Professional Documents
Culture Documents
Illiquid assets
Unwrapping alternative returns
Roger Ibbotson Are investors rewarded or penalized for holding illiquid stocks?
Sven-Christian Kindt Exploring the upside of new illiquid alternatives.
Alexander Ineichen Hedge funds overcome recent challenges.
Carol Franklin Trees represent a growth opportunity for the patient investor.
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GLOBAL INVESTOR 1.15 —03
THE ALLURE OF
LIQUIDITY –
CURSE OR BLESSING?
TEXT MARKUS STIERLI Head of Fundamental Micro Themes Research
ILLUSTRATION FRIDA BÜNZLI
Contents
Global Investor 1.15
10 42
Psychology and (il)liquidity Farmland – a fertile investment
Liquidity has its price. But, says Roger With dairy farming interests, and over 20
Ibbotson, with equities the popular choice years in asset management, Griff Williams
has a premium that may be too high. knows plenty about farmland investment.
16 44
Liquidity trends in illiquid Ins and outs of real estate
alternatives It’s an illiquid asset, but real estate is
Amid rising interest in less liquid alterna- attracting growing interest. Philippe
tives, Sven-Christian Kindt points out the Kaufmann offers his insights and advice.
reward for sacrificing unneeded liquidity.
18 48
Infrastructure on the rise
On doing your homework
Institutional investors are flocking toward
If you’ve first done your research, says
infrastructure. Robert Parker explains why
lexander Ineichen, hedge funds may
A
building for the future is a big deal today.
bring higher end returns with less volatility.
21 52
Liquidity – a key to hedge fund Looking beyond liquidity
Felix Baumgartner and Patrick Schwyzer
performance
reflect on client perspectives of the illiquid
It’s a key factor. Marina Stoop examines
asset landscape.
the role that liquidity plays in hedge funds
and for their investors.
56
24 In passion we trust
Open-end versus closed-end funds Art, antiques and collectibles: Art Market
The right investment, say Giles Keating Research and Development looks at
and Lars Kalbreier, is a function of the a different kind of alternative investment.
underlying asset type and the kind of fund.
58
26 From illiquid assets to profitable
Attractively consistent investments
At the helm of the New Zealand Super- The European Central Bank is working
annuation Fund, Adrian Orr talks about to restore the European securitization
patience, opportunity and very long horizons. market, report Christine Schmid and
Carla Antunes da Silva.
30
Talking teak 62
She has branched out. Carol Franklin has No exit?
a diverse background including language, There’s lower and more volatile liquidity in
insurance and plantation ownership. the corporate bond markets. Jan Hannappel
outlines the causes and the implications.
39
Institutional investment Disclaimer > Page 65
in t imberland
It’s not easy going green. Gregory Fleming
explains why institutional investors
see timberland as a growth opportunity.
GLOBAL INVESTOR 1.15 —10
Liquidity premium
Psychology
and (il)liquidity
Maintaining a certain amount of liquidity in a portfolio is fully justified, but investors tend
to pay up too much for it while underestimating the extra returns from holding illiquid assets.
The o verpricing of liquidity seems to be greater in equities than in bonds, in part because
in equities the price is strongly influenced by “stories,” whereas in bonds it is dry mathematics.
INTERVIEW BY OLIVER ADLER Head of Economic Research, JOSÉ ANTONIO BLANCO Head Global MACS,
SID BROWNE CIO and Head of Research Liquid Alternatives
Sid Browne: Economic theory states that cash flows, you pay a lower price and where there is mispricing because they get
there should be a premium available for subsequently you get higher returns. Now, to be “too” popular, as measured for exam-
accepting illiquidity. You’ve studied premi- what’s especially interesting in liquid mar- ple by their heavy trading. Interestingly, our
ums – and associated risks – attached to kets is that giving up a little bit of liquid- measures of stocks that trade less show
both illiquid and liquid assets. What can you ity actually can have a surprisingly big lower volatility. So these stocks don’t really
tell us about your findings in general within impact – by buying stocks that trade every seem more risky. Therefore I don’t really
a portfolio context? How should institutional hour, say, as opposed to every minute. like calling the extra return a risk premium.
and private investors invest? José Antonio Blanco: From an investor’s Sid Browne: What about in the event of a
Roger Ibbotson: Let me start off by perspective, could you call the effect you’ve squeeze, when all of a sudden you want
saying that the stocks that I study are actu- just described a risk premium, or is it liquidity and rush to sell your illiquid stocks?
ally publicly traded stocks. They may be less instead the result of market inefficiency in Isn’t there that flight-to-quality risk?
liquid than the most liquid stocks, but they’re the sense that investors focus on certain Roger Ibbotson: There could be the risk
all liquid stocks. There’s a strong theoretical companies and disregard the rest? of having to sell quickly. In actual experience,
reason why you’d expect less liquid stocks, Roger Ibbotson: It could be both. though, for example in 2008 when you had
in fact less liquid assets of any type, to be You can create a risk factor from a liquidity a kind of a liquidity crisis, it was the most
lower valued. People want liquidity, and premium. But I am rather thinking of liquid stocks that were sold and dropped the
they’re willing to pay for it. They pay a higher something I call a “popularity” premium, most. So even in a financial c risis, the less
price for the most liquid assets, and there- which I’ve expanded on in recent papers. liquid stocks do relatively well compared to
fore the less liquid assets sell at a discount. The stocks that trade the most are the the more liquid stocks. Now it is true that it
That discount means that, for the same most popular. And those are the ones is more difficult to sell the less liquid, and >
GLOBAL INVESTOR 1.15 —12
people chose not to sell them. But it is still cash payments, would actually not be
a fact that their prices fell much less than impacted by this popularity phenomenon.
those of more liquid stocks. Roger Ibbotson: It could be affected,
Sid Browne: So would it make sense to but it would not be affected by as much
have a very large exposure in your portfolio because you can see the pricing exactly in
to these types of stocks? a yield spread. And so you know exactly
Roger Ibbotson: If you’re a day trader, what you’re paying for.
you don’t want to buy these kinds of stocks José Antonio Blanco: Are you saying that
because they’re going to have higher trad- we have more serious information issues
ing costs. It really depends on your horizon. in the equity than in the bond market?
If you have a longer horizon, then buying If you compare two bonds, it’s relatively
less liquid stocks can make sense. easy to find the one that is paying too
Oliver Adler: Could you discuss the p arallels much, or too little. Whereas, for a stock,
in the bond market, or segments of the you might look at the past, but the future
bond market, in terms of what those is much more difficult to assert. So, as
liquidity or illiquidity premiums would look
like there? “What’s an investor, you tend to grab things that are
a bit easier to recognize, like brand names,
especially
Roger Ibbotson: Well, first of all, bond along the lines “if something is popular,
markets are in the fortunate position of it’s probably better.”
interesting in
having yields to maturity that you can actu- Roger Ibbotson: Yes. In the equity
ally see. You know that if the bond doesn’t markets, you can tell stories about
liquid markets
default, you’re going to get a specific return the stock. And the stories can be very inter-
in that particular currency. And you know esting. And you can pay a lot for stories.
it in advance. That’s why, for e xample, value tends to
In the equity market, you can’t see the
forward returns in the same way. You only
is that giving have higher returns than growth. Growth
gets highly priced b ecause growth
see the result. And since returns them-
selves are very volatile, it’s hard to discern
up a little c ompanies have much more interesting
s tories than value companies. In the bond
what the result really is. Moreover, the re-
turn measures differ strongly over different
bit of liquidity market, all these same phenomena may
exist, but there is more information.
periods. That’s why we can debate which
of these premiums really exist and how high
actually It’s much more mathematical. The spreads
are visible.
they are. This is quite different in bond
markets where maturities are normally fixed.
can have a Oliver Adler: How about areas like private
equity, or hedge funds, where you need
Oliver Adler: Would you say that the stock
market gives rise to more irrational behavior
surprisingly a lot of knowledge and can’t easily
tell stories? Might it therefore be fair to
in some sense than the bond market?
Roger Ibbotson: I’m sure there is irratio- big impact.” say that mispricing phenomena occur
less frequently here?
nal behavior in the bond market, too. But Roger Ibbotson: Well, mispricing can
Roger Ibbotson
yes, there is behavior in the equity market be pretty frequent in private equity as well
where essentially people are attracted to because there’s actually less information
stocks that trade a lot. And they’ll pay more for the buyer. You need more specialized
for them, just as you would do with brands expertise to understand the specific stocks.
in the consumer market. Consequently, Also, in private equity, the presumption is
the return structure is going to be different that the private equity manager not only
among the less popular and the more popu- identifies undervalued stocks, but actually
lar, and that leads to mispricing. Of course, changes the company in some way to make
you’re also going to see mispricings in it more valuable, perhaps by getting tax
the bond market, but they may be smaller benefits, restructuring management or
there and they’re more visible and thus altering incentives. So there are potentially
easier to take advantage of. more possibilities for profit if you’re really
Sid Browne: You’re saying that something good at doing that.
could be more popular in the equity market Hedge funds typically buy publically
than it would be in the bond market. traded equities or bonds – more or
So Apple stock, for example, could go less liquid securities. When you invest in
“hot” and very, very liquid, but the debt, a hedge fund, you are essentially buying
because it’s traded less and because the manager who is buying liquid
it is a discounted flow of more certain securities. continued on page 14 >
GLOBAL INVESTOR 1.15 —13
How Moody’s
the framework is used in most other regions
as well. Moody’s maintains SGL ratings on
a pprox imately 840 issuers, with USD 1.8 tril-
measures
lion in rated debt.
liquidity stress
I ndex (LSI) to provide a broad indication of
speculative-grade liquidity. The LSI is the per-
centage of SGL issuers with the weakest
(SGL-4) rating. Changes in corporate earn
ings, borrowing costs and ease of new debt
issuance are critical drivers of changes in the
LSI over time. Credit cycles tend to lead the
economic cycle because willingness to lever
age into expanding economic activity has to
occur before the activity itself gets underway
in the real economy.
Speculative-grade companies do not have
access to the commercial paper markets, so
they are generally unable to quickly raise new
financing in crisis moments. Measuring their
riskiness essentially boils down to gauging
I
n periods of market stress, investor scru- (SGL) ratings in 2002. Loss of access to fund the free cash flow from operations, cash on
tiny often moves onto lower-rated finan- ing remains a risk criterion in any assess- hand, and committed financing from other
cial instruments that have been issued ment. Defining speculative-grade liquidity sources such as revolving credit facilities (the
with a premium yield level attached. risk as “the capacity to meet obligations,” latter is not part of the SGL analysis.)
C oncerns about the ability of issuers to meet SGL s describe an issuer’s intrinsic liquidity More than 12 years after the introduction
ongoing cash obligations for coupon payments position on a scale of 1 (very good) to 4 (weak). of SGL s, the track record now includes both
can lead to investor flight from speculative Assignment of a rating is carried out under extended periods of more-than-ample liquid-
bonds, just at the moment when those issuers detailed criteria for measuring a company’s ity and phases of unprecedented risk and
most need to shore up their finances to remain ability to meet its cash obligations through market stress. The LSI’s long-term average
in business. Classic examples might be riskier cash, cash flow, committed sources of exter- value since inception is 6.8%, with a record
consumer finance companies, smaller oil and nal cash, and potentially available options for high reading of 20.9% in March 2009 at the
gas firms, and heavily leveraged property raising emergency cash through asset sales. height of the financial crisis in the US. The
d evelopers. If the stress period persists, such SGL s are a measure of issuers’ intrinsic lowest level reached by the index was 2.8%
issuers are often unable to raise suffic ient liquidity risk – meaning Moody’s assumes in April 2013, with default and illiquidity risks
short-term debt to maintain their trading companies do not have the ability to amend exceptionally low. At the start of 2015, the
a ctivities and, if undercapitalized, they may covenants in bank facilities or raise new cash index was still very benign at 3.7%, indicating
even fail. that is not already committed. Such conditions a below-average forecast of the default rate
Defaults in this riskier zone can prove con- are not typical in normal market environments, of speculative-grade companies in the course
tagious, both because of the effect on other but can occur in periods of economic and of this year. Higher risks from falling oil pric-
parties exposed to a given sector or deal, and credit market stress when companies need es were balanced against the steady earnings
due to the psychological effect on the gener liquidity support the most to avoid default. gains from US consumer spending.
al investing public. A vicious illiquidity circle Because Moody’s factors market access and
can develop, as occurred in real estate loans the ability to amend covenants into its long-
in 2008–2009, and may require government term ratings, the assumptions utilized in ana-
intervention and ultimately debt write-downs. lyzing liquidity are more stringent.
One proviso that Moody’s noted from the
Liquidity, a key element of credit analysis
outset is that liquidity assessments focus on Article by
In order to provide additional transparency in corporate capacity to meet obligations. Will- John Puchalla, Senior Vice President,
Corporate Finance Group at Moody’s
its existing liquidity assessment process and ingness to default remains a management
arm investors willing to hold speculative-grade issue that is not factored into SGL ratings, but Co-Author
debt against falling foul of rapid shifts in mar- is separately evaluated as part of the long- Gregory Fleming
Senior Analyst
ket sentiment, the rating agency Moody’s term ratings analysis. Ratings are dynamic and + 41 44 334 78 93
began assigning Speculative Grade Liquidity may be modified ad hoc, as with bond ratings. gregory.fleming@credit-suisse.com
GLOBAL INVESTOR 1.15 —14
Oliver Adler: What sorts of issues come might perform better. But the truth is that
up in terms of liquidity and premiums people want liquidity even though it some-
with some of the more obscure asset times leads them to take the wrong actions.
classes, like infrastructure, or the José Antonio Blanco: Once you know
not-so-obscure ones, like real estate? what your liquidity needs are, is there a fair
Roger Ibbotson: Well, of course, some- reward for real illiquidity? Or could you
thing like real estate is by its nature very also achieve a higher return by structuring
illiquid. But there are structures that you liquid assets, for example by exploiting
can buy, like REITs (real estate investment anomalies or special effects, as you’ve
trusts), that make it more liquid. If you put described (I don’t want to call it risk
real estate into a structure that makes it premiums)? In other words, do you think the
more liquid, it tends to be more highly val- illiquidity premium is overestimated?
ued. A REIT is a more expensive way to buy Roger Ibbotson: I think one aspect
real estate, but of course it has the benefit of what you are speaking about is the ability
of being liquid. On the other hand, if by to achieve “alpha” (a measure of outperfor-
buying real estate you actually get involved mance relative to some asset class or
in managing it, it’s a much more complicat- benchmark). To get a lot of alpha, you may
ed thing. That’s more like private equity. need to do a lot of trading. People are
All of these things are less liquid, and they overconfident, of course, of their ability to
all should have illiquidity premiums. I sus- achieve alpha. But the more you believe you
pect that a lot of the return from real estate can create alpha, the more you want liquidi-
comes from its illiquidity premium. ty because it is the lower-cost assets that
Oliver Adler: Given that the different asset may allow you to achieve alpha.
classes seem to have different characteris- In contrast, if you have long horizons,
tics, how do you deal with the liquidity then you’re the natural type of investor
issue when you put everything together to go after illiquidity premiums. The fact is,
into a portfolio? though, many people believe they can
Roger Ibbotson: People need a certain create alpha – some legit imately, and others
amount of liquidity. If you’re going to have who just think they can – and they will pay
a lot of illiquid assets, you also need some up for it. I don’t see that going away. So,
liquid assets to meet your liquidity needs. the market will tend to pay too much for
On the one hand, people should not pay liquidity, and conversely underestimate the
for liquidity they don’t need. On the other illiquidity premium.
hand, they may need more liquidity than
they think.
There’s a danger in going into too many
illiquid assets, like real estate and infra-
structure and private equity. Some of
the universities, for example, did get into
a bit of a squeeze in the financial crisis.
They could not get very good prices for
their private equity investments. One of the
b enefits of the kinds of stocks I’ve been
talking about is that they can easily be
sold in any crisis without paying much of
a discount at all.
Oliver Adler: But might it be possible
to argue that illiquid assets could help to
put a break on investors’ impulses Roger Ibbotson
to sell at the wrong time and save them The founder of Zebra Capital Manage-
from making mistakes? ment in 2001, Roger Ibbotson is also
Professor in the Practice Emeritus
Roger Ibbotson: That’s an interesting
of Finance at the Yale School of
argument. And, of course, there is evidence M anagement. He has written numerous
that overall stock market trends go in the books and articles, including “Stocks,
opposite direction of what retail investors Bonds, Bills and Inflation” with Rex
do: retail tends to sell after the crash and Sinquefield (updated annually), which
serves as a standard reference for
buy after the rise. So if retail investors were
information on capital market returns.
somehow prevented from overtrading, they
GLOBAL INVESTOR 1.15 —15
Private equity 1
in emerging
The untapped potential
of emerging markets
Emerging markets make up:
markets 39%
of global output
18%
of global stock market capitalization
Markus Stierli
Fundamental Micro Themes Research
14%
of global private equity fund-raising
11%
+41 44 334 88 57
markus.stierli@credit-suisse.com
Nikhil Gupta
Fundamental Micro Themes Research
+91 22 6607 3707 of global private equity investments
nikhil.gupta.4@credit-suisse.com
2 3 4
2009 2014
Buyout Growth PIPE Venture capital
* 2014 vs 2009
5 6 7
Not all markets are equal In search of exit Moving up the value chain
Data sources used for the article: Datastream, Emerging Market Private Equity Association, Preqin
Private equity investments expanded rapidly Asian venture capital investments have started African private equity is moving up the value chain,
in China, Brazil and Nigeria, shrank slightly in to find viable exits through IPO routes. The away from extractive industries.
India and collapsed dramatically in Russia aggregate value of venture capital exits quadrupled
and South A frica between 2009 and 2014. over 2013 – 2014 to reach USD 38 billion.
PE investments in 2014 , PE investments in 2009 ,
USD mn USD mn
Private equity capital invested
in key emerging markets, USD bn Number of Asian venture capital exits
15.7 454 Financials 253
8% 7%
5% 22% 3% 40%
5.5
2 1.5 USD 9 bn USD 38 bn 119 Oil and gas 539
4 0.1 0.3
India Russia South Africa Aggregate exit value Basic
Trade sale IPO 42 458
materials
2009 2014 Write-off Sale to GP
GLOBAL INVESTOR 1.15 —16
Liquidity
trends
in illiquid
alternatives
Investors are increasingly showing appetite to commit to less-liquid alternatives. This includes
investment opportunities in areas such as private equity, private debt and real assets. According
to a recent study, shifting from liquid assets in which the primary investment return results
from the market’s (or benchmark’s) movements to less liquid investments in which the primary
source of the return is due to a fund manager’s skill at navigating an investment to a successful
outcome typically results in a median return premium of 20%–27% over a fund’s life, and
more than 3% per year. This illiquidity premium can be further enhanced by investing with the
best-performing managers. These managers typically generate top-quartile investment returns
and outperform the median performance benchmark by as much as 20 percentage points.
Despite the opportunity to enhance overall portfolio returns (while reducing exposure to daily
market volatility), individual investors tend to be under-allocated to illiquid alternatives relative to
institutional investors. One oft-cited reason is the restriction on withdrawals of ten years or
longer before fully returning capital and profits to investors. However, the recent growth of shorter
duration and yield-producing investment strategies, such as direct lending to small and medium-
sized enterprises, coupled with the emergence of a secondary market for early liquidity,
Photo: Biwa Studio / G etty Images
may result in greater comfort with and more appropriate allocations to illiquid alternatives.
18 Allocation to alternatives
Venture capital
16
Private equity
Manager dispersion % of investment portfolio
Liquidity options
Historically, illiquid investment propositions such as venture capital and private equity funds required ten years or longer before fully returning capital
and profits to investors. However, the growth of shorter-duration and yield-producing investment strategies and a secondary market for early liquidity may
result in greater comfort with allocations to illiquid alternatives. The strategies outlined below are only a small subset of more liquid options available to
the investment community. These, and others, should make it easier for individual investors to sacrifice liquidity that they do not need in order to capture
(some of) the illiquidity premium.
Hedge funds
On doing your
homework
TEXT BY ALEXANDER INEICHEN
GLOBAL INVESTOR 1.15 —19
M
any seasoned investment professionals argue that liquid-
ity is an illusion. It is something you think you have, and
can measure in good times, but it vanishes immediately
during a perfect storm. It is a bit like your path toward
the emergency exit in a concert hall: under normal circumstances you
can run toward the exit within seconds; when fire breaks out, you
cannot. Liquidity is something everyone seems to require at the same
time. The financial crisis of 2008 is a good example. Markets literally
disappeared for a while. So-called market makers would delete their
prices on their screens and not pick up the phone, even in markets
that were considered liquid prior to the market disturbance. Another
example is the more recent decision by the Swiss National Bank to
drop its quasi-peg to the euro in January 2015. For a short time, the
foreign exchange market – considered as the most liquid market in
the world – stopped functioning properly.
of USD 100 in the average hedge fund portfolio went to USD 132
(+ 32%). This is still a big difference, but it had gotten smaller. In the “Over the last decade
five years to December 2014, a USD 100 investment in US equities
more than doubled to USD 205 (+105%). However, USD 100 in the or so, the conceptual
arguments for investing
average hedge funds portfolio “only” rose to USD 125 (+25%). As an
investor, which sequence do you prefer: –11%/+2%/+105% or
L
iquidity is an important aspect to con-
sider when investing in hedge funds.
Hedge Funds
Liquidity issues have to be managed
Liquidity –
by both investors as well as hedge fund
managers. While it is true that hedge fund
liquidity has generally improved for investors
since the global financial crisis, hedge funds
a key to
are still less liquid investments than equities.
To use Alexander Ineichen’s term, they can
be called “quasi-liquid.” In the following, we
hedge fund
take a closer look at the role liquidity plays
for hedge funds and their investors. A key
conclusion is that illiquidity is not only a draw-
back, but also a potential source of returns,
performance
which still has to be managed.
Investments in more illiquid securities on the is holding illiquid investments such as over-
side of hedge fund managers have implica- the-counter-traded distressed debt securities.
tions for investors too. Since the forced sell- Generally, investors eager to benefit from il-
ing of securities can mean selling at unfavor- liquidity premia should be prepared to take a
able prices, hedge fund managers can set up longer investment horizon and be willing to
a range of provisions to avoid losses due to accept more stringent liquidity provisions. In
this. Liquidity provisions can take the form of any case, it is important that investors clear-
Glossary of liquidity provisions redemption restrictions, lock-ups, gates, side ly understand the fund terms in order to avoid
Redemption notice period Minimum period for pockets or a combination thereof (see glos- unpleasant surprises later on.
advance notice prior to redemption. sary at the left hand side). It is no surprise
Liquidity requirements and return potential
Redemption period Frequency with which that the strategies investing in the most liquid
investors can withdraw their funds.
assets (managed futures and global macro) As Alexander Ineichen points out, hedge
Lock-up Time period from the initial investment
until it is possible to make a first withdrawal. tend to be the strategies that offer the highest funds used to be known as an asset class that
Gates A gate limits withdrawals to a certain liquidity for investors. As a result of the bad delivers superior returns at lower volatility.
percentage of assets under management during experiences made during the financial crisis, However, our view at this time is that lower
any redemption period.
with many investors not fully aware of such expected upside from traditional asset class-
Side pockets A provision that allows the manager
to keep particularly illiquid holdings in a separate
provisions, investors now desire a higher de- es (i.e. weaker beta drivers) in combination
account. There is usually no liquid market for gree of liquidity. Consequently, more liquid with structural changes is likely to dampen
these holdings. It may be difficult to establish the strategies as well as structures like UCITS the return potential of hedge funds. With re-
holdings values and may be difficult to sell
them. Hence, if an investor places a redemption (undertakings for the collective investment in gard to structural changes, the investor base
request, the manager does not need to liquidate transferable securities), which are designed of hedge funds is increasingly made up of
positions in a side pocket immediately. Pro rata to accommodate this desire, have attracted institutional investors, while private investors
proceeds of these holdings are only distributed to
investors once these holdings have been sold – more inflows. previously played a larger role. Tougher re-
which can be long after an investor has withdrawn While barriers of withdrawal can protect quirements regarding liquidity and transpar-
his capital.
investors from redeeming funds at the most ency have made it easier for institutional in-
unfavorable terms, there can also be argu- vestors to include hedge funds in their
ments raised against such policies. Investors portfolios. Further, the shift toward a more
may get the impression that hedge funds are institutional investor base has increased the
using such provisions as an excuse to earn focus on the role of hedge funds in a portfo-
further fee income before their capital is even- lio context: low correlations with other asset
tually returned. It is thus important that inves- classes and more stable return patterns have
tors are assured that long lock-up periods are become the key differentiating feature rather
well justified – e.g. because the hedge fund than the delivery of high returns. With tough-
0.90
Liquidity tight
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
Liquidity plentiful
0
Open-end versus
1800
closed-end funds
Making what turns out to be the right investment
0
1400
–7%
+
–8
Discount to NAV in %
Index points
1200 –10
In times of crisis
The discount of closed-
end funds mirrors the
–11%
development of the overall –12
market. The discount
increases as the crisis
unfolds, but is quick to
1000 revert again as recovery
begins to take hold.
–14
–16
800
–18
600 –20
01.05 07.05 01.06 07.06 01.07 07.07 01.08 07.08 01.09 07.09
I
nvestors have many choices when select- thus effectively eliminating the discount. the fund price down to a substantial discount
ing a pooled investment fund: regional D espite these measures, discounts and pre- to the apparent net asset value. In the middle
versus global, active versus passive, bonds miums rarely disappear completely, perhaps of the financial crisis in early 2009, the aver-
versus equities, famous manager versus because demand for most closed-end funds age discount of the largest US -listed closed-
start-up, and so on. But one choice can be is dominated by retail investors who tend to end funds rose as high as 25%. But the fund
overlooked: open-end versus closed-end be procyclical. manager is not forced into selling the under-
funds. On occasion, this may be the most When money flows in or out of open-end lying assets to meet withdrawals. Investors
important issue. funds, the dealing costs are in many cases who are prepared to hold their nerve through
As we will show, the practical difference spread among all investors. The impact of these the phase of stress will still own a share in
for investment returns may not be great under costs may be negligible in large funds with the balanced pool of assets selected by the
normal market conditions, but can become little movement, but can be a noticeable burden manager, with a good chance of recovery af-
significant at times of market stress, espe- on performance in small, fast-growing funds. ter the stress has passed, and they will not
cially for funds investing in illiquid assets such Perhaps, more importantly for an open-end be forcibly liquidated near the bottom of the
as real estate, small caps, or specialized cred- fund with specialist strategies in relatively il- market by the selling actions of other investors
its. In such cases, a closed-end fund may be liquid assets like small-cap or frontier-market in the fund. Indeed, after the financial crisis,
the better structure. stocks, a good performance in the early years the average discount narrowed quickly as
when the fund is small may be difficult to rep- markets recovered, providing an additional
Key differences
licate later if large amounts of new money are return driver for these funds on top of the rise
Closed-end funds have a fixed asset pool. attracted by the good results, but are not eas- in price of the underlying assets.
This can grow (or shrink) due to good (or bad) ily investible in the same way. So many suc-
Conclusion: Horses for courses
investment performance, but normally no ex- cessful open-end fund managers in specialist
tra capital is added from investors or paid out. areas close their funds for new investments to The conclusion is that investors should choose
An existing investor who wants to exit must protect existing investors as they approach between open-end and closed-end funds
sell on the open market to another investor capacity limits. If a manager does not do this, largely on the basis of the underlying asset
who wants to put money in. In contrast, the there can be style drift, making the track record type. For investments in mainstream, liquid
assets in open-end funds can change be- of a fund manager less relevant. markets like developed economy large-cap
cause of shifts in market prices as well as due equities, an established large open-end fund
Operation in stressed markets
to net inflows or outflows of capital from in- is probably the better choice in most cases.
vestors. When net new money comes in, the When markets become stressed, such as dur- It avoids the fluctuating premiums/discounts
manager invests in extra underlying assets, ing the financial crisis, some assets may be- of closed-end funds and should be large
while exiting investors sell units back to the come illiquid, while others remain easy to sell. enough to avoid issues of dealing cost attribu-
fund manager, who disposes of underlying When this happens with an open-end fund, tion, although it would likely not have leverage
investments to meet net redemptions. the first investors to exit will tend to receive capability.
cash obtained by the manager from sales of In contrast, closed-end funds are likely to
Operation under normal market conditions
the more liquid assets. While this is good for be the better choice for underlying assets
Investors in open-end funds buy and sell units these faster-moving investors, slower-moving such as real estate, frontier markets, small
at a level equal to the underlying asset value investors are left with units in an imbalanced caps and low-grade credit, since these are,
(subject to enough liquidity, see below). By fund that holds mainly illiquid assets that can- or are at risk of becoming, illiquid with all the
contrast, the price of closed-end funds is typ- not be readily sold and for which the theo- potential issues described above (see article
ically at a premium or discount to the underlying retical valuation may fall further than the more on Swiss real estate funds on page 47 for
assets, reflecting the balance between the sup- balanced portfolio existing before the stress more details).
ply from exiting investors versus demand from began. Well-known examples in recent years
those entering. Academic studies have argued include some frontier-market, real estate and
that a premium might reflect the skill of the credit funds. Fund managers may have some
manager or the rarity of the underlying assets, ability to restrict (“gate”) withdrawals. If this
while a discount might indicate lack of confi- is done early in the stress situation, it in effect
dence in the manager. Morningstar data shows temporarily makes the fund closed, protecting
that, over the long term, closed-end US funds remaining investors. But in a worst-case sce-
have on average traded at a slight discount. nario, this closure happens after the faster
This tends to deepen when markets go down, investors have left, which leaves remaining
while it narrows or moves to a premium when investors trapped with a pool of illiquid under-
markets go up and investors become more lying assets that may then eventually be sold Giles Keating
Head of Research and
optimistic. as soon as some limited liquidity reappears, Deputy Global Chief Investment Officer
Some closed-end funds buy back their which unfortunately is likely to be near the +41 44 332 22 33
own shares to try to narrow the discount, en- bottom of the market. giles.keating@credit-suisse.com
hancing value for remaining investors. Some- Clearly, this process simply cannot happen Lars Kalbreier
Head of Mutual Funds & ETFs
times, external predators try to gain control in a closed-end fund. Faster investors who +41 44 333 23 94
and liquidate the fund at the market value, try to exit will likely find few buyers, forcing lars.kalbreier@credit-suisse.com
GLOBAL INVESTOR 1.15 —26
Attractively
(NZ Super Fund), as a national
sovereign wealth vehicle?
Adrian Orr: We are a “buffer” fund.
Our aim is to smooth the increasing finan-
cial burdens for future generations. For
consistent
that reason, we have a very long-term
investment horizon: no money will come out
of the fund until at least 2031. That pro-
vides us great certainty around our invest-
ment horizon and our liquidity needs. These
“endowments,” as we call them, together
with our governance and our ownership
Patient, yet opportunistic. Those are two key characteristics (i.e. our control over our capital) allow us a
of the New Zealand Superannuation Fund, whose very long-term very high level of risk appetite and also
investment horizon allows it to pursue contrarian and illiquid the ability to invest in what can be called
strategies if the price is right, all while managing liquidity at the illiquid assets.
whole-fund level. Oliver Adler: How do you decide
your investment strategies?
Adrian Orr: We have a number of
INTERVIEW BY OLIVER ADLER Head of Economic Research investment beliefs against which we contin-
JOSÉ ANTONIO BLANCO Head Global MACS uously test ourselves, for example, that
there is some concept of fair value for an
asset, and that prices may deviate from
fair value, but should also revert to it over
time. These beliefs give us the confidence
to pursue contrarian strategies, as well
as illiquid strategies, if we think the price is
right. All potential investments, regardless
of asset class, are measured in terms of
their attractiveness – either as a diversifier,
or as a (mispriced) opportunity – and, more
generally, their consistency with our beliefs.
Oliver Adler: Isn’t that what the vast
majority of funds do?
Adrian Orr: Most funds have specific
strategic asset allocations (SAA s) to which
they are always rebalancing, whereas
we are opportunistic: we are continuously
shifting from the least attractive to the most
attractive asset classes or assets, based
on our confidence in our strategies. We are
least invested in black-box hedge-fund-type
strategies that are purely skill-based. We
have low confidence in skill as a basis for
adding investment value because we really
struggle to be able to assess it, and we
also have low confidence in its consistency.
José Antonio Blanco: What kind of horizon
do you use to estimate the attractiveness
of an asset mispricing? How much do
you want to have in illiquid assets? And how
much in liquid ones?
Adrian Orr: We define a long-term in-
vestor as someone who has command over
the capital. So at any point in time, we >
GLOBAL INVESTOR 1.15 —27
Photos: Jamie Bowering
Adrian Orr is CEO of the New Zealand Superannuation Fund, which has posted annualized returns between 17% and 25% over the last five years.
GLOBAL INVESTOR 1.15 —28
Talking
teak
GLOBAL INVESTOR 1.15 —31
Giselle Weiss: You describe “falling into” FSC (Forest Stewardship C ouncil). What
the business of growing trees but finding it plantations do is to take the pressure off
interesting. Why? the primary forests, as people no longer
Carol Franklin: Investing in trees have to go and cut trees in the jungle.
means you give your money away for And the reason for doing it in Panama?
20 years. The concept is difficult to sell Carol Franklin: Teak only grows in
in the sense that if you go about it properly, tropical regions, but you probably wouldn’t
it really is illiquid. Most of our competitors want to invest your money in many of the
say that you will get a first payout after countries along the equator. Panama has a
three to five years, and that they will relatively reliable legal system and, due to
reimburse your investment if necessary, its narrow shape between two oceans,
which is absolute rubbish. They also there is always a port nearby. If you plant in
tell you that returns are between 9% and Brazil, for example, and p eople do, the
15% a year, which is also rubbish. We nearest port can be 3,000 kilometers away.
compare our return to what you used to Getting the timber there costs a fortune.
get on a savings account – so something Unlike overland transport, sea transport is
like 6% to 7% per annum, 85% of not very expensive. Panama a lso has tax
which comes in after 20 years when incentives for reforestation.
the trees are harvested. Who should invest in a teak plantation?
How does it work? Carol Franklin: It’s not about quick
Carol Franklin: The basic concept money. So patient money, possibly. People
is that the investor pays all the money who have an affinity for trees. People who
up front, on a shareholding basis. In other are ecologically minded and who want
words, we have enough money for the to do something to save the world. Pension
20 years it takes for the trees to grow. funds would be ideal b ecause it’s a long-
We buy the land, plant the trees, and main- term asset and pension funds have calcula-
tain them very carefully. If all goes well, ble long-term liabilities. It’s well suited
we have the first non-commercial thinning to family offices: traditional families used to
after four to five years. Then after eight, have their own woods, and some still do.
14, and the final harvest after 20 years. We have many grandp arents! They think
Let’s backtrack just a bit. Why trees, as long-term, and teak is a shorter return than
o pposed to vineyards or fancy cars or German forests, for example. A German
P icassos or a nice little chemical start-up? oak takes 100 years to mature.
Carol Franklin: I personally have always And who should not invest?
been interested in ecology. And trees are Carol Franklin: Someone who might
vital for our survival. They help slow down need the money in the next 20 years.
climate change by capturing CO 2 . They I’d also never invest more than 10% of my
are something that you can see and touch, available money in something like this.
as opposed to, say, derivatives. Why teak? We’re not listed, which means the invest-
After 20 years you can sell the wood. ment is even more illiquid. But this also
Carol Franklin There are a lot of beautiful and interesting means we are decoupled from the financial
Chairman of the Board of Forests for
trees, but they have no international market, markets. So if everything goes down,
Friends and of the Tree Partner Company,
she earned her PhD in English literature whereas there is a functioning international which it will again of course, at least your
before assuming a series of management teak market. At the moment, we are s elling trees will continue to grow. And if the wood
positions at Swiss Re over the course all our wood to India, which could buy price happens to be unattractive at any
of 20 years. She subsequently became the entire worldwide harvest. Recently, the given m oment, we can just let the trees
the Executive Director of WWF (World
markets of Vietnam and China have been stand and wait. It’s not rice or oranges or
Wide Fund for Nature) Switzerland.
growing, and some of the wood is g oing v ineyards.
to these countries to make very nice Could you describe the planting cycle?
garden furniture, doors, cabinets, whatever. Carol Franklin: You buy the land.
It would be nice if the US and European You prepare the land. You plant the trees.
markets became stronger again in the You have to get the right soil and the right
near future. seedlings. Over the past ten years, seed-
Just to be clear, we’re talking about tree lings have improved dramatically. B ecause
plantations, not tropical forests, right? our plantations are ecologically certified,
Carol Franklin: Yes. We plant the trees you can’t use certain pesticides and her
on former cattle land. Plantations are not bicides, so you have to keep the grass and
ecological, although ours are all certified by shrubs down with the machete.
GLOBAL INVESTOR 1.15 —33
2
1
GLOBAL INVESTOR 1.15 —35
Tree Partner
Province Darién
Shareholders’ investment 2014: CHF 4,207,407
1 The Tree Partner Company comprises two teak plantations totaling 170 hectares, located within three hours driving distance of Panama City.
2, 3 Engineers periodically gather statistics on how well the trees are growing. The first commercial thinning occurs at about eight to ten years, when the tree
trunks measure 40 centimeters circumference minimum.
GLOBAL INVESTOR 1.15 —36
6
GLOBAL INVESTOR 1.15 —37
4 Trees cut from the first thinning will be made, for example, into door frames. 5 Panama’s proximity to ports is a huge advantage in terms of cost. 6 Harvest takes place
around 20 years after the planting, when the entire plantation is felled, or “clear-cut.” 7 The plantations provide jobs and learning opportunities to the local communities.
8 The fruit of 10 years’ labor: the wood from thinnings is collected at the entrance to the plantation, then loaded into 12-meter containers and shipped, primarily to India.
GLOBAL INVESTOR 1.15 —38
8
GLOBAL INVESTOR 1.15 —39
Institutional
intermediate investment funds make exposure
to timberland simpler for non-specialist insti-
tutions, but the larger pools of capital often
investment
prefer purchasing the assets directly. Returns
for institutions that acquired undervalued
holdings have been strong, initially driven by
a lower discount rate boosting long-duration
in timberland
assets like timber, and recently supported by
better wood demand.
L
and devoted to investible timber world- interested in pioneering private equity to ex- China and India, continuing urbanization and
wide amounts to 165 million hectares plore the scope for investing in timberland, as construction means these markets are still
(408 million acres), roughly equivalent a component of natural resource portfolios. growing. Chinese plantations cannot meet
to the land area of Alaska. Institutiona l Front-runners were the endowment managers demand and are under some pressure to be
investors now own timberland in Argentina, for Yale and Harvard Universities. Yale alone converted into development land.
Australia, Brazil, Canada, Chile, New Zealand, holds three million acres of forests. Increasing institutional investment is a
South Africa, the United States and Uruguay. Harvard’s Head of Alternative Assets, safe prediction due to low current allocations
Just under half of these assets (by area) are Andy Wiltshire, worked in the New Zealand within alternative asset portfolios and since
in North America. There is much less harvest- forests sector early in his career, and drove wood usage follows wealth development.
able timberland worldwide than forested land. the 2004 purchase of a 408,000 -acre New Thus, there is growing orientation toward
In Australia, only 1% of forested land is devel- Zealand timber estate by the Harvard Man- the Southern Hemisphere. Recent surveys
oped as timber plantations. agement Company. Kaingaroa Forest was the indicate that investor interest in emerging-
Broadly defined institutions, such as the largest commercial forest property on the market forests is primarily European, and
military, universities and even royalty, have country’s North Island. A 30% share of this that smaller-scale investors favor emerging-
held exclusive property rights in forests for huge forestry block was divested two years market timberlands. Sustainability is a criti
centuries. Interest in timber assets by purely ago to the Canadian Public Sector Pension cal concern – particularly with indigenous
financial institutions developed in the 1980 s Investment Board with an additional stake hardwood trees – but a wide range of tools
in response to both the growth of institution- taken up by the New Zealand Superannuation are at hand, including forest and manager
ally managed retirement accounts seeking Fund. Broadening of interest from private in- certification, NGO oversight and replanting
diversification, and a wave of forest divest- stitutional to public institutional investment is requirements.
ments by large forest-product companies. thus well underway.
Timber has appealed to observers noting Gregory Fleming
Institutions enter into forestry Senior Analyst
long-run real annual returns of 10%–15% on + 41 44 334 78 93
In the first two decades of investment by in- intensively managed, short-rotation planta- gregory.fleming@credit-suisse.com
stitutions outside the wood-products industry, tions. Seeing the very positive returns from
activity was confined to large university en- timber and its low volatility, sovereign wealth
dowment funds. US timber companies using funds and large public pension funds have
GAAP accounting had to pay tax on forest been acquiring exposure to commercial forest
owned – even when it was not being logged, assets. Corporate pension plans now own
thus incentivizing them to sell such plantations around 10% of the asset class.
to US tax-free pension funds. Preferential tax Based on measured returns on invest-
treatments for real estate investment trusts ment, timber is not positively correlated with
( REITs) also encouraged corporate divest- other assets. But, because the timber price
ment. During a period of strong equity market is responsive to house-building cycles, the
returns and declining inflation, the motivation run-up to the credit crisis in 2008 saw tim-
for institutional investment was limited to berland prices climb and then drop sharply.
those with a long time horizon for returns and The sluggish recovery in US housing led to Find additional details on
an unusually broad mandate on alternative a multiyear opportunity for pension funds our map on pages 40–41
investments, enabling direct holdings of un- to acquire timberland assets at reasonable
listed assets. This led the same institutions valuations, and most have entered the market
GLOBAL INVESTOR 1.15 —40
Farming and
forestry investment
Timberland is the investment term for China
harvestable forests, as is farmland for agriculture d pulp to
n d wo o
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GLOBAL INVESTOR 1.15 —41
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Find more
Farmland Mature, intermediate Excellent climate for
information in
Investing in farmland means and emerging timberland a griculture, total annual the articles
investing in rural land along investment regions r ainfall
on pages NEW
with specific crop and livestock With most US forestry assets Agricultural productivity is
a ssets. Crops may be row crops already in institutional owner- greatest in the world’s temper- 39 and 42 ZEALAND
like soybeans or permanent ship, investor interest has turned ate zones. Nonetheless, other
fruit and nut crops. to non-US markets, e.g. Asia. In regions, such as South America
Soybeans Europe, forests are generally in and Africa, where water is still
Dairy products private hands. plentiful, are drawing investor
Meat Mature interest.
Paper and paperboard Intermediate 475–4974 millimeters rain
Cotton Emerging
Lumber Selected international
Wood pulp agri-trade flows in USD
GLOBAL INVESTOR 1.15 —42
Farmland –
ing on and structuring of farmland
investments. What motivated this move?
Griff Williams: A desire to make agricul-
ture investment accessible to institutional
a fertile
investors. Agriculture is an asset class that
delivers real benefits to savings and retire-
ment portfolios, but lamentably, it is very
investment
difficult to access it in a pure-play format.
It is also an asset class that requires specific
expertise that generally does not reside
in the financial services sector. As a farmer
who has spent over 20 years in the asset
One doesn’t often think of institutional investors and farmland
management sector, I am blending the two
in the same breath. Yet, global population growth and the worlds to deliver this objective.
accompanying demands on our food supply have made agriculture What kind of investor considers farmland?
an asset class worth considering. But bridging the worlds of Griff Williams: Investors seeking expo-
farming and financial services requires rather specific expertise. sure to assets that benefit from long-term
secular themes such as population growth,
changing dietary habits, growing middle
INTERVIEW BY GREGORY FLEMING Senior Analyst classes, water and conservation manage-
ment. Farms offer a hedge against inflation,
combined with an income yield. At the
Global same time, investors need to be able to
2014 2055 population is trust the farm managers, or at least the
expected partner selecting them. No one really wants
to increase by to have to go down to the farm and
some 50% check what’s happening there in person.
Is agriculture sufficiently exposed to
the modern, services-based economy to
2014 offer good returns?
Griff Williams: The global population
is expected to increase by 50%, to more
2055 than nine billion in the next 40 years, while
food demand is set to grow by over 60%
as the world becomes wealthier. Shifts in
diet preferences toward protein foods are
well-attested in enriching societies, and this
will increase the demand for land resources.
Food demand So investors can potentially benefit from
is set to grow value-added gains in food or crop quality,
by over 60% but also from the very limited expected
as the world increase in the world’s available arable land.
becomes The investment time frame is important
wealthier in illiquid assets. What is the best time
frame for taking a stake in farming?
Griff Williams: Farming lacks the thrills
of daily commentaries on network television.
The farmer is almost the archetype of
a patient investor, and non-farmers also
Find additional
need some patience. Much depends on the
details on
mode of investment, but an investment
our map on
horizon of five to ten years or a longer-term,
page 40
strategic allocation is reasonable. For inves-
tors preferring the fund route to a direct
investment, between three and five years is
GLOBAL INVESTOR 1.15 —43
“Maximizing sustainable
the shortest time frame to see results, but
that renders the investment rather prone to
the fortunes of just a few growing or pro-
duction seasons. Capital gains on farmland
are also likely to accrue more reliably over yield and minimizing
environmental risks means
longer horizons.
What kind of return can investors expect?
Griff Williams: A good internal rate of
that it is critical to
return would be around 12% to 15% per
a nnum. This is likely to be split between a
cash yield on the farm products of 6% to
8% and a similar appreciation in the capital
value of the farmland, as it is improved.
Would you say that any one kind of crop
partner with real farm
or product is superior, from an investor’s
point of view?
Griff Williams: I have looked at opportu-
operators.”
nities in dairy, livestock, cotton, sugarcane Griff Williams
and fruit, soya, grains, and other rotational
crops. Each has unique and demanding farm subsidies virtually overnight in the
characteristics that require very solid expe- mid-1980 s. The New Zealand dairy sector is
rience on behalf of the farm managers. now the most efficient in the world, and few
Investors may have an affinity with a partic- farmers would seek a return to government
ular farm product, which is legitimate, but involvement in the price-setting process.
it shouldn’t bias the objective judgment of Australia has also largely cut out farm
their returns and risk levels across the cycle. support. Other countries, such as the USA ,
All the farm products benefit from intracta- have more recently and gently modified
ble global demographic trends, but within farming subsidies. The 2014 US Farm Bill
this rising demand trend, some crops are took the positive, though modest, step of
considerably more volatile. Alternatively, lowering direct payments and replacing them
some are more demanding – for instance, with crop insurance provisions. Globally,
dairying requires much more investment rich-country transfer payments to the agri-
and stock management than sheep farming. culture sector have been a major obstacle
What approach should investors take? to free trade agreements. It’s important
Griff Williams: Maximizing sustainable to stress that agriculture can survive and
yield and minimizing environmental risks thrive in a high-income country, without
means that it is critical to partner with real state price support. Finding those liberalized
farm operators. The skills the investor land opportunities, and conducting the vital
should try to access are centered on rural due diligence on legal systems, security of
productivity, rather than on land speculation title, environmental and marketing systems,
or investment vehicles that mainly back does require a broad range of skills.
trades in the agricultural futures markets. Have you identified some best-practice
These markets have quite distinct returns markets, or does it vary from farm to farm?
time frames and performance drivers from Griff Williams: The set of undistorted
the farmland itself. farm product opportunities is quite small, in
What are the special characteristics of country terms. The best operating environ-
investing in farmland globally? ments are seen across Australasia and in
Griff Williams: The key point is that selected Latin American countries such as
agriculture, in many countries, remains a Griff Williams Uruguay, Paraguay and Brazil. Once a
politically defined investment universe. The New Zealand national comes from number of farmers in a given country adopt
a farming family on the North Island,
C ertain governments restrict direct farm the best technologies and practices,
where he continues to have dairy farming
ownership to residents, while others link the pressure on the other farmers builds up
interests. At Milltrust he is responsible
subsidy payments to the farm’s output. A for designing and co-managing the rapidly. This is as true of yield-enhance-
set of agricultural economies, however, has globally diversified agricultural strategy ment techniques as it is of sustainable
liberalized its farming sector to reflect global with special focus on Australia and farming practices. Still, there are enough
market prices, and these countries have New Zealand. Prior to Milltrust, he was underperforming farms in countries with suf-
Head of Europe and Interim CEO of Itaú
seen substantial efficiency gains. New ficiently good investment conditions to pro-
Asset Management.
Zealand is the classic example here, ditching vide opportunities for a portfolio approach.
GLOBAL INVESTOR 1.15 —44
W
hen talking about illiquid assets, or objective price. Target prices depend on the
real estate is at the forefront as type of valuation model used and on investor-
it belongs to the most prominent specific preferences. Finding a price becomes
Hints for investors of illiquid assets. In developed even more difficult when there is only limited
markets, real estate is the most important data available on similar transactions and if
1 / Adopt a long investment
wealth contributor in household portfolios and assets have rare characteristics. This often
horizon. Transaction costs
adds up to enormous amounts of wealth. It is makes price negotiations time-consuming, and
are best absorbed by having a
not surprising that regulators and central adds to illiquidity. Determining a fair price is
long investment horizon.
banks pay a lot of attention to real estate especially important when one considers the
2 / Mind the leverage. Sufficient
markets. Residential real estate accounts
large size of the transaction.
own funds help to avoid
for almost 30% of net worth in portfolios of Several other real estate characteristics
fire sales as price and liquidity
ultrahigh-net-worth individuals (UHNWIs) (see contribute to illiquidity, mostly from a cost
cycles can be long.
Figure 1), and pension funds also have a sub- perspective. For example, the design and, to
3 / Know your product.
stantial share of their allocation in real estate some degree, the location of a building pre-
Legislation is very different for
(see Figure 2). determine its suitability for certain activities.
distinct types of real estate
The conversion of a big department store
funds and country-dependent. Causes of illiquidity of real estate assets
into many small retail units is relatively costly,
Some setups are more
The illiquidity feature of real estate results and regulation must also be taken into ac-
exposed to liquidity problems.
from a combination of several characteristics. count. Changing the use of a property from
4 / Take your time. Avoid
To begin with, real estate assets are always a legal point of view, such as the conversion
making your decision to buy
tied to a certain location. The combination of of apartments into shops and vice versa, may
or sell too quickly. This could
a particular location and a specific object be difficult or even impossible. Investors must
turn out to be very costly.
quality creates a unique tangible asset. Con- bear this in mind and should therefore have a
5 / Add real estate to your
sequently, every building requires a one-off clear strategy when investing in real estate.
p ortfolio. Do not be frightened
analysis and, on a microlevel, prices can even Other costs include legal expenses and taxes
of illiquidity. Real estate is
differ heavily on the basis of, for example, at the transaction stage. In total, there are
a good d iversifier in portfolios.
exposure to noise or view. All this is reflected five steps in the acquisition of a commercial
in the valuation of a property: there is no true building (see Figure 3). At each step, different
types of costs occur. Purchasing a commer-
cial real estate building typically needs a
negotiation time of about three months, plus
several months to conclude the transaction.
One last reason for the illiquidity of real estate
is simply the state of the market, which can
dry up quickly in periods of excess demand
(when nobody wants to sell a property) or,
01_Allocation to property in 02_Asset allocation of more seriously, in a situation of weak demand.
UHNWI investment portfolios Swiss p
ension funds as
While residential property (main residence and of September 2014 Investors are facing difficult decisions
any second homes) makes up almost 30% of Swiss pension funds traditionally have a sub
the total net worth of UHNWI s, real estate also stantial allocation to real estate. As of September The main question for investors is whether it
plays an important role when it comes to making 2014, almost 20% of their funds were invested is worth accepting this disadvantage from
investments. On average, property accounts in real estate. This number typically decreases to
for 24% of UHNWI investment portfolios. some degree when equity markets are doing a risk-return perspective. This depends on
In over 40% of all cases, this share has even p articularly well and therefore make up a larger the time horizon. As high transaction costs
increased in recent years. part of the asset allocation.
Source: Knight Frank, The Wealth Report 2014
associated with illiquidity are fixed costs,
Source: Credit Suisse Swiss Pension Fund Index, Q3 2014
it makes sense to hold such an asset for a
1.2% longer period. Therefore, pension funds and
2.1%
in percent
7.0% other institutional or private investors with
35 19.7% a long time horizon are typical real estate in-
30 vestors. In addition, these investors need to
25 accept that their real estate positions may not
20 4.9% 33.7% be 100% liquid at any time. For wealthy inves-
15 tors, these constraints are easier to cope with
10 (a fact that is reflected in the higher real es-
5
tate allocations of UHNWI s, see Figure 1). For
31.3%
0
these investors, it makes sense to accept the
illiquidity and be compensated for it. For ex-
ia ia IS a al e st rica rica
las A s i a /C A f r i c G l o b u r o p e E a e e Liquidity Bonds Equities ample, the historical average premium to the
s tra ss E dl h A m n A m Alternative investments Real estate
Au u i d ti
R M rt a
N o L Mortgages Rest intrinsic net asset value (NAV ) for listed >
GLOBAL INVESTOR 1.15 —46
Philippe Kaufmann
Head of Global Real Estate Research
+41 44 334 32 89
philippe.kaufmann.2@credit-suisse.com
GLOBAL INVESTOR 1.15 —48
Infrastructure
on the rise
Source: Preqin
2014
282 bn of
USD
infrastructure assets
2007
94 bn of
USD
infrastructure assets
90%
of surveyed investors plan
to invest at least USD 50 mn
e ach over the y ear 2015
Illustration: -VICTOR-/Getty Images
25%
of surveyed investors plan
to invest over USD 4 00 mn
ach over the y ear 2015
e
GLOBAL INVESTOR 1.15 —49
T
Largely due to the current low interest rate here is clear evidence that insurers and pension funds
environment, institutional investors such with long maturity liabilities are increasing their asset allo
cation to infrastructure as an asset class. Other categories
as insurers and pension funds are increasingly
of investors are larger family offices and sovereign wealth
moving toward allocation into longer-term funds. The investment case is that infrastructure projects or busi-
illiquid assets, in particular into infrastructure nesses offer long-term yields that are theoretically fairly stable
as an asset class. This trend has been a and normally can provide inflation protection. Typically, investors
significant one. In fact, global infrastructure are t aking a s even- to ten-year view on the risk / r eward of investing
assets under m anagement have seen a in infrastructure assets, but frequently the time horizons can be
c onsiderably longer. According to Preqin, global infrastructure
300% increase over the past seven years.
assets under management in unlisted funds are at a record high of
Investors are increasingly putting their money USD 282 billion, having increased threefold since 2007. Of the inves-
into the transport, telecommunications, tors surveyed by Preqin, 25% plan to invest over USD 400 million
technology, energy and resources s ectors, each over the next year in infrastructure, and 90% plan to invest at
and backing the large-scale construction least USD 50 million. Preqin estimates that “dry powder”, i. e. uncalled
projects these sectors require. While not capital already committed, could be USD 107 billion, while insurance
without risk, such investment is s upported by companies are planning to increase their asset a llocation to infra-
structure to 3%.
governments and supranationals alike.
Infrastructure: The different components
Financing
Infrastructure bonds
Apart from equity investing on the part of long-term investors, there 1 Workers laying railway track in northwest
is a clear recognition among investors that the infrastructure bond China. 2 Pipeline pipes at the ready with
oil rig in background. 3 Bales of paper ready
market requires further development. Historically, infrastructure was
for recycling.
financed either by bank lending or by bond issues made by suprana-
tional institutions, governments, or companies involved in the construc-
tion or maintenance of projects. Investor risk was limited to a direct
credit risk on the issuer without any recourse to the project assets.
With banks deleveraging and reducing maturity mismatch risk by
focusing on floating-rate rather than fixed-rate assets and reducing
proprietary positions, bank financing for infrastructure will decrease
on trend, and therefore lead to greater reliance on access to funding
from investors and the bond markets. Since investors are reluctant
to act as equity providers in greenfield projects, they likewise will not
be providers of longer-term financing for new projects. They will, how-
ever, be active participants in bond issues made by existing infrastruc-
GLOBAL INVESTOR 1.15 —51
ture management companies such as train operators, pipeline manag- encourage market sources of finance, including transparent securiti-
ers, etc., while they will also purchase bonds where there are credit zation, particularly for small and medium enterprises and we endorse
guarantees either by government, supranational institutions or banks. the multiyear program to lift quality public and private infrastructure
investment.” It is obvious that at the level of individual governments
Risks
and also the IMF, OECD and EU, accelerating infrastructure projects
While the current low interest rate environment encourages increased is a clear macropolicy objective. S & P has estimated that infras tructure
allocation into longer-term illiquid assets such as infrastructure, it is financing needs worldwide could total USD 3.4 trillion annually until
important to focus on the risk factors in the industry and highlight 2030. For governments, infrastructure investment is clearly attractive
some examples where investor losses have been generated. For given the initial positive impact on employment and the longer-term
new projects, the obvious key risk is that projects are either not com- multiplier effect on the economy.
pleted or have serious delays and /o r cost overruns. Recent examples
Trends
include escalating costs of building new nuclear plants, projected
overruns in high-speed train lines and toll road tunneling projects. There are a number of clear trends in the infrastructure sector. First,
Political risk has to be carefully assessed; there have been a number new investment from investors such as pension funds that need
of instances, notably in mining projects in higher-risk emerging mar- long-term assets and do not need liquidity will increase significantly.
kets, where a change of government has led to contracts /c oncessions Second, investment in infrastructure will have the support of govern-
being cancelled and assets sequestered. Another example of political ments and supranational institutions given the strong economic
risk is the possible change in government subsidies and / or support. m ultiplier effects. Third, the environment for investing in greenfield
A number of alternative energy projects and notably wind farms have projects / s tart-ups will remain challenging and will require project and
faced deteriorating economics as government subsidies have been credit support. Fourth, investors will focus on areas where there is
withdrawn, and likewise social infrastructure projects, which might be inflation protection, minimal systemic risk, and where leverage and
in the form of a public / private partnership, can suffer from reduced financial risk is intelligently managed. Finally, the flow of equity cap-
government funding. Environmental issues are critical, notably in the ital will be matched by the development of the infrastructure bond
transport, energy and waste management sectors. Examples of prob- market as an alternative to bank financing.
lems have been the imposition of environmental fines on projects and
infrastructure assets and projected cash flows being delayed because
of disputes over environmental issues. Certainty of cash flows is Robert Parker
Senior Advisor
o bviously important, but in a number of cases, cash flow projections +44 20 7883 9864
have been too optimistic. One example has been in toll roads where robert.parker@credit-suisse.com
they have competed with toll-free roads and traffic has not switched
to the toll roads, with a mediocre outcome for revenues and cash
flows. Another risk is the threat from new technology. For example,
in telecommunications, the future viability of mobile masts has to be
questioned, while initially the excessive installation of fiber-optic
c abling led to major losses. Market price movements can change the
economic viability of infrastructure. At present, the sharp decline in
oil prices is challenging a number of alternative energies, and invest-
ment in oil and gas fracking is becoming less attractive.
Financial risks involve the threat of higher interest rates and /o r
wider credit spreads. Increased financing costs will challenge the
economics of infrastructure, make alternative asset classes more
attractive and could delay projects if refinancing needs are not met.
Other market-related risks can be changes in foreign exchange rates
where hedging longer-term assets can be problematic, shifts in
yield curves (which might affect swap pricing where swaps have been
used to hedge borrowing risks) and the use of excessive leverage.
In 2008–09, a number of infrastructure funds had to be restructured
since reduced cash flows could not meet increased borrowing costs
Photos: Imaginechina, Lowell Georgia, Anna Clopet/Corbis
Government policies
In the recent G20 communiques, the G20 stated “we are working
to facilitate long-term financing from institutional investors and to
GLOBAL INVESTOR 1.15 —52
Looking
is that “this” client is invested approximately
40% to 50% in equities and 30% in cash.
The cash tends to come from fixed income.
In other words, when a bond expires, the
money goes into the cash portion of the
account owing to the lack of opportunities
beyond
in fixed income. Now, clients are a bit
worried about staying in cash, and conse-
quently they’re looking for other opportuni-
ties, including illiquid assets.
Are some investors more open
liquidity
to illiquid assets than others?
Patrick Schwyzer: There are different
ways of characterizing investor preferences:
by geography, by what stage investors are
in in their lifecycle, by their background
and by the country they live in. For example,
the USA is certainly more open to illiquid
Global Investor asked two Credit Suisse wealth managers a sset investment. Switzerland not so much.
There are a number of reasons for the dif-
to describe the illiquid asset landscape from the point of
ference, one of which could be that in the
view of investors. Do clients feel it is worth trading liquidity USA , people have to administer their own
for a dditional returns? How much of their portfolios do clients pension money. That means thinking through
allocate to illiquid assets? Are some assets more popular the range of investments for the best yield
than others? And how does culture affect asset choices? and return, whereas in Switzerland we
still delegate the entire business of pensions
to outside parties or the companies’
INTERVIEW BY MANUEL MOSER Senior Financial Editor, Credit Suisse p ension scheme.
What about preferences for various kinds
of illiquid assets, such as real estate or
hedge funds?
Felix Baumgartner: The order of
preference that we observe is: real estate,
then hedge funds, followed by private equity.
Traditional Swiss investors, in particular,
look for real estate in Switzerland. But there
is not much left here. It’s all been bought
up. Some traditional investors still like gold,
which is not an illiquid asset, of course,
but still very volatile.
How satisfied are clients with the
r eturns on their investments in illiquid
assets?
Felix Baumgartner: I’d say they’re
satisfied with real estate, and with hedge
funds. Private equity could be the next
boom in the coming years because it offers
a long-term investment, diversification and
good returns. But clients are too little in-
vested in it at present to reap the benefits.
For Swiss-based investors, I would estimate
that private equity currently represents
only about 1% or 2% of their portfolio.
Patrick Schwyzer: I would say it’s more
like 0.5%! >
GLOBAL INVESTOR 1.15 —53
Photos: Luca Zanetti
Patrick Schwyzer (left) and Felix Baumgartner from Private Banking & Wealth Management, Credit Suisse, take a moment to exchange viewpoints.
GLOBAL INVESTOR 1.15 —54
product, and the liquidity provider will literally are a family of two or three people Are fees an issue for clients?
t ypically buy at a discount to the actual net have one investment specialist who needs Patrick Schwyzer: Certainly, pre-2008,
asset value of the product. to cover everything from bonds to alterna- the predominant means of investing in
Are entrepreneurs more likely than other tives. In that case, they’re looking to us to hedge funds for the private sector was fund
investors to favor illiquid assets? help them put together their own portfolio of of hedge funds. And there you had a double
Felix Baumgartner: It’s a good question. hedge funds. Bigger family offices typically layer of fees: the underlying managers
As owners of their own company, they’re employ their own private equity specialist who on average were going to charge you
more open to illiquid investments. They or hedge fund specialist, but like to talk to a 2% management fee and a 20% perfor-
probably have 80% of their total wealth in- us as a “sparring partner.” mance fee; and the additional level on
vested in the company, and they’re com Felix Baumgartner: Investment behavior the fund of hedge funds where the manager
fortable with that because they know what and interest can also change dramatically. would pick and choose those funds. We
is going on with it. Of course, if they already We’ve seen that over the last one or have seen a clear trend toward single funds,
have 80% invested in their company, it two years. Some family offices that previ- which has removed one of the fee layers.
makes no sense to put the rest in illiquid ously invested only in traded equities with no The second layer is also under pressure.
a ssets as well. So we would tend to advise a llocation in private equity because of It comes down to performance. Good
them to maybe put 5% in private equity, worries over illiquidity, decided to go into it p erformance is clearly needed to justify the
if they really want that, and keep the rest within the space of three or six months. fee levels.
in cash or in liquid assets.
How much do clients want to know before
they decide on an illiquid investment?
Patrick Schwyzer: What I see in most
discussions is that clients want to under-
stand the thought process and how we
do things. They want to understand how
we come to the selection of a particular
manager, be it in the private equity or the
hedge fund space. They don’t really want
to receive the full package on the due dili-
gence report and go through it themselves.
That’s exactly why they come to us.
In terms of cycles, is it fair to say that
investor appetite is back where it was
b efore the financial crisis?
Felix Baumgartner: Absolutely. Inves-
tors are looking for opportunities. Clients,
and especially Swiss clients, often want to
leverage their portfolio, also the illiquid
parts. It’s analogous to taking out a mort-
gage on real estate. And banks are increas-
ingly amenable to offering credit (assessed
on the basis of loan to value, or LTV ) on
illiquid assets. We clearly limit the risk in the
interests of both the client and the bank.
Patrick Schwyzer: Another cycle-related
example: before the 2008 financial crisis,
“The order of preference that
there was a lot of movement into the so-
called fund of hedge funds space, particu-
we observe is: real estate,
larly in Switzerland. After the crisis, those
private investors left that space. And now then hedge funds, followed
we see them coming back, as providers
b egin to offer a selection of c arefully vetted by private equity.”
single-manager hedge fund products or
Felix Baumgartner
advisory services.
Has the rise of family offices played
a big role in increasing the allocation
to illiquid assets?
Patrick Schwyzer: It depends on the
type of family office. The smaller ones that
GLOBAL INVESTOR 1.15 —56
Market overview
Indexes compare each sector’s
growth over a ten-year period,
using the central 80% of
data and a 14 -month moving
AMRD 2003 = 1000
average (14MMA ).
Chinese Contemporary Art
12,000 AMRD Contemporary 100
Jewelry
Classic Cars
10,000 Watches
8,000
6,000
4,000
2,000
05 06 07 08 09 10 11 12 13 14
In passion
we trust
The idea of objects of desire as investments of passion took off in the UK in the late 1970s
with the publication of “Alternative Investment.” As an investment analyst in the City of London,
Photo: malerapaso / G etty Images Sources: Art Market Research & Development (AMRD)
the late Robin Duthy noticed that, while conventional investments were intensely studied for
past performance and future potential, no systematic analysis of the markets for art, antiques
and collectibles had been undertaken. Working with the late Sir Roy Allen at the London School
of Economics, he devised a sophisticated methodology of trimming and smoothing mechanisms,
which eliminated seasonal and other distortions. It is important to remember that when the
media reports eye-catching prices for collectibles sold at auction, the prices paid by the buyer
will be substantially higher than the cash received by the seller; transaction costs in these
markets (e. g. auctioneers’ or agents’ commissions) can be sobering, reflecting the price paid
to overcome the illiquidity inherent in trading high-value idiosyncratic items.
in oneself, and was noted for selling off some of his younger
German artists collection in order to fund his
12,000
10,000
for confidence Kong in 2010 for over USD 1.2 million. Last year, 6,000
his “ Publication 2 No. 4” sold for over USD 7.6 4,000
million. AMRD’s methodology enables comparison
in oneself with other a rt sectors, for example, as represented
by the AMRD Contemporary 100, a leading
2,000
reveals that sales of top Chinese contemporary AMRD Contemporary 100 top 25%
Robin Duthy “Alternative Investment” – artists have been outperforming the competition Chinese Contemporary Art bottom 25%
Founder of Art Market Research for the last five years. AMRD Contemporary 100 bottom 25%
1,000
sale of a Patek Philippe 1933 “Henry Graves
1,000
Jr. Supercomplication” pocket watch, which sold in
01.04 01.06 01.08 01.10 01.12 01.14 2014 at Sotheby’s in Geneva for CHF 23.2 million 01.04 01.06 01.08 01.10 01.12 01.14
Ferrari 1959–1982 Maserati 1958–1982 ( USD 24 million). This set a new record for any Jewelry (general) Pearls
Triumph 1946–1977 timepiece ever sold at auction.
GLOBAL INVESTOR 1.15 —58
European securitization
I
n the aftermath of the financial crisis, the European securitization ECB as an asset-backed securities buyer
market collapsed. New issuance in European securitization de-
In 2014, the ECB released details of its asset-backed securities ( ABS)
creased by more than 75% compared to volumes in 2008 and has
purchase program, which was followed by the release of a legal act
not recovered since then. Primary market activity in 2013 was be-
enabling implementation of the purchase program with actual pur-
low EUR 200 billion, corresponding to only 14% of US issuance over
chases having started. The ECB has appointed four executing asset
the same time period (see Figure 1). The lack of a functioning secu-
managers for the purchase program. The asset managers will conduct
ritization market is a major disadvantage for European banks, the
the purchases on behalf of the Eurosystem and undertake price checks
economy and investors. Regulatory-forced deleveraging and its neg-
and due diligence prior to approving the transactions. The program
ative impact on lending and economic growth could have been better
will involve the purchase of senior tranches and guaranteed mezzanine
mitigated, in our view.
tranches of loans originated in the euro area. Greek and Cypriot ABS
For the European Central Bank (ECB) to be successful in fostering
will also be included in the purchase, albeit with tighter provisions.
economic growth, the current pool of assets for Quantitative Easing
The combined size of the ABS purchase program and covered bond
(QE) might prove to be too narrow, so that the issuance of securitized
purchase program will reach EUR 1 trillion.
investment products based on high-quality assets – so-called Quali-
Several other measures have also been taken in the meantime
fying Securitization (QS) – needs to pick up in order to broaden the
to facilitate the development of the securitization market in Europe.
ECB’s investment base. As the ECB is pressuring interest rates and
Among them, we would highlight the changes to Solvency II >
yields into negative territory, banks are in need of margin expansion.
If structured correctly, this can be achieved by QS and align the banks’
need to earn profits with the ECB’s need for economic growth and
the investors’ need for attractive yield opportunities.
To make the securitization market grow in Europe, it must become
economically attractive for banks. So far, the maths have not quite
worked out, mainly due to regulatory rules with respect to securitization
that result in a lack of “capital relief” for the banks (see box on the
risk capital treatment of different loans and securitizations on p. 61).
Given their need to remain exposed to the part of the securitized a ssets
with the highest risk, to which a risk weight of 1,250% is applied, the
transaction simply lacks economic appeal for the banks.
forcing them to take immediate action, the ECB made it very clear that
the adjustments would become part of its ongoing supervision of cap- 500 20%
ital requirements as it continues to forge ahead with the agenda
of improving the quality of European banks’ balance sheets. More
0 0%
importantly, we believe that the process toward a European Banking
Union has significantly contributed to increased disclosure and trans- 2006 2007 2008 2009 2010 2011 2012 2013 2014
parency, which is building the basis for a greater investor attraction
Total European ABS placed Total US ABS placed
toward banking assets. European ABS placed in % of US ABS placed (rhs)
GLOBAL INVESTOR 1.15 —60
1 When a bank grants a mortgage to a borrower, 2 The bank then bundles a number of home loans –
the bank earns an interest income. both risky and less risky – into a pool of mortgages.
3 The bank places these pools of mortgages 4 The return and the risk of the bonds depend on the
into a trust. The trust then sells bonds, which riskiness of the mortgages which secure the bonds.
are secured by the mortgages. To create different risk categories of bonds, the
bank divides the mortgages into risk groups called
tranches. Rating agencies such as Standard &
Poor’s or Moody’s then often rate the tranches to
reflect the risk of default. The bank is required by
regulation to keep a tranche of the highest risk
category.
No exit?
in riskier securities such as corporate bonds.
According to the paper, this trend suggests
an increased fragility of the latter. As data
availability is limited, the International Capital
Market Association, a self-regulatory organi-
zation, conducted a series of interviews with
market participants to analyze the topic from
a market view. The study, titled “The Current
State and Future Evolution of the European
The efforts of regulators to strengthen the financial system Investment Grade Corporate Bond Second-
ary Market,” finds that liquidity in secondary
have led to both lower and more volatile liquidity in the corporate
European corporate bond markets has de-
bond markets. As a result, investors could potentially find clined; interviewees described the decline
themselves in a situation where no one will buy. To properly ranging from “significantly” to “completely.”
manage expectations, and to be able to plan ahead, investors Another survey of large banks published by
need to understand this new landscape and what it means. the European Central Bank (ECB) in January
2015 focused on Euro-denominated markets
and arrived at similar results. More banks re-
ported that their market-making activities for
credit securities had decreased during 2014
rather than increased, and a further decrease
is expected in 2015. The study also found that
participants’ confidence in their ability to a ct
as market makers in turbulent times had
diminished in 2014 compared to 2013.
S
Regulatory tightening a driver
ince the financial crisis in 2008, intermediaries. Further, the market for cor
regulators have tightened rules porate debt is much more fragmented than We believe that the decline in corporate bond
on financial institutions to improve the market for equities as companies usually market liquidity can be attributed to an in-
the stability of the financial sys- offer very few classes of equity, but a large crease in regulation in the financial sector.
tem. Banks and dealers have subsequently number of different debt instruments. Within This matches with the ECB survey results
strengthened their financial profiles and the bond market, different classes of debt mentioned above, as banks most often cited
scaled back risky capital market activities. exhibit different liquidity characteristics. The regulation and balance sheet capacity as rea-
This structural change is especially important market for government bonds is perceived as sons for a decline in market-making activities.
to bond markets as they depend on interme- more liquid compared to the market for cor- The financial crisis in 2008 revealed a
diaries willing to warehouse risk and facilitate porate bonds, partly due to the different struc- number of shortcomings of financial regula-
trading activity. As a number of studies by tures of securities issued. Governments issue tion. Since then, governing institutions have
governing institutions suggest, liquidity in in larger lots, have fewer maturities and usu- been actively improving and tightening the
bond markets has decreased since 2008: ally do not add exotic features to their debt. regulatory framework, thus leading to a re-
investors now find it harder to enter and exit The corporate bond market is much more duction of market-making and trading activi-
positions or are incurring higher transaction fragmented and thus shallower. Moreover, in ties by banks. The Basel regulations for banks
costs. This could increase the risk of more the corporate bond market, different risk seg- have increased the amount of equity banks
severe price swings. In an extreme scenario, ments exhibit different liquidity traits. Invest- need to hold against their risky positions. This
investors might find themselves trapped as ment-grade debt is usually more liquid, while makes market-making activities, which re-
nobody is willing to buy. Here, we take a high-yield and emerging-market debt are quire sizable balance sheet capacity, less
closer look at this structural change in bond perceived as less liquid. profitable. Additionally, the newly introduced
markets and how it interacts with current Liquidity Coverage Ratio and Leverage Ratio
Declining liquidity raises awareness
market conditions, and analyze what investors are steering banks toward holding more
can expect. A number of recent publications by regula- liquid securities, reducing high-volume/low-
tory institutions and think tanks suggest margin business such as trading activities,
Corporate bond markets
liquidity in bond markets has changed. In and limiting their reliance on short-term fund-
Compared to equities, the fixed income N ovember 2014, a paper published by the ing. Moreover, banks have cut proprietary
market relies more on dealers and over-the- Bank for International Settlements on market- trading in view of, for example, the Volcker
counter structures, which makes it more de- making activities found that liquidity in debt Rule in the USA . Proprietary trading has
centralized and dependent on functioning markets has shown a diverging trend since the been a source of liquidity, especially during
GLOBAL INVESTOR 1.15 —63
volatile markets. As a result, banks and deal- the liquidity premium increased in European
ers have reduced their fixed income trading investment grade issues from approximately 01_Corporate debt market up
activities since 2008 as well as their ability to 50 basis points in 2007 to 200 basis points A growing gap between primary dealers’ inventory
warehouse risk and facilitate capital market the following year. For European high-yield and the size of the US corporate debt market is
fueling liquidity concerns.
activities. issues, the rise was even more extreme, from Source: Credit Suisse, Federal Reserve, SIFMA
The structural change stemming from finan- This suggests that, in times of crises, inves- 8,000 250
7,000
cial regulation comes at a time of historically tors chase liquidity and also quality. Further- 200
6,000
low interest rates fueled by quantitative eas- more, according to the study, the liquidity 5,000 150
ing programs adopted by central banks around premium is fairly low at the moment. To us, 4,000
100
the globe. On the one hand, we believe that this raises concerns that current market pric- 3,000
2,000
this accommodative stance has reduced mar- es influenced by low volatility and low interest 50
1,000
ket uncertainty and thus eased investors’ rates do not compensate investors enough 0 0
concerns about liquidity. On the other hand, for the ongoing decline in liquidity and a po-
2001 2004 2007 2010 2013
low interest rates have increased the corpo- tential hike in turbulent times.
Outstanding corporate debt USD bn (US)
rate debt markets as companies take advan- (left-hand axis) Primary dealer inventory USD bn
Implications for investors (US) (right-hand axis)
tage of the lower funding costs. In Figure 1, we
show the increasing gap between primary We believe that investors need to recognize
dealers’ inventory and the size of the US cor- the structural change toward lower liquidity
porate debt market. Moreover, investors’ moti as well as the volatile nature of liquidity, es-
vation to drop low-yielding government debt pecially buyers of higher-yielding corporate 02_Turnover ratio down
and pile into higher risk and most often less bonds. Certainly, liquidity is more relevant in The turnover ratio of corporate debt is much lower
liquid securities has also risen due to monetary turbulent market times, but we think investors than the ratio of Treasuries and the total debt
policy, in our view. This in turn adds to liquid- should plan ahead and assess to what degree market. The turnover ratio of the US debt market
has decreased on average by more than 30%
ity concerns again (see Figures 2 and 3). they rely on markets. If holding fixed income since 2007. Source: Credit Suisse, SIFMA
securities to maturity is an option, investors
Liquidity most relevant in times of stress
can shrug off liquidity concerns. If not, inves- in %
So far, the decline in bond market liquidity tors should analyze each case to see if they 14
has not caused much of a headache for inves- are rewarded for the risk of not being able to 12
10
tors as corporate bonds are in good demand. sell at their convenience.
8
However, it is quite easy to imagine a sce- Investors are not alone. Supervisory insti-
6
nario of many investors exiting at the same tutions are increasingly aware of the struc-
4
time with no one willing to buy or provide tural changes in bond markets. A policy re-
2
market-making activities. In this case, liquid- sponse to cushion abrupt movements is not 0
ity would evaporate quickly, leaving investors unlikely, in our view. In the long term, we
2007 2009 2011 2013
high and dry. The modest decrease in liquid- believe that the gap left behind by banks will
US Treasuries US total debt
ity in the last few years might therefore not be filled or that banks will adjust their trading US corporate debt
be a good indicator of what to expect during activities to cater to their clients more specif
turbulent times or in case demand for corpo- ically. As traded corporate debt is a substan-
rate bonds falls. This could, for example, occur tial part of the financial system, new forms of
when interest rates increase from their his- trading are evolving quickly. Electronic plat-
toric lows. We believe the asset management forms that rely on peer-to-peer trading instead 03_Outstanding US bond
industry is particularly exposed to a sudden of dealers already exist and are likely to grow. market debt
US debt markets have increased 14-fold from
drop in corporate bond market liquidity. Inves- Another approach would be to standardize the
1980 to 2013. Source: Credit Suisse, SIFMA
tors’ expectations of their ability to redeem corporate bond market more to reduce com-
mutual fund shares or sell ETFs (exchange- plexity and simplify trading and market making. USD bn
traded funds) on a daily basis could reveal the A combination of both seems pragmatic to us 40,000
low liquidity of the underlying bonds bundled as electronic trading requires standardized 35,000
30,000
into these funds. In case of a pronounced units to flourish. In the meantime, a closer look
25,000
outflow from funds, many asset managers at how much an investor relies on liquidity 20,000
could be forced to sell into dry markets and when a security is purchased will help to avoid 15,000
incur significant losses. most of the concerns. 10,000
5,000
The Bank of England’s Financial Stability
0
Report, published in June 2014, aims at ex- Jan Hannappel
1980 1990 2000 2013
tracting the liquidity premium inherent in bond Equity and Credit Research Analyst –
European and US Banks Municipal Treasury Mortgage-related
prices by comparing credit derivatives and +41 44 334 29 59 Corporate debt Federal Agency securities
actual bond prices. The analysis found that jan.hannappel@credit-suisse.com Money markets Asset-backed
GLOBAL INVESTOR 1.15 —64
Authors nikhil.gupta.4@credit-suisse.com..................................
+91 22 6607 3707......................................................
robert.parker@credit-suisse.com..................................
+44 20 7883 9864.....................................................
Nikhil Gupta joined Credit Suisse Private Banking and Robert Parker is a Senior Advisor to Credit Suisse in
Wealth Management in 2011, and is currently part of the Investment Strategy & Research. He has worked in the
Fundamental Micro Research team. Before joining a sset management industry for 42 years and joined
Credit Suisse, he worked for a management consulting Credit Suisse in 1982 as a founder of CSFB Investment
firm for four years. He has an MBA from the Indian M anagement. He chairs the Asset Management and
School of Business, Hyderabad. > Page 15 Investors Council and is a board member of the Interna-
tional Capital Markets Association. He has a BA and MA
in Economics from Cambridge University. > Pages 48–51
Jan Hannappel
Equity and Credit Research Analyst – European
and US banks.............................................................. Christine Schmid
jan.hannappel@credit-suisse.com................................. Head of Global Equity & Credit Research........................
+41 44 334 29 59....................................................... christine.schmid@credit-suisse.com..............................
+41 44 334 56 43.......................................................
Jan Hannappel is a Research Analyst in Global Equity and
Credit Research at Credit Suisse, focusing on European Christine Schmid is Head of Global Equity & Credit
and US banks. Before joining Credit Suisse in 2014, Research at Credit Suisse Private Banking and Wealth
he was a corporate finance analyst. Jan Hannappel holds Management. She has covered financials for 15 years
an MA in Accounting and Finance from the University of and coordinates the global financial view. She holds an
St. Gallen. > Pages 62–63 MA in Economics from the University of Zurich, and is
a CFA charterholder. > Pages 58–61
Gregory Fleming
Senior Analyst.............................................................
Sven-Christian Kindt
Head of Private Equity Origination & Due Diligence.........
gregory.fleming@credit-suisse.com...............................
sven-christian.kindt@credit-suisse.com.........................
+41 44 334 78 93.......................................................
+41 44 334 53 88.......................................................
Gregory Fleming joined Credit Suisse in 2006 as a senior
analyst for the Investment Decision Cockpit and Investment Sven-Christian Kindt is Head of Private Equity Origina-
Committee. Previously, he worked in portfolio strategy tion & Due Diligence at Credit Suisse Private Banking
for Westpac and Grosvenor Financial Services Group, and Wealth Management. Before joining Credit Suisse in
and for the International T
extile M anufacturers Federation 2008 , he worked for Bain & Company and A.T. Kearney
as a global economist. He holds an MA with Distinction in London. He holds degrees from ESCP Europe and the
in Economic History from the University of Canterbury, University of Michigan’s Ross School of Business.
New Zealand. > Pages 13, 38–39, 42–43 > Pages 16–17
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