superior returns on a risk-adjusted basis.

The increasing sophistication of financial markets and innovative product development has seen the use of asset classes for portfolio management purposes extend well beyond the traditional mix of equities, bonds and cash. Property, commodities and a wide range of alternative investments, including private equity, hedge funds, and debt vehicles, are now relatively common additions to portfolios in order to achieve reduced correlation benefits and add stability to their return profile. Derivative strategies are often used for efficient portfolio management purposes and to provide a measurable form of risk protection.

There is a body of research that is emphatic that asset allocation determines performance rather than stock selection.

Brinston, et. al., (1986) determined that 94% of portfolio returns came from asset allocation decisions and not market timing (under or overweighting of an asset class due to market movements). Eugene Fama (1997) from a study of 31 pension funds with assets of $70bn, concluded that asset allocation accounted for 97% of returns while Ibbotson and Kaplan (2000), analysing the ten-year performance of 94 funds, concluded that 100% of absolute return is explained by asset allocation. Irrespective of the percentage, which can be very high, asset allocation and the implementation skill of the portfolio manager should determine the risk and reward of fund returns.

Within the South African investment landscape, a major benefit in investing in a multi asset fund is that over a three to five-year period, these funds have achieved inflation-beating returns (real returns). Through allocations to various local and global investments, investors are exposed to actively managed asset classes that are geographically diversified, and with the benefit of lower volatility relative to just equities as an example.

MULTI ASSETS

investments producing purely an inflation return. Moreover, this theoretical fund would have declined around 14.8% during the 2008 financial crisis and recouped that loss within a year. Compare this to many global equity markets which took about five years to regain their 2007/2008 highs.

Climbers in Indian Creek, Utah, USA. Image: Gallery Stock

An example of the benefit of investing in a diversified fund is illustrated in Figure 2.

A R100 investment in a fund in 1988 comprising 80% South African assets and 20% offshore assets in the ratio 60% equity, 25% bonds and 15% cash (using index returns) would be worth R4,134.54 (May 2014) compared with R726.27 for

In South Africa, it is clear that multi asset investing is becoming a preferred way of investing for many investors and financial advisors. While the art of generating superior risk-adjusted returns lies in the blending of differently correlated asset classes, there is a further caveat of course. There remains a need to continuously manage asset allocation and, to a lesser extent, security selection on a tactical basis within a changing business cycle environment, the successful achievement of which can add significant value to the returns generated.

As an investor it is crucial, given the plethora of multi asset funds available for investment, to determine your investment objective. In all instances these funds, as a minimum, should have a mandate to beat inflation. In the South African single manager unit trust investment category, Ashburton Investments has two multi asset investment offerings.

The investment mandate of the Ashburton Targeted Return Fund seeks to achieve a benchmark of CPI plus 3.5% over a rolling three-year period and aims to generate positive returns over a rolling 12-month period. This is a conservatively structured fund with a maximum equity holding of 40% including offshore equity. At the other extreme is the Ashburton Balanced Fund which falls within the ASISA Multi Asset high equity category. The Fund has as an internal benchmark of a 60% equity holding with an 80% local and 20% offshore geographic allocation.

Furthermore the Fund has a maximum equity ceiling of 75%.

Multi asset funds holding a diversified number of asset classes do not represent the holy grail of portfolio safety, however, these funds do minimise the risk of negative returns and portfolio volatility which is even more pertinent given the stock market gains of the past five years. / References Cited Brinson, G.P., Hood, L.R., Beebower, G.L., (1986).

Determinants of portfolio performance. Financial Analysts Journal, Vol. 42, No.4, pp.39-44.

Fama, E., jr., (1997). Ninety-seven percent of performance variation is due to asset class structure. Dimensional Fund Advisors Conference, University of Chicago Graduate School of Business.

Ibbotson, R.G., and Kaplan, P.D., (2000).

Does asset allocation policy explain 40%, 90%, or 100% of performance? Financial Analysts Journal, Vol. 56, No. 1, pp. 26-33.

Markowitz, H. (1952). Portfolio selection.

Journal of Finance, Vol. 7, No. 1, pp. 71-91.

Figure 2. Idealised multi asset fund and inflation returns between 1988 and present Multi Asset Portfolio (SA 80%, Foreign 20% and Equity 60%, Bonds 25%, Cash 15%) Balanced Fund R 4,134.54

4,500 4,000 3,500

14.8% decline

2,500 2,000 1,500

R 100 in 1988

SA Inflation R 726.27

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Source: Ashburton / JP Morgan

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MULTI ASSETS

Managing risk to enhance returns Protection strategies are an important sourceof risk-adjusted return for multi asset portfolios. Like mountain biking, the end result is a function of the conditions you need to manage en route to the finish line.

Andrew Wolfson

Multi Asset Solutions Specialist, Ashburton Investments.

Mountain biking is a thrilling, but risky sport. It takes in steep climbs and more perilous descents, generally taken at speed while negotiating various obstacles along the way. Yet a growing number of people overlook or even embrace these risks to participate in the sport. Clearly it is not the prospect of bodily damage that pulls them in, but rather the lifestyle aspects, the competitive nature of the races and the sheer thrill of participation.

One can draw many parallels with managing multi asset portfolios.

It requires a clear focus on managing risk. Riders ensure that they have a good understanding of what lies ahead of them, to the extent of walking tracks where practical to assess how best to approach it. Even trails which are well known require continuous evaluation and reassessment.

Nothing can be taken for granted if you are to limit the chance of any nasty surprises.

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Global Perspectives

MULTI ASSETS

“Depending on the severity of the terrain, different layers of protection will be necessary; some being more essential than others.”

The right equipment is important.

Bikes have heavy treads designed to provide more grip; over-sized brakes to provide more efficient braking in wet or muddy conditions; and front and rear suspension that allows the bike to adjust and absorb uneven ground.

Depending on the severity of the terrain, different layers of protective clothing will be required,some more essential than others. Helmets, goggles, elbow and shin guards, globes and protection for the spine and kidneys may all be brought into play at times.

Like mountain biking, investing is about positioning yourself and adapting for the terrain in front, knowing you have protected yourself as best you can.

It is not all about how talented or skilful you may be, it is as much about being prepared in case something goes wrong.

No one layer of protection can save you, but all of them working together can make a significant difference to the condition in which you finish the race.

Riders in the annual ABSA Cape Epic mountain bike stage compete in Stage 5 of the 7 day stage race near Wellington, South Africa. Image: Corbis

It is about preparing for the unexpected, with a ‘just in case’ mindset.

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MULTI ASSETS

> Similarly, our active investment approach,

in adding various layers of protection to our multi asset portfolios, aims to provide a level of comfort that is designed to result in bumps and bruises rather than something far more serious. Risk management is a necessity, not a luxury.

For that reason, managers of our multi asset portfolios are as much risk managers as they are portfolio managers.

Following the traumatic events of 2008, risk and its management have become the most visible subjects for asset owners. The global financial crisis of 2007-08 was remarkably severe, not only in the magnitude of drawdowns suffered by individual asset classes, but also the drawdowns experienced by portfolios thought to be well diversified.

As part of the management of risk, hedging has taken centre stage.

Protecting portfolios involves a multi-layered approach. A multi asset manager’s first line of defence is asset allocation, then diversification, and once efficient, various levels of protection may be added.

Asset Allocation The conventional manner of protecting portfolios is the use of “traditional” asset

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Global Perspectives

allocation techniques, and to complement it with hedges in a variety of markets.

Mountain biking in Bolivia. Image: Corbis

As multi asset managers, our methodology for applying protection in our portfolios is three-fold: • s imply reduce the risk in asset allocation (an extreme measure would be to move to an all cash portfolio); • create diversification via instruments negatively correlated to existing portfolio positions (it is not always easy to find true diversifiers); • complement dynamic asset allocation with several protection techniques (both direct and indirect across all asset classes).

Diversification The investment manager’s first tool to curb tail risk is typically to diversify among asset classes with low correlation.

However, simply diversifying global equity with fixed income, for example, does not always do enough to limit downside risk. A portfolio with a traditional 60% equity, 40% fixed income allocation may derive over 90% of the entire portfolio risk from the equity component alone.

90% Over 90% of portfolio risk may derive from the equity component of a diversified portfolio

MULTI ASSETS

“Even though the ‘crisis’ is now over five years old, memories of risk-management mistakes are fresh in investors’ minds.”

A further limitation to the diversification approach is that asset class return correlations tend to rise in times of crisis, which underscores the challenges when using diversification as your only protection tool. Finding truly uncorrelated asset returns is difficult, and many non-equity asset classes are positively correlated to equities. Furthermore, correlations rise just when they are needed most and your multi asset portfolio could end up behaving like a single asset.

Hedging Risk Typically, it is only when markets experience large losses that hedging comes back into fashion, leading to a surge in demand for derivative strategies that drives up volatilities across all asset classes. This, in turn, can reduce the overall effectiveness of protection techniques, emphasising again that proactive consideration and allocation to risk strategies needs to occur on an ongoing basis.

The goal of protection techniques should be to support the portfolio when asset prices fall or rise unexpectedly and should not compromise or undermine the goals of the portfolio. Behavioural economics suggests that investors will overweight the probability of rare events, for example equities falling an extreme 30% in one month, and underweight the probability of more likely or common events such as equities falling 5% or 10% in any given year. Bearing this in mind, multi asset portfolios need to consider forms of ‘just in case’ protection to help enhance risk adjusted returns.

but protection for risk management purposes could help prepare for other situations; not just to mitigate their effects but ultimately to benefit from them.

Not only can protection mitigate losses in a significant downturn, but appreciating value in the protection portfolio has the potential to provide greater liquidity in the portfolio that may allow the portfolio manager to be a buyer when others are forced sellers.

Hedging strategies further add value by allowing for a more aggressive portfolio, tilted towards more attractive risks, since steps have been taken to help cushion the downside exposure.

Closeup of bike wheel. Image: Getty Images

Even though the ‘crisis’ is now over five years old, memories of risk-management mistakes are fresh in investors’ minds.

Quiet markets, low volatility and a lack of visible risks on the horizon can lead to complacency and increasingly overweight positions in riskier assets. In doing so, these conditions could set the stage for the next cycle of deleveraging and potential losses in portfolios. With market volatility currently at historically low levels, this is a key area of focus within our investment process. /

Traditional diversification strategies may help weather a normal bear market,

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EMERGING MARKETS

A supporter of the Bharatiya Janata Party (BJP) celebrates with a poster of Prime Minister Narendra Modi, in Bangalore, India. Image: Corbis

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Global Perspectives

EMERGING MARKETS

Emerging market assets and risk premia If emerging markets like India and China and frontier markets like Africa (excluding South Africa) are more risky than developed markets such as the US or UK, why do investors allocate some of their funds to these regions and assets?

PAUL CLARK,

Fund Manager, Ashburton Investments.

It is generally assumed (some might say intuitively) that investors expect higher returns from investing in riskier assets.

This is also true within a single geography, where investors expect higher returns from investments made into equities than they would from a government bond.

Active investment managers, like Ashburton Investments, therefore invest with the objective of maximising risk-adjusted returns, taking care to ensure that the risks taken on in portfolios is justified by the returns expected.

To get a bit more theoretical, the value of an asset today is the sum of all the future cash flows that the asset is expected to generate, but discounted to reflect future inflation and risks. It is this discount factor or rate which is highly debated and the main source of the value an active manager can add. When most investors are pricing in more risk (i.e. using a higher discount rate, which will reduce the value of the asset today) than the manager thinks there really is, there is the potential for the asset to provide additional return to the portfolio if the manager is proved right.

Emerging Markets When investing in emerging or frontier market equities, there are a number of components of risk to consider.

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EMERGING MARKETS

“The extreme pressure exerted on India via the markets last year did indeed produce results.” > Firstly, there is the relevant country risk

that encompasses both the economic and political environment. Bond investors typically look at the ‘spread’ or difference in yield in a country over US bonds as an indicator of the extra return that they expect to get for the additional country risk they are taking. Equity investors have to consider additional risks, especially the uncertainty of future cash flows. This additional risk over bonds is usually termed the ‘equity risk premium’. Many studies have shown that investors in equities typically expect to get between 4% and 6% higher returns from taking the additional risk over simply buying government bonds.

Another way to explain the equity risk premium is the volatility or variability of the earnings and therefore the cash flows of companies compared to the almost certain and predictable cash flows received from a government bond.

Liquidity in smaller markets, Africa for example, may be quite low and therefore this is typically built into the current price (i.e. the discount rate is higher because the equity risk premium used by investors is higher).

A good example of mispriced risk can be illustrated by an investment we made in an Egyptian company last year. At the time, investors were pricing in a very high premium for Egyptian shares, but this had been applied across the market. Certain companies did not face the same risks and we were able to purchase shares in a carpet manufacturer, Oriental Weavers, at what it considered a significant discount.

While the market has rallied 50% since then, as risks in Egypt have reduced, shares in Oriental Weavers have more than doubled; indicating how this mispriced risk has subsequently unwound to the benefit of investors.

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Global Perspectives

Bharatiya Janata Party (BJP) supporters shouting the party slogan during election campaign rally in Allahabad by Narendra Modi. Image: Corbis

Many retirement savers or retirees do not realise that they are taking an implicit view on the equity risk premium that constantly occupies the thoughts of active equity investment managers. If you were to overestimate the equity risk premium for example, you might save too little or invest in assets that are too risky.

At Ashburton Investments, our investment professionals, especially our emerging and frontier market specialists, are constantly considering the appropriate equity risk premiums to enable them to select shares with the suitable risk adjusted returns for their mandates. /

EMERGING MARKETS

66.38% of the population - the highest percentage turnout to date in any Indian election

Jonathan Schiessl,

Head of Global Equities, Ashburton Investments.

As Paul highlights, there are many factors that any investor into emerging or frontier markets must consider. Considering risk and the equity risk premia are vital parts of valuing equities and other assets in the space. Of course risk premia are not static beasts. India is a good example where political and macro changes have led to dramatic fluctuations in the premium that investors demand when considering Indian assets.

If we go back to the third quarter of last year, India was in the midst of a perfect storm of macro and political issues. The now famous ‘taper tantrum’ occurred after comments from Ben Bernanke (Chairman of the Federal Reserve at the time) caused a mass exit of investors from emerging market assets, both bonds and equities as well as currencies. This sell-off was due to investors repricing emerging market assets in an environment of reduced global liquidity (due to the withdrawal of quantitative easing). In other words, investors were demanding an increased risk premium to own Indian and emerging market assets.

The ensuing sell-off derated emerging market assets to the point at which the risk to reward balance reflected the new higher risk premium being demanded. India also

was suffering from domestic issues (high inflation, an unstable government and poor finances) that further pressured markets.

Reform Turn the clock forward a mere few months and the picture looks very different. The extreme pressure exerted on India via the markets last year did indeed produce results. The Congress Government initiated a reform programme, India’s Central Bank finally introduced credible policy and ultimately India has just concluded an election that has introduced a Presidential style leader with a mandate for growth and change. We have seen a massive influx of capital back into Indian assets over the last few months, resulting in hefty gains in markets. In our opinion, a great deal of these gains can be justified on the improved macro and political outlook in India, and therefore the reduced risk premium that investors are demanding.

As an investor, would you rather trust your money to an economy with a fractious and unstable coalition government, or to an economy that has just elected the first right-of-centre party in India’s history with a clear majority in its own right?

In our opinion the answer is obvious, and emphasises how important it is for investors to consider what premium they should demand when considering investing in emerging market and frontier markets. /

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CREDIT risk

Liability driven investing in South Africa Liability Driven Investment (LDI) is a term that is used to cover a broad church of investment strategies whose primary focus is on better matching assets to liabilities.

Matching could be interpreted in a number of ways but it is generally interpreted to imply that changes in the value of the client’s assets mimic changes in the value of its liabilities.

LDI, often used in the retirement industry, provides a mechanism for specific liability risks to be managed through the application of appropriate investment strategies.

Two of the biggest risks leading to volatility in liability values are interest rate risk and inflation risk. Interest rate risk arises when changes in interest rates impact the present value of the liabilities – a decrease in interest rates leads to a higher liability value. Inflation risk arises when higher than expected inflation increases the value of inflation-linked liabilities. Fixed interest and inflation-linked bonds are two key instruments used in constructing LDI portfolios.

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Global Perspectives

In the wake of recent market experience, we consider the merits of adding credit risk when constructing Liability Driven Investment (LDI) portfolios.

Shalin Bhagwan,

Head of Solutions, Ashburton Investments.

Jana Kershaw,

Credit Fund Manager and Analyst, Ashburton Investments.

Since the issue of the first inflation-linked South African government bond in March 2000, the universe of inflation-linked bonds available in South Africa has expanded beyond just government bonds. As at the end of May 2014, there were nine issues of government inflation-linked bonds listed on the Johannesburg Stock Exchange (JSE) with a market value of R369.3bn.

This compares to ten non-government issuers (excluding special purpose

vehicles and notes) of listed inflation-linked bonds with an outstanding market value of R72.1bn across 38 issues. Within the non-government issuers of inflation-linked bonds, the local banks are the largest issuers. Their total issuance of R38.3bn across 65 issues amounts to 53% of non-government issuance and exceeds that of even the State Owned Companies (SOCs). By comparison, the SOCs have issued inflation-linked bonds with a market value of R33.4bn across nine issues.

Liability driven investments LDI portfolio managers have been buying bank-issued inflation-linked bonds introducing the additional element of credit risk to their de-risked portfolios.

The credit skill and experience of the LDI manager therefore becomes an important criteria in the mandate granted to LDI portfolio managers.

CREDIT risk

Workers at the construction site of Eskom’s Medupi power station, a dry-cooled coal fired power station, in Limpopo province. Image: Corbis

Bond investors are, in effect, lending money to bond issuers. Investors expect this money to be repaid when the bond repays or redeems.

In the case of utilities or infrastructure providers, such as Eskom and The South African National Roads Agency Limited, generally known as SANRAL, issuing inflation-linked bonds to fund their borrowing requirements makes sense since their revenues are in part linked to inflation.

understand the risks and rewards of doing so. With sophisticated treasury teams, banks are able to hedge any risks posed to them from the issuance of such debt whilst ensuring that the favourable economics on offer, such as being able to capture greater borrowing for longer, is retained.

• At redemption the buyer of an inflationlinked bond is repaid their invested amount plus growth in line with inflation

The fundamental case for banks issuing inflation-linked debt is less clear although banks are probably best placed to

The chart on the previous page shows the total size of all nongovernment issuers’ inflation-linked

Inflation-linked bonds (or linkers) have significantly different cashflows to their fixed rate counterparts.

• At redemption the buyer of a fixed rate bond is repaid their invested amount only.

>

Total issue size of all inflation-linked bonds and notes by type of issuer (RM) 16,000

If this were the full story then this would be an unfair deal for the buyer of a fixed rate bond. However, the fixed rate bond buyer typically receives a higher interest payment through the lifetime of the bond. This observation is important for a lender, especially if the investor has concerns about the creditworthiness of the borrower. Inflation-linked bondholders expect their invested capital to be returned also later than if they had invested in a comparable fixed-rate bond. Bond issuers understand this feature of inflation-linked bonds. It is a feature that implying that they effectively lend the bond issuer money for longer.

14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 ABSA African Bank Airports CSA

FirstRand Eskom Eqstra

Standard Bank Sanral

Investec TCTA

Source: JSE: 30 May 2014

www.ashburtoninvestments.com

21

CREDIT risk

“The unlisted market could, in our view, assist South African investors in their diversification efforts by offering access to at least a further 400 different companies.” > bond programmes across all maturities

and issues. Apart from Eskom, SANRAL and the Trans Caledon Tunnel Authority (TCTA) the other main issuers of inflation-linked bonds are the banks.

The aggregate issuance by the banks is greater than the aggregate issuance of Eskom, SANRAL and the TCTA. Bank issued inflation-linked bonds present a very different credit risk profile to their government and government-guaranteed counterparts and needs to be evaluated differently before inclusion in an LDI portfolio.

Clearly a thorough credit analysis must be carried out prior to investing in bank-issued inflation-linked bonds.

More than that, the long-term nature of the funding being provided by the debt holder should be understood and properly compensated for.

This is critical in an LDI portfolio which is designed to be a hedging portfolio intended to mitigate risk.

This should extend to mitigating risk in stressed market conditions.

A further risk is liquidity risk. Since bank issued bonds tend to be of a smaller size, trading in the secondary market is much more limited and bid-offer spreads (the costs of buying and selling) are higher than government and governmentguaranteed inflation-linked bonds.

The total size of bank issues (per issuer) range between 27% - 46% of the total issue size of government-guaranteed Eskom bonds. This feature, combined with the government guarantee on

22

Global Perspectives

Eskom bonds, makes the latter far more liquid than bank-issued bonds.

Moody’s, in a report on the South African banking system, released in May 2014, noted that the outlook for the local banking sector remains negative – mainly the result of subdued economic growth, which will continue to exert pressure on asset quality. We have also seen recent negative rating action on some South African banks, and rating outlooks, in most cases, remain negative. In our view, this places any decision to hold non-government guaranteed bonds in the LDI portfolio firmly in the spotlight.

The Katse Dam, part of the Lesotho Highland Water project, for which issuer of inflationlinked bonds Trans Caledon Tunnel Authority (TCLA) is responsible for some of the work. Image: Corbis

The investment decision to increase the pension fund’s strategic exposure to inflation-linked bonds, could, in our view, be separated from the decision to take credit risk…

For funds that are comfortable awarding their LDI manager a degree of flexibility then the LDI manager could access a ‘wider toolkit’ to enhance the yield on relatively lowyielding government inflation-linked bonds.

This ‘wider toolkit’ would include allowing the manager flexibility to synthetically create the exposure to the inflation-linked bond and use the cash to invest in a diverse portfolio of credit-risky bonds. …and credit risk, in turn, should be further decomposed to ensure a proper diversification of idiosyncratic credit risk as well as some consideration of the asymmetric nature of credit risk.

When investing in credit one of the commonly held tenets is to diversify

R369.3bn The market value of the nine issues of government inflation-linked bonds listed on the Johannesburg Stock Exchange (JSE)

idiosyncratic risk by ensuring exposure to a wide spectrum of issuers. By synthetically creating the inflation-linked bond exposure, the manager is free to diversify the credit-risky bond portfolio across different issuers (irrespective of whether the bond itself was inflation-linked) and in so doing avoid concentration risk to a single issuer.

CREDIT risk

overall LDI portfolio, that diversification of idiosyncratic credit risk has taken place.

A bond-only LDI portfolio may be stocked with government and governmentguaranteed bonds. Adding a relatively small holding in a single name bank bond such as our example above may be considered prudent since the holding is small relative to the total LDI portfolio. Is this really the case?

In our view, a more appropriate way of evaluating the holding would be as set out below: • For the pension fund to consider what total exposure it would like to credit as an asset class (through a risk budgeting and strategic asset allocation exercise which allows for differences in the risk-return profile of different credit instruments e.g. listed versus unlisted; secured versus unsecured).

However, the South African listed corporate bond market is concentrated and so the benefits of this diversification are limited.

As an example, there are only 52 different companies with listed bonds. Even if we extend our definition of credit, beyond listed bonds, to include loans to companies that have been syndicated by the banks making those loans, our estimate is that the average South African investor is only able to access no more than 100 different South African companies.

This is in stark contrast to the world’s most liquid corporate bond market, the USA, which has more than 600 different issuers.

With the nascent state of our corporate bond markets, achieving further diversification requires investors to consider the unlisted debt space as an avenue for obtaining credit risk exposure to a wider spectrum of South African companies.

The unlisted market could, in our view, assist South African investors in their diversification efforts by offering access to at least a further 400 different companies.

The second commonly held tenet is that any consideration of credit risk should include a proper evaluation of the asymmetric risk-return profile of corporate bonds. By ‘asymmetric’ we mean that, unlike equities, corporate bonds have

limited upside and unlimited downside.

‘Limited upside’ means that the maximum annual return is known at the outset and is defined by the gross redemption yield on the bond. This is in contrast to equities where the potential for capital gain is, in theory, unlimited. But both corporate bonds and equities have ‘unlimited downside’. That is, as with an equity investment, investors in corporate bonds can lose their entire investment.

To properly account for the asymmetric nature of their investment in credit, investors should expect their manager to also consider the risks associated with default and the subsequent likelihood of recovering if not all, then at least some, of their initial investment. This then leads to the concept of secured credit versus unsecured credit.

Listed corporate bonds are generally unsecured in nature. Diversifying into unlisted credit can allow investors to access secured credit assets which, in turn, can offer investors greater protection should the credit worthiness of the borrower deteriorate.

It is a fallacy to believe that because an LDI portfolio’s holding in a credit-risky bank issue is only a small part of the

•T o then control for idiosyncratic risk by setting appropriate parameters such as issuer, issue and sector concentration limits.

Not to follow such an approach raises the risk that the pension fund can end up overexposed to a specific issuer or sector at portfolio level. This could arise since the fund’s other asset managers (i.e. those not managing the LDI portfolio) could also be exposed to the same creditrisky issuer through their portfolios which hold their equity or indeed their bonds.

When drafting the investment guidelines for an LDI mandate, clients should set explicit parameters around the types of inflationlinked bonds that the manager is permitted to include. For managers with appropriately skilled credit teams, allowing the manager to buy credit-risky inflation linked bonds could enhance the yield on the LDI portfolio. However, even then clear limits should be agreed with the LDI manager and those limits should be set based on the pension fund’s risk budget.

Ashburton Investments’ Solutions team comprises internationally experienced LDI managers who have managed some of the largest LDI mandates in the world across the UK, USA and now South Africa. We also have a deeply experienced credit team. /

www.ashburtoninvestments.com

23

Product Development

The European Congress Centre, Luxemburg. Image: Corbis

Our perspective on changes Ashburton Investments prides itself on staying abreast of global product development.

24

Global Perspectives

Product Development

Juan Coetzer

Product Development.

SA Hedge Fund legislation developments

Jeff McCarthy

Head of Product Development.

Launch of RMB Fusion Funds

World markets are influenced by global events and with increasing regulatory changes it is vital in this industry to stay abreast of development and respond accordingly. Ashburton’s product team is at the forefront of this effort and in this section they discuss some of the new product launches and recent global regulatory changes on the horizon.

An exciting development for Ashburton Investments in South Africa was the successful launch in June of a suite of low cost, multi asset funds by the Global Markets Fund Solutions unit within Rand Merchant Bank (RMB), a division of FirstRand Bank Limited. The “Fusion range” complements our existing, active suites of Multi Asset Funds by providing investors with low cost access to asset allocation strategies in both local and offshore assets, with three Funds catering for differing investor risk appetites. Their objective is to deliver returns in excess of inflation (CPI), and their exposure to each asset class is via indices and index tracking investing and is managed to long-term strategic asset allocation models. These asset allocations may be adjusted by the fund manager, but only within parameters specified in the mandate of each Fund.

The Fusion range is an important element in our strategy to extend Ashburton Investments’ offering to the wider market and will be available on Ashburton Investments’ investor platform.

The South African Treasury and Financial Services Board released draft regulations earlier this year setting out a proposed framework for the regulation of the South African hedge fund industry. This is likely to change the landscape of this industry dramatically. The legislation appears to borrow heavily from existing European UCITS fund regulation; an encouraging step in that this will bring South Africa more in line with global regulatory practise.

Although hedge fund managers are regulated under the Financial Advisory and Intermediary Services Act, hedge funds themselves continue to operate within a largely unregulated arena. The proposed changes seek to bring hedge funds under the Collective Investments Scheme Control Act (“CISCA”). The new framework will split hedge funds into two categories: (i) restricted hedge funds, which will be reserved for private investment amongst “qualified investors” and (ii) retail hedge funds, available to the general public. However, the latter will be subject to increased regulatory oversight and their mandates will be restricted in order to provide adequate investor protection.

We expect these restrictions, which have not been promulgated, to cover leverage, liquidity, risk management and client obligations. Guidance is still awaited on the tax treatment of hedge funds under CISCA.

www.ashburtoninvestments.com

>

25

Product Development

Craig Sherman

Product Development.

The future of rail travel in South Africa? State-owned Prasa rail network has just announced a R51bn ten year revitalisation project.

Image: Getty Images

Launch of Africa Credit Co-investment Fund In June 2014, Ashburton successfully launched its Africa Credit Co-investment Fund. The Fund invests in a diversified portfolio of USD denominated debt instruments, predominantly loans advanced to African corporates and state-owned enterprises. The Fund has a unique and exclusive co-investment right to participate in all qualifying transactions originated by RMB. Serena Dingle

Product Development.

UCITS regulatory developments

>

26

Global Perspectives

UCITS V, the latest EU fund directive in the series, is likely to go live in 2016, having been signed into law in May this year. This legislative update focuses on Depositaries (Custodians), tightening up definitions of their duties, delegation and liabilities. The directive also lays down rules governing remuneration of functionaries, including investment managers, to enhance alignment between management of a fund and shareholders’ interests. In addition, the directive also puts in place sanctions for certain regulatory breaches. These measures will further increase the existing strength of the UCITS brand to the benefit of shareholders. Ashburton Investments launched its own UCITS range in May 2013 and currently has five funds and some $200m on its platform in Luxembourg.

RMB’s deep experience in the African market provides access to assets through its extensive relationship networks and market insight. Additional yield is influenced by strong growth-driven demand for funding across the continent. The Fund targets a gross yield of Libor + 4.5% per annum without the use of gearing.

This is the second Fund to be launched based on co-investment principles established with RMB, the first of which being the R5bn South African Credit Co-investment Fund which has now been in operation for a full year. The coinvestment principles allow these Funds the right, but not the obligation, to invest in all qualifying transactions originated

by RMB as defined in the Fund mandate.

This co-investment approach ensures alignment of interests and partnership with a strong pan-African asset originator, giving these Funds the potential to deliver superior risk-adjusted returns. /

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Ashburton (Jersey) Limited 17 Hilary Street, St Helier, Jersey, JE4 8SJ, Channel Islands Tel: +44 (0) 1534 512000

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Issued by Ashburton (Jersey) Limited (“Ashburton”) which has its Registered Office at 17 Hilary Street, St Helier, Jersey JE4 8SJ, Channel Islands and which is regulated by the Jersey Financial Services Commission and also authorised as a Foreign Financial Services Provider in South Africa in accordance with Section 8 of the Financial Advisory & Intermediary Services Act 2002 (FSP number 42500). The views expressed in this document represent the collective views of the Ashburton investments team and its external advisers, which will change with altering market conditions. It is for information purposes only and must not be regarded as a prospectus for any security, financial product or transaction. Ashburton does not in any way represent, recommend or propose that the securities and/or financial or investment products or services that may be referred to in this document are appropriate and/or suitable for a particular investment objective or financial situation or needs. This document does not constitute advice in respect of any other financial, investment, trading, tax, legal, accounting, retirement, actuarial or other professional advice or service whatsoever. While all care has been taken by Ashburton in the preparation of the information contained in this document, Ashburton does not make any representations or give any warranties as to the correctness, accuracy or completeness, nor does Ashburton assume liability for loss arising from errors in the information irrespective of whether there has been any negligence by Ashburton, its affiliates or any other employees of Ashburton, and whether such losses be direct or consequential.

Ashburton and its affiliates disclaim any liability for any direct, indirect or consequential damage or losses that may be sustained from using or relying on the information contained herein. The value of investments, and the income from them, can go down as well as up, is not guaranteed, and you could receive back less than you invested. This could also happen as a result of changes in the rate of currency exchange, particularly where overseas securities are held. Past performance is not necessarily a guide to future performance. If you undertake investment business with a non-UK firm, you will be excluded from the benefit of the rules and regulations made under the UK’s Financial Services and Markets Act 2000, including the UK Financial Services Compensation Scheme. Approved for issue in the UK by FirstRand Bank Limited (London Branch), a branch of FirstRand Bank Limited, whose Registered office is at Austin Friars House, 2-6 Austin Friars, London EC2N 2HD. FirstRand Bank Limited is authorised and regulated by the South African Reserve Bank. Authorised by the Prudential Regulation Authority. Subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of our regulation by the Prudential Regulation Authority are available from us on request. Approved for issue in South Africa, by Ashburton Fund Managers (Proprietary) Limited which is a licensed Financial Services Provider (“FSP”) in terms of section 8 of the Financial Advisory and Intermediary Services Act, 37 of 2002 (“FAIS Act”), with FSP number 40169, regulated by the Financial Services Board.

Funds or investment products issued by Ashburton Fund Managers or its affiliates in South Africa are only intended for South African investors unless authorised for distribution or marketing in your jurisdiction.