Frontier Markets - the Next Growth Investment?

Five professional investors from four buyside firms believe that frontier markets have a greater opportunity set than emerging markets.  They carry less risk (i.e. less volatile) and have less correlation with the developed world markets.  According to Andrew Brudenell, portfolio manager at HSBC Global Asset Management, they are cheaper and have higher dividend yields.  Chad Cleaver and Howard Schwab, portfolio managers at Driehaus Capital Management agree.  In addition, the best opportunities are in small and mid cap stocks and in markets with native consumers.  These ideas have outperformed the MSCI BRIC index handily.  Since the summer of 2009, this index is flat or down slightly.  Other customized indices based on the above investing themes include ASEAN index, ANDEAN index and a consumer stock index.  The ASEAN index is comprised of Thailand, the Philippines and Indonesia.  It is up 70% for the same timeframe.  The ANDEAN index is comprised of stocks from Colombia, Peru and Chile and is up 65%.  An index comprised of consumer discretionary and consumer staples securities (50%/50% split) is up 75%.

Kemal Ahmed, portfolio manager at Investec Asset Management, adds another wrinkle to the frontier markets theme.  He has coined the term horizon markets which consists of frontier markets plus the 14 smaller countries in the MSCI Emerging Markets index.  He calls them Smaller EM.  The seven larger countries account for 80% of the index's capitalization and are called Large EM.  The BRIC nations make up 60% of the index.

According to David Stein, chief investment officer at Parametric, the correlations within the frontier markets has remained low (approximately 0.3) while they have been rising between countries in the developed and emerging markets.  While investing in a particular country in the frontier markets may be riskier, diversification among country risks should lead to safer and less volatile returns.

These factors make frontier markets a compelling alternative to a standard investment in the BRIC countries.

CalPERS Reviews Hedge Fund Strategy

The California Public Employees Retirement Systems (CalPERS) is in the midst of changing its allocation strategy for its hedge fund investments.  There are $5.2 billion in assets out of a total of $254.9 billion.  As part of its total portfolio, it is not that important but the absolute dollar numbers are impressive.  They are seeking to reduce their equity exposure by investing in assets that are not correlated with long only funds, private equity and high yield bonds.  Edigio Robertiello, senior portfolio manager of absolute return strategies, has proposed the following changes:

• CalPERS will have to raise the percentage of assets allocated to hedge funds to much more than currently
• Classifying the hedge fund allocation separately from the global equities allocation
• Limiting the beta to global equity markets to 0.20 
• Setting a standard deviation target for returns to 8%

While CalPERS is considering Robertiello's recommendations, he is reviewing the current hedge fund investments and making the following changes:

• Reducing the number of hedge funds to concentrate assets in fewer strategies
• Reducing the fund of funds allocation to 15% from 29%.  Emerging fund of funds will have a 10% allocation.
• Reducing the investments in Asia and Europe to 5% from 19%
• Increasing the allocations to equity market neutral and global macro to 10% each
• Adding an allocation to event driven to 5%
• Increasing the allocation to equity long/short to 15%

Since the portfolio has underperformed its internal benchmark by 2% since it was begun, Robertiello is hoping that the changes will improve its performance.  Against this backdrop, CalPERS is evaluating whether or not passive management is more efficient than active management.

The source for this article can be accessed here.

Private Equity: End of Life Fund Assets

The traditional methods of exiting private equity investments (i.e. IPO) are not working for many investments bought in 2006 to 2008.  These companies were acquired using unrealistic projections or at high prices and have no buyers.  They are perhaps the last holdings of a fund.  According to Andrew Hawkins, CEO and Founder of NewGlobe Capital Partners, there are $75 billion worth of companies in this category.  NewGlobe and two other firms, Vanterra and Hamilton Lane, will buy these assets, allowing the private equity fund to close and return cash to its investors.  This allows the fund manager to start up a new fund.  What does NewGlobe receive?  Oversight of the new fund and a chance to invest in the new fund.

There are two other exits that are available:  (master limited partnerships (MLPs)) and employee stock option plans (ESOPs).  The fund would sell the company to the MLP.  Then the MLP would offer an IPO.  This would be a good resolution for a company that is still too small to be publicly traded or have a low valuation.  The ESOP route would sell the asset to the employees and management of the firm.

The source for this article can be accessed here.

Increased Risk Appetite Leading to More Block Trades

As the conditions in the equity markets have improved in 2013, the sell side has been engaging in riskier transactions.  In a Reuters article written by Anthony Hughes and Stephen Lacey, an increasing percentage of the Equity Capital Markets business has gone the route of the block trade.  This is a secondary or follow-on offering of a stock where the bank buys the shares and sells them to the buy side within the same or next day.  Another term for the trade is capital commitment.

The sources of stock in 2013 are private equity firms seeking exits from past leverage buyouts.  In the past, they would be early investors in or founders of a company seeking to diversify their investments.  Think Bill Gates and Microsoft.  Some large divestments in February of private equity deals include $1.8 billion for HCA (KKR and Bain Capital), $1.5 billion for LyondellBasel Industries (Apollo Group), $500 million for Sensata Technologies (Bain Capital), $321 million for Team Health Holdings (Blackstone) and $930 million for NXP Semiconductors (KKR).  Through February of 2013, follow-on offerings comprise of 40% of the entire capital markets business.  The share was 24.5% in 2012 and 18% in 2011.

Since the shares are owned by the bank, it is exposed to increased risk.  If the offering price was not above the buying price, the bank would suffer large losses.  Since the stock market has experienced rising returns, low volatility and investor optimism, there is an increased appetite for risk.  As one banker said in the article, "It is going to keep working until someone gets their face blown off."

Timber, a Natural Resource Alternative Asset

In the February 2013 issue of ai-CIO, there were two articles about timber, the natural resource investment. In Paula Vasan's article, she states that the returns of this asset type were 15% per year during the period from 1987 to 2010.  This statistic was sourced from the National Council of Real Estate Investment Fiduciaries.  The returns for the Standard & Poor's 500 were only 11.5% per year.  The future is also bright as Jeremy Grantham of GMO Capital predicted that timber prices will rise 6.5% annually for the next seven years.  In the current interest rate environment, those returns are stellar.

The second article, named Location, Sustainability, Growing Trees, was an interview with TIAA-CREF's timberland investing team:  Jose Minaya, Managing Director and Head of Global Natural Resources and Infrastructure Investments, and Sandy LaBaugh, Senior Director, Portfolio Manager - Global Timberland and GreenWood Resources' timberland team:  Clark Binkley, Ph.D., Managing Director and Chief Investment Officer and Jeff Nuss, President and Chief Executive Officer.  I have compiled a short summary of important points.

Institutional investing in timberland started in the late 1970's when companies in the forest products sector sold their land in order to concentrate on their core businesses.  Assets under management grew approximately 20% per year until 2005.  The growth rate has slowed as there are less assets for purchase.  The goals for investing were to earn good risk-adjusted returns with some cash flow, diversify into a non-correlated (with equities and fixed income) asset and have a hedge against inflation.  There are three ways to invest:  1.  the manager owns the land and hires timberland specialists to manage the timber, 2.  buy timber funds or assets or 3.  buy Real Estate Investment Trusts (REITs) that have timberland exposure.

TIAA-CREF investments into timber are split 75%/25% U.S./non-U.S. geographically.  They are currently looking at assets in Chile, Brazil, Uruguay, Europe and any supplier close to China.  The team likes the fact that there is a finite supply of timber and the corresponding effect on prices.

Greenwood Resources is a forest manager that works with institutional investors to maximize their returns on timberland.  They are seeing more investment in international timber and greenfield plantations.  The latter is when they plant trees for harvesting.  They are not harvesting old forest growth which is fraught with social and political risks.

Housing Recovery Makes Mortgage Bonds Attractive Investments

At the beginning of the year, there was a consensus among sell side analysts, mutual fund managers and hedge fund managers that mortgage bonds that were not tied to Fannie Mae and Freddie Mac (non-agency) were the most attractive fixed income investment for 2013.  Non-agency bonds backed by subprime mortgages of the pre-2007 vintage jumped 41% last year.  High yield bonds gained 16% and agency debt gained 2.6% for the same period.  These returns were sourced from bond indices run by Barclays and Bank of America Merrill Lynch.

Major hedge funds investing or invested in these securities are Goldman Sachs Group, D.E. Shaw, Angelo Gordon, Hayman Capital and Elliott Management.  Elliott Management only sold their bonds because their yields had fallen too low.  The giants of fixed income mutual funds:  PIMCO, TCW and DoubleLine believe prices will continue to run up even though more and more investors are buying the asset class.  Projected returns for non-agency mortgage bonds are 8%.  Compare that to high yield projections (7%) and investment grade projections (3%).

The source for this article can be accessed here.

Most Popular Hedge Fund Strategy is Relative Value

Assets under management for hedge funds using the relative value strategy have surpassed the equity long/short strategy for the first time in the fourth quarter of 2012.  As of September 30, both strategies had a market share of 26.7% of the $2.192 trillion hedge fund industry.  The next most popular strategies were event driven at 24.5% and macro at 22.1%.  To give you a sense of where equity long/short was coming from, it was 56.3% of all assets under management for hedge funds in 2000.  Several factors accounted for the shift:

• Investors reducing their exposure to equities to diversify and reduce their portfolios' volatility
• Investors investing directly into hedge funds and away from fund of hedge funds, which are heavily weighted towards equity strategies
• Underperformance of equity long/short strategy over the past five years

Year	HFRI Equity Index	HFRI Relative Value Index
2008	(26.65)%	(18.04)%
2009	24.57%	25.81%
2010	10.45%	11.43%
2011	(8.38)%	0.15%
2012	7.39%	10.04%

Funds that have experienced significant inflows include BlueMountain Capital Management, Pine River Capital Management, Marathon Asset Management, MKP Capital Management and Brigade Capital Management.

However, for 2013, several investors are reviewing the value proposition of equity long/short funds.  Fixed income returns are projected to be low and stockpickers will be in vogue again as macroeconomic moves such as Quantitative Easing 3 fade.

The source for this article can be accessed here.