UBS Charity Compendium 2012

About us UBS Wealth Management
UBS Wealth Management, a business division of UBS AG, is one of the worlds leading financial services firms with a diverse client base. We have a presence in all the worlds major financial centres and, in the UK, have offices in London, Birmingham, Edinburgh, Leeds, Manchester and Newcastle. In the UK we offer bespoke discretionary and advisory portfolio management and have built-up a reputation as one of the UKs leading wealth managers with assets in excess of 25 billion under management. UBS Wealth Management provides investment services to over 300 charities. We have a varied client base ranging from large national charities and foundations to smaller individual trusts. We have built this leading presence in the charity sector through the breadth of our investment capability and the high quality of the advice we offer to our clients.
UBS 2012. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. November 2012. Crown copyright material (sourced as National Statistics) is reproduced under the terms of the Open Government Licence from HMSO/National Archives. While every care has been taken in the compilation of the data in this book, neither UBS AG, London Branch, UBS Global Asset Management (UK) Ltd nor any of the other data sources quoted will be liable for any consequences arising from the inclusion of inaccurate data. Some historic data may no longer be available from the original sources but is reproduced from earlier editions of UBS Global Asset Management (UK) Ltds Pension Fund Indicators.
Contents
1 2012 review 2 Social Bonds - Key Issues 3 Socially responsible investing 4 Charities & borrowing 5 Equities Introduction Equity characteristics What is an equity? Uncertain long-term returns Volatility Diversification Sensitivity to interest rates and inflation Equity valuation Equity markets The global equity market Emerging market equities Equity management Approaches Active management Style Value Growth Momentum Small company equity Unconstrained equity investment Active quantitative techniques Passive equity 6 Bonds What is a bond? Who issues bonds? Credit risk and the growing importance of non-government bonds The global bond market Some important bond terminology Emerging market bonds 7 11 15 26 32
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UBS Charity Compendium 2012
7 Real Estate What is real estate? Gaining exposure to real estate Real estate derivatives Key benefits and challenges of investing in real estate Global real estate investment The UK and European real estate markets Market performance Differences in market practices Commercial real estate sectors The US real estate market Market performance Commercial real estate sectors The Asia Pacific real estate market Market performance Within-region diversification benefits Growth of Asia Pacific real estate markets 8 Alternative sources of return What are suitable alternative investments? Hedge funds Hedge fund strategies Performance Private equity Private equity as an asset class Private equity investment characteristics Increasing investor interest The private equity industry in 2011 The private equity market in 2012 Infrastructure A defensive component in portfolios can enhance long-term overall returns Defining infrastructure assets Infrastructure as an asset class How does infrastructure compare with other asset classes? Risks Investing in infrastructure Key attributes of best-in-class infrastructure managers Key issues in 2012 and beyond Global tactical asset allocation Currency How does currency affect returns? Equilibrium risk and return Currency effects in non-equilibrium conditions The case for dynamic management Separation of currency investment decision Gold Commodities Art
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Appendices
A - Risk measurement B - Derivatives C - Performance measurement 97 104 109
Foreword
Whilst some normality has returned to markets, the consequences of the events of 2008 & 2009 and their underlying causes continue to dominate markets. Sovereign, corporate and personal debt levels, particularly in Europe, are having an impact both on economic growth and market sentiment and are likely to continue to do so for some time. At the same time, banks face strong pressures to improve their balance sheets and as well as enforcing strict ethical and risk cultures. Arguably, the latter is long over due. However, one consequence of this process is likely to be less lending and lower market volumes. The size of the debt problem also means it will take some time to resolve and there are likely to be a number of stress points as the process of resolving the current issues slowly grinds its way through. Therefore, economic growth in high debt economies will be anaemic and volatility in markets is likely to be higher than normal as sentiment reacts to changing political realities. Against this background charities have experienced higher volatility in their income and investment returns at a time when debt levels have resulted in a sustained reduction in state support within the sector. Moreover, the UK governments flirtation with changing the tax rules, around substantial donations, has increased uncertainty and made planning more difficult. The importance of a robust reserves policy in these circumstances cannot be over emphasised. Trustee investment policies need to focus on achieving the Trustees requirements within a reasonable risk framework. The key to this is ensuring Trustees have a clear understanding of the expected volatility in their portfolios and the investments they hold. The UBS Charity Compendium is an objective way for Trustees and investment committees to gain a broader practical understanding of the asset classes and techniques for running investments. In current conditions it is vital for charities that they understand and manage the risks of investment and ensure they clearly understand the range of strategies available. All investment mangers skills will need to encompass all the options available to navigate through what looks like a difficult decade for investment. We hope the Compendium provides you with some valuable facts and informative insights to enable you to navigate difficult economic conditions and a helpful resource to draw up in thinking and formulating your charities investment strategy and attitude to risk. Andrew Wauchope Head of Charities UBS Wealth Management November 2012
2012 review
1. 2012 review
Review of 2012 Jane Tully - Head of Policy and Public Affairs, Charity Finance Group
2012 has proved to be another turbulent year for charities. With the economy tipping back into recession, tales of charities facing a perfect storm and double or triple whammy of reduced income, at the same time as increased demand for their services and rising costs, are commonplace. The findings from many of this years charity surveys confirm this; our own research, Managing in a New Normal, showed a net reduction in all income streams and a clear, if somewhat depressing, expectation that this trend will continue. However, it appears that not all parts of the sector are affected as badly, or in the same way. And quite positively, many do appear to be seeking out new opportunities and adapting to the new normal. While supporting beneficiaries is a charitys foremost concern, it is rare that attention is not also focused on sustaining and stabilizing their income streams. This year, thats more pronounced than ever. Those charities reliant on public funding appear to be particularly badly affected financially, most notably organisations that work on homelessness, training and health, who find themselves victims of government cuts and the gradual withdrawal of state funding. In an increasingly competitive marketplace, some are better placed than others to adapt to new models of commissioning that involve sub-contracting, spot purchasing or personal budgets, often depending on how well capitalized they are. While no doubt there will be those that thrive in this new world, along the way there are bound to be some casualties. The general fundraising environment has got tougher too, despite evidence that charitable giving in the UK remains strong. Key fundraising concerns include more competition among charities, the impact of the wider economic climate on donors inclination to give over the longer term and the impact of donors having less disposable income. Attrition rates for fundraising are not as strong as they used to be worrying if this is a trend that continues. In response 66% of charities plan to increase their current fundraising activity returns on investment in fundraising are consistently high. Fundraisers are also exploring new fundraising options, opportunities for collaboration and general efficiencies. The potential of new technologies, particularly mobile, is one area thats generating interest and looks set to take off - no doubt many charities will latch on to this trend , however the investment requirements may be substantial. Grant funding, the bread and butter of many small charities, appears to be in decline too, however, at the same time the expected flood of applications to charities continues to be unfounded. Asset maximisation is a strategy employed by many. Investment returns have been variable this past year and the trend for actively reviewing investments continues. Later on in this guide, Yogita Rajani discusses how Trustees can maximise the financial returns from investment portfolios by interacting with their investment managers more effectively. Charities are also tightening their own belts and reviewing labour, fixed costs and contemplating structural changes. To say the sector is going through a considerable upheaval is not an exaggeration - barely a day goes by without the announcement of yet another merger between charities or indications in that direction. Our research showed that one in five charities are considering mergers now, double the number looking at it in 2011. Outsourcing too is an increasingly popular choice for many. Following a decade or so of relatively easy growth and abundant funding, some might argue that what were now experiencing is a great rationalization or shake-out where only the strongest will survive. The optimists declare this a natural evolution; the pessimists say its a gradual decline. How the face of the sector will look in 20 years time remains to be seen. In terms of policy developments, 2012 has held some nasty surprises. Who could have predicted the shock announcement hidden in this years budget, where the government sought to cap tax reliefs on charitable donations for the wealthy, reducing the incentive for people to give vital income to the sector at a time it needs it most. The fiasco that followed, before the government wisely announced a u-turn had put charities and charitable giving in the headlines for many of the wrong reasons. Questions about what qualifies for charitable status were more at home in Lord Hodgsons review of the 2006 Charities Act. While these were given considered treatment and the review was broadly a vote of confidence in our regulatory system for charities, Lord Hodgson had a couple of controversial recommendations around the payment of Trustees and charging for registration. How these will be taken forward will is a decision for government and with resources tight across central government and umbrella bodies, prioritization will be key. Radical and progressive proposals around social finance have also gained ground and will no doubt move the social investment market forward. With the launch of Big Society Capital in early 2012, expectations as to what it can deliver for charities are high and need to be carefully managed. Under proposals 600m will be available for investment in the next few years. For some, this will provide vital new sources of capital, allowing them to scale up, expand their services and, where relevant, compete in tough public service contracting markets. But, while this is a hugely exciting area for some, its not for everyone and there are considerable risks for individual charities and the sector as a whole if a mass trend towards gearing goes wrong. Finally, 2012 was also a significant year for us at Charity Finance Group. Now with 25 years of supporting finance directors under our belt, it has been fascinating to reflect on how far funding, financing and financial skills and services, in and to the sector, have come. While the spirit of the sector and the publics trust in it remains largely undiminished, its reach and professionalism have grown exponentially, and that can only be a good thing! 8
Helping your Investment Manager achieve your Investment Objectives Yogita Rajani
Introduction This article will examine how Trustees should be engaging with their Investment Manager to maximise financial returns from their charitys investments within acceptable risk parameters and in harmony with their charitys aims. A number of factors have been identified by industry practitioners and within academic literature as to what is considered best practice when devising, reviewing and implementing an investment policy statement and the level and quality of interaction required between the Trustee board and their Investment Manager. These factors include but are not limited to trust and open communication; the significance of the investment portfolio to the charitys overall finances, the size of the charity, relevant investment experience and skills either on the board and/or via the employment of external consultants and realistic and reasonable expectations of what is achievable. Before exploring how Trustees should be engaging with their Investment Manager it is useful to outline the background and framework around charity investments. Background and Framework around Charity Investment Management The charity sector is very diverse and complex. The Charity Commission website confirms that there are approximately 180,000 registered charities in England and Wales with over 84bn of investment assets in 2011. Significant investment assets are however held by relatively few charities and 47bn of assets are held by just 100 charities, in other words 55% of assets are held by 0.05% of charities (Pharoah, C and Pincher, M; 2011). The top 100 charities by investment assets held are mainly trusts and foundations giving grants and operating programmes across a diverse range of charitable activities including social welfare, medical research, education, and international aid agencies, housing associations that have charitable status, arts organisations and environmental organisations. Charity Trustees are the people who serve on the governing body of a charity. They may be known as Trustees, directors, board members, governors or committee members. Trustees have, and must accept, ultimate responsibility for directing the affairs of a charity, and ensuring that it is solvent, well-run, and meeting the needs for which it has been set up. The great majority of Trustees serve as volunteers and receive no payment for their work. In 2009/10 there were 834,000 Trustee board positions within voluntary organisations in the UK. NCVO Almanac 2012 CC14 is a guide published by the Charity Commission for Trustees about investing charity funds within their duties and how to manage associated risks. The guide states that if there is sufficient expertise on the board then investments can be managed in house however there is a duty to seek advice if there is no relevant experience or there is limited experience and/or lack of time and resources on the board. CC14 strongly recommends that Trustees draw up an investment policy and if investments are being managed by Investment Managers on a discretionary basis then this policy is a legal requirement. The Investment Policy Statement A written investment policy is a crucial document for charities however many are inadequate and it often appears that only investment managers are responsible for writing them. The Investment Managers should be consulted but investment policies are the sole responsibility of the Trustees (Palmer, P; 2008). There is a need to devise a very clear unambiguous investment policy, a good adviser can help clarify the charitys goals but they should be prepared to spend time upfront to do that. It is essential for Trustees to establish their objectives from the outset, evaluating how it fits into the wider financial and investment priorities of the charity. The Trustees and Investment Manager must be clear on what the risk and return objectives are but they must also be realistic and achievable in the current economic environment. These goals need to be periodically reviewed and redefined if circumstances change. The investment policy statement should include detail regarding investment objectives and strategy for achieving these objectives, risks associated with the strategies, liquidity needs and asset allocation approach. Best practise would be for Trustees to provide a clear statement of investment beliefs and provide specific measureable investment objectives. A suitable benchmark aligned to the charitys strategic asset allocation is important against which the portfolio can be measured. It is also useful to clarify the maximum and minimum percentages that the Investment Manager can deviate from the benchmark tactical asset allocation. There should be information about performance for varying time periods although if the charity has a long term horizon then being overly concerned by performance every quarter may not be very informative. In UBS view a minimum of three years and ideally five years should be the time horizon to properly judge an Investment Manager. If there is a much higher income target than the portfolio can generate and a particularly restrictive ethical policy this should also be taken into account. Use of Investment Committees Some charitys find it helpful to set up a separate investment committee including a smaller group of Trustees with relevant experience. Investment committees vary in size and behaviour larger groups can be more diverse although more likely to
1. 2012 review
lose focus, smaller groups can be more engaged but they may lack expertise. Best practice outlined in the Journal of Portfolio Management by Ellis, C (2011) suggest an ideal size of 5-9 members; large enough to have diverse experience, small enough so everyone gets heard and understood. Investment Managers sometimes experience high turnover of staff and this can be unsettling, it is important for Trustee boards and those responsible for monitoring investments to develop long term working relations with their Investment Manager. Ellis, C; 2011 argued that the tenure on best practice committees should on average be 6-7 years. He explains that it is not wise to rotate committee members too quickly, some turnover is good and helps keep discussions fresh but if it is done too quickly the group will lose the stabilising benefits of institutional memory. Ethical Investment Policy A large number of UBS charity clients have an ethical investment policy. An ethical policy can help to align your investments with your mission and to avoid potential risks to reputation and potentially alienating donors and supporters. An ethical policy can range from negative screening excluding those companies that you do not like or positive screening seeking out companies that align with your mission. Social investing and programme related investments are also permissible under CC14 guidance. It is however also important to be realistic and objective and to ensure that Trustees personal ethical values are not blurred with those of the charity. Over-reliance on Investment Consultants It is important that Trustees do not become dependent on an investment consultant for monitoring and managing their Investment Managers. The investment consultant should interact with the Investment Manager prior to meetings to discuss the portfolio and background, meetings can be unproductive when the Investment Manager has to provide background to decisions made historically which can dominate the agenda during an already time pressurised meeting. If Trustees employ a consultant they need to ensure their contribution is beneficial and empowers rather than emasculates the knowledge and authority of the Trustees themselves. Investment consultant performance should also be reviewed. Conclusion Charity Trustees all too often seem to rely on infrequent and already time pressurised meetings to discuss investments and not all if any will want to stay informed in-between meetings. In order to ensure meetings are more productive, Trustees should make time to discuss investments. They should set an agenda, read material sent to them between meetings, plan what they want to discuss and agree with co- Trustees their objectives before-hand so its clear what they want to achieve from the meeting. Trustees should help their Investment Manager better understand the charitys position and regular conversations should take place to ensure that the portfolio continues to be managed in line with expectations and to give Trustees the opportunity to adjust their mandate if there are any changes to the overall objectives. Trustees need ensure they have a complete understanding of the on-going needs of the beneficiaries to whom they owe their duty of care. If the Trustee does not understand what the current and future needs of the charity are then it is extremely difficult to translate these to the Investment Manager. Disappointment and discord will be the inevitable consequences if all stakeholders in the process do not have a shared vision of what the end result is supposed to be (Masterton, K; 2012). Regardless of the size of the charity and the experience of the Trustees, the ability of the Chair is also critical. Not all members are able to attend all meetings and the Chair should ensure minutes are taken and distributed to members. It is also important that the Chair does not allow members to dominate. A Trustee must be actively involved in on-going management and interaction with the Investment Manager as they must manage and monitor the investment relationship and not just wait to receive reports or receive reports and do nothing with them. How UBS can help devise an Investment Policy for our charity clients We appreciate that Trustees are under enormous pressure and often have limited time and resources. UBS employ the services of Professor Paul Palmer and he can spend a day (including a few days prior for preparation) with Trustees, senior staff including the Chief Executive to help create an appropriate investment policy that is consistent with the risk and reserves policy. Using the example of one of our clients recently; the day involved breakouts and open debate covering appropriate social responsibility criteria and stakeholders concerns. The need to hold an appropriate level of reserves was correlated to the risks identified, including issues of funding sources and both contractual and moral spending commitments. Once the policy was agreed, UBS was able to suggest an appropriate strategic asset allocation. The charity now has a transparent and grounded investment policy in place.
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Social Bonds Key Issues
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2. Social Bonds - Key Issues
Social Bonds New Dawn or False Promise? Key Issues for Investors. Professor Paul Palmer
The five principle sources of charity funding have been: 1. Donations from the Public 2. Donations from Corporate 3. Investment Income 4. Trading 5. Government. Traditionally Government funding was in the form of grants, but by 2006, service contract income surpassed the longestablished methods of state giving to charities. Contracts were awarded on running services that had either been previously provided by Government or where new issues had arisen and the voluntary sector was encouraged to provide. By 2010, Government funding from either service contracts or grants had almost reached the same level as donations from the public. However, over the last two years as Government austerity measures have been introduced, this source of income has declined. For a variety of reasons, from whether you take the view that social investment is a cover for Government cuts, or the Governments perspective that charities have been held back by a hand to mouth funding environment and so this is now an opportunity to open up new affordable long term finance. Social investment is the new high profile game in town and charities whether as seekers or investors need to understand what this new form of finance is and whether it is for them. In early 2012, a UBS charity client - The Bank Workers Charity (previously the Bankers Benevolent Fund), went on such a journey. Supported by UBS and myself at the Cass Business School we held a series of round tables with various stakeholders from potential investees; intermediaries and investors exploring key issues. With the kind permission of the Bank Workers Charity (BWC), we share their findings and observations with you. What is Social Investment? Social investment seeks a social return in addition to or instead of a financial return. Investors may accept a lower financial rate of return, or a higher level of financial risk, where they can see clearly defined social benefits from their investment. For example, an arts organisation which needs capital to redevelop its premises might be seen as a bad risk by a mainstream lender, and might not be able to offer a rate of return to investors that is competitive with the wider market. But investors who value the social returns, which will be enabled by the redevelopment project, may be willing to reduce their expected financial return to enable the venture to move forward. Even if the risk is higher than the investor would otherwise take, it remains different from a donation where there is no prospect of seeing a return, so the arts organisation in the example should find it easier to raise the necessary capital for its project compared to traditional fund-raising. Scope provides an example of a high-profile recent social investment. It announced in October 2011 that it would issue a 20 million social investment bond. The charity plans to use this funding to expand its fund-raising programmes and its network of charity shops which generate funds for its core activity of working with disabled people. The interest rate will be lower than on a regular commercial bond, but the product offers investors the opportunity to choose a social return. Social investments can be made in individual organisations, or bonds can be offered by intermediaries which package up a portfolio of investments in different organisations, reducing risk by diversification. The funding may come from individual or corporate investors, but also from charities such as BWC the latest CC14 guidance makes it clear that charitable Trustees are permitted to invest part of a charitys funds in programme-related investments (PRI), i.e. investments which contribute to the charitys aims, even if this does not maximise return. Currently about 80% of social investment is asset-backed, rather than in more risky areas, but in ten years it is likely that there will be a range of funds available, at different levels of risk. More rapid change might come if a social enterprise grows quickly and becomes recognised as a success. Round table outcomes The people who attended the round table sessions were enthusiastic and knowledgeable about their industry, and committed to its success. Collectively, they had a great deal of experience as investees, intermediaries and investors. Many were interested in taking advantage of the new CC14 charity regulations, they also hoped that more precedents would soon be established that they could then follow, and that others would resolve the apparent practical difficulties.
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While some charities hoped to raise social investment directly from retail investors in the future, there was general agreement that it was preferable for trusts and foundations to take a lead in the next few years. For now, social investment is unlikely to be attractive to ordinary retail investors, due to the illiquidity and long-term nature of the investment, as well as the uncertainty of repayment. All categories of investor will be more likely to take part in social investment as more examples of successful repayment emerge, and as investees improve the ways they demonstrate evidence of their social impact. Existing social investments mentioned at the round tables largely fell into two categories: -- Asset-backed investments: An example was the Scope bond, backed by the property assets of the shops which the charity could use to raise additional funds. -- Payment by results: An example was the Peterborough initiative to help rehabilitate prisoners. This bond raised capital to establish a business which would receive payments from the Government for its results in stopping prisoners reoffending. Although attendees mentioned fewer current examples, the payment by results approach can also be applied to commercial agreements with private companies, not just with Government. For example, an employer may make a commercial agreement with a charity to provide support to its employees. Any social investment raises several challenges for the organisations involved: It would be necessary for any investee to develop a clear vision, business plan and financial model. Documents would have to be prepared, with specialist legal and financial support needed on all sides. Investees would have to make presentations to potential investors, including convincing details on the financial return element. To save costs, there is a strong case for investors co-operating with each other, which would require strengthening of existing relationships. To improve the likelihood of success, there is a case for larger investors and investees working in some form of partnership, rather than at arms length. Key risks of social investment Most organisations are new to social investment, and there is not yet a shared language of terms for discussions or legal documents. Starting a social investment project from scratch is as challenging as creating a start-up business. Even if a pilot project succeeds, scaling it up may fail. Many charities are worried that if a social investment opportunity is offered, existing donors might switch to become investors. In many charities, major culture change will be needed among staff and Trustees. Different skills are needed compared to current fund-raising. Smaller organisations are less likely to have the skills and experience to take advantage of the opportunities. Investors may find that the promised social impacts do not materialise. Investors will probably take time to develop due diligence skills in this area. Investees would prefer to see more examples of successful repayment along with positive social impact before entering the market themselves, and investors would prefer to see more examples of how to mitigate the new combination of risks in this area. Key benefits of social investment Moving from grants to investments gives the opportunity to scale up fast, by drawing on new sources of finance. Social investment can enable new types of project, including preventative work, that have been relatively neglected in the past. There is the potential for social investment to bring improvements in charity governance. Social investment encourages increased rigour in measuring a projects impact. Even activities without a clear income stream can benefit if the overall funding available to charities increases. Many organisations see social investment as a vital alternative to previous dependence on Government funding that is now being removed or reduced.
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2. Social Bonds - Key Issues
Key recommendations The following points were raised as the main actions that those organisations that want to participate in this new market should follow: Key players should work together to develop the social investment market. This requires a focus on areas where investor funding can be pooled for maximum impact. Trustees of both investors and investees need to be given evidence of the positive potential from taking part in social investment. Investees should actively explore how they can extend their capabilities in ways that will meet investors social and financial requirements. Investors should publish information on the types of social investment that they would be willing to make, so that investees can discover more easily what funding is available. As much as possible, standard social investment instruments should be developed, along with standard language around social investment. As much as possible, investees should use standard ways of measuring social impact. Case studies of successful social investment should be shared, to encourage participation by trusts and foundations, benevolent funds, philanthropists and charity investors.
Further Information The full report of the Bank Workers Charity research is available on their website. - info@bwcharity.org.uk An excellent report looking at investors perspectives was produced by ClearlySo for the City of London and City Bridge Trust www.cityoflondon.gov.uk/economicresearch Growing the Social Investment Market: Progress update was published by the Government in July 2012. www.cabinetoffice. gov.uk/sites/default/files/resources/growingthesocialinvestment marketprogressupdate1.pd Details about the SCOPE bond and other social investment opportunities can be found at www.investingforgood.co.uk Professor Paul Palmer is an Associate Dean at the Cass Business School, London and Director of the Centre for Charity Effectiveness. Since 2002 he has also been UBS Independent Consultant on Charities and assists clients with a variety of issues.
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Socially responsible investing
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3. Socially responsible investing
Socially responsible investing for charities Harry Pope

Introduction Climate change, water scarcity, urbanization, poor nutrition, pollution, disease and access to education are just some of the challenges the Third Sector aims to address. Whilst charities direct their operations towards solving these problems they can also make their financial investments work to achieve similar goals. Charities have a duty to manage their endowments for the best possible return, the exception being ethical investment clarified in the Bishop of Oxford case where it was determined that investments which compromised the mission of the charity could be excluded. Traditionally ethical investment has been seen as screening out inappropriate stocks. More recently there has been a trend towards pro-active strategies where investors instead look for investments which actually complement the aims of the charity. Recent guidance by the Charity Commission in the revised CC14, a guide for Trustees on charities and investment matters, has provided clarity on this issue. How then can charities ensure that their financial investment practices reflect their missions? Wise and careful investment decisions can help to build and develop companies whose impact is socially or environmentally positive and in some cases further the progress in solving the issue the charity is operationally involved in. This provides donors with the reassurance that their money is being put to good use and that their chosen charity invests its original endowment or surplus in line with its mission without compromising on returns. This investment philosophy is known as Socially Responsible Investing (SRI). Background to the SRI market Today, total invested assets in SRI and impact investments represent a low double-digit value of the total invested assets of major providers in the investment industry. SRI, which began in the 1980s, is today a growing industry with USD 7 trillion under management globally1. A survey carried out by the Charity Finance Group (CFG) and Ethical Investment Research and Information Service (EIRIS) in March 2009 examines the drivers for socially responsible investment. Question: What are the main drivers for adopting and retaining an ethical investment policy? (5 = important and 1 = not at all important)
Source: CFG/EIRIS Foundation Survey (March, 2009)
1 Monitor Institute (2009); JP Morgan (2010)
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The main driver shown by the graph above is avoiding conflicts with the charitys aims and activities where 73% of those surveyed saw this as a very important consideration. 62% of those surveyed responded that Reputational risk was very important. The survey also highlights that the influence within the organisation came from Trustees 75% with Finance Directors being rated second 45%2. Based on research carried out by Just Pensions and the Charities Aid Foundation, it was revealed that in 2003 nearly two thirds of the UKs largest charities had no ethical policy3. By 2009, the CFG/EIRIS survey indicated that the ethical investment market had grown and that 60% of larger charities had an ethical policy. Furthermore the study shows that 70% of fundraising charities have an ethical policy compared to 59% of grant-makers. The survey showed that 32% of service charities had an ethical policy4. Negative & Positive screening trends Traditional SRI strategies apply negative screens to a portfolio to remove companies with poor environmental or social track records. Early examples include provisions in the 18th and 19th century which sometimes prevented banks from offering financing to slave holders. Increasingly charities are using this exclusion method to rid portfolios of investments that do not align with personal values, for example, excluding investment in tobacco or the arms industry. SRI can also take on a more proactive approach to negative screening. This means that charities actively look for sustainable opportunities such as those companies that have developed the strongest strategies to deal with environmental and social challenges in their industries. Investors can also choose to focus on a particular theme such as renewable energy or water. Whether a charity invests by negatively screening out investments or by positively engaging with companies will be influenced by their ethical policy as well as by practical considerations. For example fundraisers with limited resources may find that the use of a negative screen to be more practically suited given their financial circumstances. Conversely, large grant giving charities have more of an opportunity to engage positively with companies and themes through the use of their investment portfolio. In the aforementioned CFG and EIRIS survey it was shown that 88% use negative screening methods whereas only 25% use positive screening as an alternative to, or alongside a negative screen. The study went on to show that most commonly those engaging positively did so through their Investment Manager. Charities developing an SRI policy in recent years have sought more and more to engage positively when investing ethically. David Locke, Finance Director at BMS World Mission said that, until recently our statement of investment principles was one of the briefest you could find. It was entirely negative in character, consisting simply of a list of things we didnt invest in. Since then we have developed a more positive stance. How should charities approach SRI? With charities increasingly looking to develop an ethical policy, where should Trustees turn to for advice and what is the process for implementation? EIRIS, the CFG and NCVO have all released guides on the ways to develop and implement such a policy. The NCVO guide on implementing a Socially Responsible Investment Policy highlights a 5 step process which is summarised below: Step One: Review and fact find. Current investments should be reviewed, the governing document should be consulted to see whether this includes any restrictions and the charitys legal position should be taken in to account. Step Two: Set aims Trustees should address their motives for considering implementing an ethical policy. Step Three: Agree policy This should result in a final written policy which lays out the charities aims and restrictions. The process for completing a policy should involve consulting with beneficiaries or stakeholders, referring to the CFG and NCVO guides for support, looking at the experiences of other charities and consulting your Investment Manager for guidance. Some Investment Managers will be able to offer assistance in developing a policy that is relevant in the current market environment.
2 CFG and EIRIS Ethical Investment Survey (March, 2009) 3 Green, D., Do UK Charities Invest Responsibly? A survey of current practice, (Just Pensions, CAF and EIRIS, 2003). 4 CFG and EIRIS Ethical Investment Survey (March, 2009)
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Step Four: Implement policy Trustees should ensure that the policy is adhered to and the aims set in the policy are achieved. The Charity Commission advises that Trustees are unlikely to be criticised for adopting a particular policy if they have considered the correct issues, taken appropriate advice and reached a rational result This should involve consulting with Investment Managers to establish whether they have the practical capabilities to deliver on the charities aims. Step Five: Review and report A review process should be established whereby Trustees decide on whether performance aims have been achieved, whether ethical aims have been met and ensuring that the Statement of Recommended Practice (SORP) requirements have been met for accounting and reporting. The SORP 2005 requires that Trustees report on the extent to which social, environmental or ethical considerations are taken into account within the investment policy5. How the Investment Managers approach SRI SRI investments can be made in a number of ways including funds and listed equity stocks. Impact Investing, regarded as one area of SRI (discussed in more detail by Professor Paul Palmer in his article in this compendium), has historically used asset classes such as Private Equity and Bonds to facilitate investment. Whilst these methods offer charities an effective way to engage directly with their mission, high costs and the difficulties in measuring returns remain obstacles. At present the methods available for ethical investment are as follows: An SRI Fund A negatively screened customised portfolio A positively and negatively screened customised portfolio SRI Funds tend to have the following characteristics: Higher expenses due to the screening process involved They are smaller than ordinary funds, putting upward pressure on fees The investment policy is pre-determined by the fund and charities must choose the fund that suits their policy best Performance - discussed later in the report However, a customised screened portfolio will offer charities the following: Flexibility around implementing an ethical policy Managers will not typically charge additional fees for a customised portfolio An opportunity for charities to engage with companies positively In the Screening process how are companies actually evaluated and how can charities be sure that the companies they invest in are implementing good practice? Many companies are evaluated using environmental, social and governance (ESG) factors. These are non financial performance indicators that include sustainable, ethical and corporate governance issues such as energy efficiency, corruption levels, or green house gas emissions. At UBS, companies selected undergo a multi-stage examination which is monitored by an SRI team over a number of years. At the outset, third party agencies such as Oekom and Inrate are used to produce an ESG rating. Companies may score poorly due to elevated risks as a result of controversial activities or they may score well due to strong environmental or social business opportunities. A selection process then takes place where any specific exclusion criteria are applied and companies with leading ESG scores are selected. These are aggregated into a database of companies and bond issuers, providing the basis for a stock and bond universe, which is used by financial analysts and portfolio management specialists for the development of SRI portfolios.
5 Para 55d SORP 2005, www.charity commission.gov.uk
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The performance debate and other considerations One of the common concerns regarding SRI is that the implementation of an ethical policy could result in lower returns. Since the 1980s there have been numerous empirical studies attempting to show that ethical funds have performed better or worse than conventional funds. However, these claims often say more about the particular political philosophy of the author, as depending on the particular measurement period chosen, the figures can be constructed to their advantage. As Paul Palmer observed Responsible advocates of ethical funds generally conclude to a neutral perspective on the relative performance of ethical against general funds.6 What the future holds Looking beyond the performance debate, the major advantages of SRI have been shown to be that it helps charities address reputational risks, SRI investments can be used to further the work of a charity through engaging positively or through impact investing and that SRI can address concerns around alienating supporters, donors and staff. However, before implementing a policy, charities must take practical considerations into account and consult the experts as the process can be time consuming and expensive. SRI can provide the interface between charities who expect their assets to generate a sustainable return and the companies and investments that achieve strong financial and social performance. SRI is fast becoming an accepted and integral investment approach, which has prompted more companies to embrace sustainable business practices. The total of SRI assets under management in the UK at end December 2009 was 938.9 billion7. Both socially responsible investing and impact investing will continue to grow as the business of doing good becomes both more institutionalised and values-based. Moreover, greater scrutiny of corporate governance continues to widen the scope of socially responsible investing and provide additional criteria for evaluating corporations. What had once been viewed as a niche market or satellite strategy will become increasingly mainstream as charities seek more than just financial returns.
6 Palmer, P et all (2005). Socially Responsible Investment: A Guide for Pension Schemes and Charities - Keyhaven publications 7 Eurosif European SRI Study 201
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SME Impact Investing in Frontier Markets: A Novel Value Proposition for Private Investors Andreas Ernst - Head of Impact Investing.
A new industry in the making In 2003 Ngo, the owner of a successful medium-sized wire factory in Vietnam was looking for capital in order to enlarge his operations. At the time, the company was already generating close to $10m/year in revenue but had no chief accountant and most of the accounting was done by hand. The company had poor quality control, high waste and significant defects yet was still cash flow positive and highly successful with growing demand. However, Ngo was not able to find financing to expand his business because banks and private equity companies were not providing capital to small and medium enterprises (SMEs). He was able to find a private investor who took a 20 percent stake for USD 1.8mn who took an active role in the management of the company. The investor worked with Ngo to restructure the accounting department, firstly hiring a finance manager, and secondly introducing Activity Base Costing1 giving the company a better understanding of its cost structure allowing it to improve its pricing and win new clients. The investor then introduced the company to Six Sigma Quality Management 2 to reduce defects in the manufacturing process which resulted in energy and water consumption decreases of more than 70 percent. International best practice labour and environmental standards were introduced and the Kaizen process3 was implemented which resulted in improvements throughout the factory. Since the time of the investment the factory has doubled the number of employees; many of which are unskilled workers from low-income communities who now receive vocational training. Ngo has also been able to invest in the education of the children of his employees, and provides a small health care centre for all his staff. The company is now one of the largest producers of wire in the region and was successfully listed on the Ho Chi Minh Stock Exchange. The investor was an institutional investor from a development finance institution (DFI) that invests with development mandated government money into SMEs in developing countries. The underlying investment thesis is that business is a highly efficient way to propel social change. Many DFIs have been doing this successfully for the past 15-25 years. These DFIs have gone through the learning curve and making market-rate or market-beating returns whilst always making sure that companies not only are profitable at the time of investment but commit themselves to improve the value chain and make their products and services available to low-income communities. Foundations and private investors have also begun to embrace this investment style, pursuing social and financial objectives and have dubbed it impact investing or mission related investing. Foundations in quest for impact also on the finance side In the foundation world, doing good and doing well at the same time is often referred to as blended value or mission investing investing (a part of) the endowment to achieve both financial and social returns. Conceptually, this is straightforward. If charitable foundations look holistically at expenditure and investment policies as complementary ways to further their mission, they can generate greater social impact. In addition to distributing 25 percent of assets every year, a foundation could also invest some part of the other 9598 percent of its assets in investments furthering its mission, provided it can do so without sacrificing the financial returns on endowment assets. After an article in the Los Angeles times in 20074 in which the Bill and Melinda Gates Foundation was criticized for their adverse effects on their investment side that were contrary to their philanthropic work, the foundation decided to align their investments to their expenditure side and set up a compartment of USD 500mn to only invest in impact investing opportunities. Another example is the Esme Fairbairne foundation one of the largest charitable foundations in the UK which runs a 21mn million impact fund created in 2008. Among its 48 investments are social enterprises active globally in the area of microlending, private equity, alternative energy and conservation. In the US and the UK the legislators have introduced new legal vehicles that allow for more tax efficient treatment of investments (and returns) if they qualify as Project Related Investments (PRIs) or Mixed Purpose Investments.
1 Activity-based costing (ABC) is a special costing model that identifies activities in an organization and assigns the cost of each activity with resources to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing models 1 Six Sigma seeks to improve the quality of process outputs by identifying and removing the causes of defects (errors) and minimizing variability in manufacturing and business processes. 3 Kaizen is a daily process, the purpose of which goes beyond simple productivity improvement. It is also a process that, when done correctly, humanizes the workplace, eliminates overly hard work, and teaches people how to perform experiments on their work using the scientific method and how to learn to spot and eliminate waste in business processes 4 http://www.latimes.com/news/la-na-gatesx07jan07,0,2533850.story
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Definition of Impact Investing and delimitation to traditional SRI The term impact investing is relatively new. It was reportedly coined a few years ago by the Rockefeller Foundation which defines it as investing for social impact and financial return. The social impact should be intentional and measurable. Its motivation stems on the one hand from the fact that delivering social change at scale will require more capital than philanthropy and public resources can provide, especially in times of scarce public resources5. Thus, impact investing belongs to the broad and expanding field of social investing, where social considerations are important in driving investment decisions. Importantly, this form of investing is not the prerogative of philanthropic foundations or financial and government institutions, but also pertains to private investors. Impact investing, and its close relatives; mission-based investing5, blended-value investing6 and programme-related investing8 are different in two ways: They take a much more proactive route to create social impact as opposed to the traditional SRI approach which aims to avoid negative impact. Here, investors actively seek to identify worthwhile investment opportunities that promise positive impact on society and/or the environment, while not necessarily compromising on the financial return. They commit to measure the social impact they create. Whilst there are many competing methodologies, there are attempts to create industry standards. SME Impact Investing in Frontier Markets: A Response to Market Failures Impact investing can target a wide range of objectives, including for example productivity growth, food security, education, sanitation etc. Most impact investments aim to target a number of these objectives. Impact investing can take different forms: traditional equity, debt, loan guarantees or more innovative structures. A common form of impact investing is through the provision of private equity capital, whereby an investor takes a share in an unlisted company, typically SMEs in developing countries or frontier markets. According to the International Finance Organisation (IFC)9 private investments in SMEs are the best way to achieve the greatest social impact on the local economies. To better understand the opportunity it is important to understand the two main underlying investment hypotheses: The focus on low-income communities as consumers and productive parts of the value chain The focus on small and medium sized enterprises as engines for social change The Focus on low-income communities as consumers and productive parts of the value chain Most of the impact investing discussion focuses on the inclusion of disenfranchised communities, predominantly in developing countries, and embraces them as a productive part of a value chain but also as consumers. Multiple reasons, often present for various generations, have resulted in low-income classes in developing countries accessing goods and services at a significant disadvantage. This is the case whether the low-income person is acting as a consumer of goods and services (for essential items such as healthcare and deferrable ones such as carbonated drinks) or as a member of a productive chain (where the need may be for credit, equipment or logistics). Many factors cause, and then help perpetuate, the disadvantages faced by low-income people. As Professor V. Kasturi Rangan of the Harvard Business School has observed, among these are: Lack of complete information Lack of perfect competition Entry barriers Lack of property rights High transaction, search or switching costs
5 According to UNDP Millennium goals progress report most of the goals are currently not on track or even deteriorating. There is an annual gap of USD 138bn only for these eight global issues that neither public resources nor philanthropic resources can fill. 6 Refers to a foundation endowment investment strategy and means to invest in line with the foundations mission on the expenditure side. 7 Coined by Jed Emerson, blended value investing refers to the concept of blending both social and financial return objectives in ones investment strategy. 8 Program Related Investing is a legal term in the UK and the US. Program related investments qualify for tax exempt status. 9 IFC, Access to Finance Report (2010)
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This has resulted in two signature characteristics of low-income communities (this is the case even when the goods or services are free of charge). Goods and services reach the poor under extremely deficient value propositions The poor pay prices that are often substantially higher than in conventional markets (the poverty premium) The sizable aggregate purchasing power of the low-income segments is not dependent on public policy. Unlike in the United States and Western Europe where social safety nets are effective, the poor in most of the developing world, do not receive meaningful subsidies on a regular basis and earn themselves the monies they need to survive on a daily basis. Aside from very isolated rural communities, this provides the basis for a large cash market, often under-reported by conventional means. The market of the low-income communities is also a market that has strong underlying growth potential. In addition to demographic trends, this income market is a segment where access to virtually all the essentials taken for granted by the conventional market from healthcare, education, housing, and basic utilities are highly unsatisfactory. This pent-up demand represents a secular trend, which cuts across normal business cycles and grand super-cycles, available to be tapped by business models able to package access within the cash flow of the poor. Low-income communities in developing countries consume goods in excess of US$ 5m every year and this number is projected to triple over the next 10 years.10 The Focus on Small and Medium sized enterprises as engines for social change Small and medium sized enterprises (SMEs) constitute the backbone of most economies and are a critical driving force for entrepreneurship, economic growth and job creation. This is particularly true in frontier and developing markets, where SMEs and the informal sector contribute to a major portion of Gross Domestic Product (GDP), and account for a significant portion of employment. Most of these newly created jobs are for low-skilled workers from the lower and middle-classes, which enter the company at low and competitive salaries and get trained to do the job. According to a study by Small Enterprise Assistance Funds (SEAF)11, each dollar invested in SMEs in developing countries generates US$ 13 of value to local stakeholders.
The multiplier effect
Owners & Financiers Customers
National Government
5.2 1.6
3.2 1.4
Suppliers
Community 0.6 & Other Stakeholders
1.0 Employees 13 USD
1 USD
Source: SEAF In addition, investing in such SMEs indirectly creates business volume and employment for their suppliers, which typically benefits even less privileged social groups. However, in many emerging markets, inadequate access to finance is, and continues to be, one of the most significant impediments to the creation, survival, and growth of SMEs (the so called missing middle, between large companies and individuals). Up to 90% of SMEs have no or insufficient access (at prohibitive rates) to capital.
10 McKinsey & Company Quarterly (2010) 11 SEAF 2011 Development Impact Report
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Therefore SME financing has been a focus for DFIs and now also increasingly for private investors interested in market-oriented solutions to poverty-reduction, income-creation, economic development, and long-term sustainable development, whilst also tapping into nascent growing markets, more decorrelated than regular portfolios. Investments in frontier market SMEs is thus a new opportunity for private investors to do good and do it well. How foundations and charities can participate in the impact private equity SME opportunity? As with any kind of investment, investors have very heterogeneous expectations. Consequently there is no single best approach for all. In order to decide on ones engagement option one has to take the following vectors into account: a) Investment Restrictions & Regulatory Environment This depends on whether the foundation or charity has investment restrictions that prevents them or limits them to invest in certain asset classes or geographies. b) The desired degree of complexity or simplicity to implement This is a new investment style that requires the buildup of new expertise. Many investment offices do not have the capacity to build up this new expertise. Others may want to invest into the Research and Development to acquire it or hire third party managers. c) Financial and risk considerations This naturally depends on the overall risk return profile of a charity where the invested funds come from. If they are part of an non Traditional Asset Class (NTAC) allocation, whether they come from cash or even from the grant allocation. Furthermore there is still a notion that impact investing (like socially responsible investing) may violate fiduciary duties. d) Social impact and the ability to influence the social impact as a single investor There are three main investment vehicles to participate in social private equity impact investing. 1. Direct equity investment in SME 2. Investment in a private equity fund 3. Investment in a private equity fund of funds
Direct vs Indirect Investments

High High High High
Direct Investment
Inv Inv Inv
Fund
Fund of Funds
Requirement
Easy implementation Easy access High availability Large volumes Financial feasibility Low risk Low costs High liquidity High return Social impact Direct influence Targeted social return
Inv
Fund of Funds of Funds Fund Fund of Funds Fund of Funds Fund Fund A Fund B A A Fund Fund B B Fund Fund Fund Fund A Fund B Fund Fund Inv 1 Inv 2 Inv 1 Inv 2 Inv 3 Inv 4 Inv 1 Inv 2 Inv 1 Inv 2 Inv 3 4 4 Inv 1 Inv 2 Inv 1 2 Inv2 3 Inv 3 4 Inv Inv Inv 1 Inv 2Inv 1 Inv Inv Inv
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While social impact is easier to influence with direct investments, the overall reach is lower and the implementation more costly. Furthermore the risk return profile is more attractive with a Private Equity Fund. For the majority of charity investors, who want to engage in this field, the last option is the most suitable, because direct investments as well as single Fund investments in SMEs require significant effort in identifying, evaluating and monitoring the investment. Naturally, fund managers need to be selected and vetted properly given the limited transparency in this business area. This also requires charities to show the necessary skills to select the managers. But there is a relatively small universe of private equity fund of funds with an established track record in impact investing. As in many investment fields as investors become more educated and sophisticated they will start potentially moving up the chain to single funds and eventually direct investments. Challenges & Opportunities While the idea of impact investing idea is intellectually straightforward and compelling to foundations, it has so far not been adopted widely in the global foundation and charity community. There are a number of drawbacks that every potential investor needs to take into consideration. All forms of private equity investing are long term, running over 6 to 12 years or longer. Consequently assets can be illiquid for long periods of time and this general disadvantage is aggravated by the illiquid markets in developing countries. For charities and foundations in an anyways low-yield environment, some of them struggling to fulfill their annual expenditure commitments or obligations, this can be close to prohibitive. Therefore many chose to only dedicate a relatively low allocation to these investments. Many foundations that want to invest in these kinds of investments feel shackled by what they perceive as a legal obligation and their fiduciary duty to make the maximum risk-adjusted returns on their investments. Traditionally, the courts have interpreted a Trustees legal duties simply as that. However, that has changed with the Charities Commissions most recent guidance published in October 2011 that gives the green light for foundations and charities to take their charitable objectives into account when investing. This act has redrawn the territory by giving foundations the permission to invest in ways that are relevant to their beneficiaries. Further to these challenges, there is a multiplicity of idiosyncratic impact investing challenges laid out in the graph below.
Challenges of a sector in its infancy
Source Intrinsic High -risk investment environment Challenging economics/high involvement Performance measurement ( nancial and social) Environment Non -existing standards and infrastructure Limited track record of managers Regulatory constraints for investors Market Limited sourcing pipeline Limited liquidity Limited access for investors
Challenges for early investors
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Impact investments tend to focus on small companies at early stages in their development, and are hence exposed to a different risk structure. In addition the risk of company fallouts, the investor is also exposed to increased country and political risk, as well as an augmented legal risk. Furthermore, due to the infancy of the market the exposure to first time managers is automatically higher. On the other hand there is no leverage involved in developing countries SME Private Equity transactions a fact that decreases financial engineering risk significantly. Also, management and due diligence costs are substantially higher due to the remote locations and different expertise needed that is not broadly available at this stage and often needs to be sourced externally. Finally, measuring social or environmental impact is not trivial. Standards and institutions to harmonize the measurement with the view of creating comparability is evolving especially under the auspices of the Global Impact Investment Network (GIIN), an organization that was formed to provide the infrastructure necessary for impact investing to gain traction.
The GIIN The GIIN was conceived in October 2007 and in June 2008 in Bellagio, Italy, where the Rockefeller Foundation gathered a small group of foundation investors to discuss how to solve social and environmental challenges with greater efficiency. In June 2008, a broader group of 40 investors from around the world met to discuss what it would take for the impact investing industry to be able to solve more social and environmental challenges with greater efficiency. They organized a number of initiatives, including the creation of a global network of leading impact investors, the development of a standardized framework for assessing social and environmental impact, and a development of a working group of investors focused on sustainable agriculture in sub-Saharan Africa. Just over a year later, the GIIN was formally constituted as an independent organization and since then serves as the industry body for institutional and private impact investors and practicioners. Its mandate is to establish and build the impact investing infrastructure and to provide a convening platform for impact investors to meet and exchange ideas.
Conclusions While the mechanics of impact investing private equity in frontier markets are not entirely new, the opportunity opening up to private investors is new and is enormous. Many believe that the niche investing of today will be the mainstream investing of tomorrow. For foundations and charities the challenge is to balance additional illiquidity with potential future returns and investments with high social impact that complement their philanthropic expenditure.
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topic
Charities & borrowing
26
Charities and borrowing an analysis of the current issues in the charity sector Pradeep Kachhala
Introduction In the current market environment, the concept of borrowing, and thereby the possibility of increasing risk and liabilities on charity balance sheets may seem a questionable idea. Not enough attention is paid to the concept of finance and lending to charities in particular, most publications on lending have been written with the private sector in mind. This article looks to identify the key reasons for and against charities taking out borrowing in addition to questioning traditional attitudes of Trustees toward this issue. Furthermore it looks to analyse overall levels of borrowing and the concept of borrowing against an investment portfolio to fund long term projects. Finally from a governance perspective, it looks at the recommendations regarding borrowing from the Charity Commission.
Fixed assets Intangible assets Tangible assets Investments Current assets Stocks Debtors Cash
Short-term liabilities Long-term liabilities
Net assets
or
Total funds
-40
-20 Total current assets Total fixed assets
20
40
60
80
100
23.1 85.9
Total liabilities
-18.9
Source: NCVO
Why should a charity borrow? There are 3 traditional methods of borrowing for charities that come to mind. These are Term Loans (either fixed or variable interest rates in nature), Overdrafts and Mortgages. There are two further types of borrowing that are less traditional in nature, such as taking out long term debt in the form of a social impact bond (which is discussed by Professor Paul Palmer in another article) and secured lending against an investment portfolio, which is discussed in more detail later on in this article. Charities are becoming more entrepreneurial in identifying and taking opportunities, largely due to external funding pressures, as a consequence earned income now represents over half of overall total income. However new initiatives may require additional funding, which either may not be available through the traditional routes of fundraising and philanthropy, or beyond the current capacity of a charitys reserve funds. With this is mind borrowing should be seen as an opportunity for charities to fulfil their missions. Banks offer two key benefits to charities looking to borrow, firstly if there is a clear business plan for repayment, the availability of finance will be quick. Secondly banks have access to larger pools of capital and will not be limited by large requirements for ambitious projects. With current underlying interest rates at historic lows, it may be an ideal opportunity for charities to consider taking out some form of borrowing. Some charities may not be as affected by the current economics turbulence and hence would be an attractive proposition for lenders, such as charities related to health and social care and others based in contract based service delivery. Excessive lending and relaxing of capital ratios were partly the cause for the 2008 banking crisis, now that banks have become more cautious with lending, charities may become more attractive customers. It will come as little surprise that according to the NCVO, mortgages are the biggest part of a charitys loan finance. The purchase of a building provides the means for potential long term capital appreciation along with the ability to generate an income stream which may help offset the repayments on borrowing taken out. It is also worth considering mortgage lending
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4. Charities & borrowing
from an efficiency perspective, where headquarters are consolidated by moving into one main building, leading to a reduction in overall costs. When is borrowing inappropriate for a charity? While the above section argued the case in favour of borrowing in order to aid a project or a long term benefit, there are situations where such a strategy would be deemed wholly out of place. The obvious initial point to make is that where there is a risk that the Charity would not be able to repay the debt then any type of lending facility should not be considered. Furthermore should the loan be for anything other that deviates from the charitys mission statement or objectives, such a facility should be reconsidered as a viable long term option. The concept of borrowing to pay bills, or fund deficits without the means of generating sufficient income or reducing costs to cover the lending should also raise concerns for Trustees. Borrowing and subsequently deciding the appropriate amount that should be taken out may be a complex issue requiring a level of expertise that incumbent Trustees may not have. As such a failure to understand the precise terms of borrowing arrangements will be to the long term detriment of the charity and its ultimate beneficiaries. Where possible financial and legal advice should be sought, particularly in the latter case Trustees should also determine whether they in fact have the power to borrow. Current borrowing trends in the charity sector The Voluntary sectors liabilities by size of organisation
0% Small Medium Large Major Total
Creditors due after one year 20%
Creditors due within one year 40% 60%
Pension liabilities Provisions 80%
100%
0.3 1.0 2.4 4.8 8.5 6.0 8.5
0.2 0.6 1.7 0.3 1.5 1.8
0.0 0.0 0.0 0.01 0.0 0.03 0.04
Source: NCVO/TSRC, Charity Commission
Data produced by the NCVO suggests that from 1994/95 and 2001/02 loans doubled in value to 2.2 billion. Using the ratio of loans to liabilities and applying this forward once more for the periods 2009/10, implies that loans worth 3.5 billion are held by the charity sector. However, while financing for social enterprises is becoming increasingly important and the figure of 3.5 billion seems large, as a funding source, borrowing actually remains a small part of total charity liabilities. Perhaps more telling is the NCVOs estimates, which state that total borrowing in the charity sector is only at 3% compared to the total net asset value of charities, which the NCVO believes to be at above 90 billion. It indicates that Trustees may be unable, unwilling or unaware of the borrowing opportunities available. Furthermore, the NCVO also noted that only 2% of the charity sector was satisfied with access to loan finance in their local area, while on a national level this statistic increased to 7%.
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Estimate in the total value of loans 2001/02-2009/10 (millions)
Loan finance 2001/02 2008/09 2009/10

Source: NCVO
Total liabilities* 10,888.3 15,909.1 17,051.2
% of liabilities 20.5 20.5 20.5
2,226.7 3,253.5 3,487.1
In its 2012 UK Civil Society Almanac, on the subject of borrowing, the NCVO commented; Civil Society should see the potential of the market not only as a replacement for declining funding from other sources, including public spending, but as part of a wider move to embracing change in the way the we operate and finance our activities. So, while the NCVO believes that the range of borrowing opportunities that charities have to hand is beginning to increase, it seems that the sector as a whole has yet to grasp the potential of utilising debt in an efficient manner. The next section this article looks to explain lack of borrowing by identifying the key concerns that Trustees may have on this subject. The GuideStar database sheds some more light on the type of lending that is currently being undertaken by charities. Of the 169,000 charities that they monitor, only 7,000 had lending, or alternatively only 4% of charities borrowed. Within this, 4,700 were in short term loans, such as overdrafts to manage cash flow issues while 4,000 were for long term loans. It should be noted that some charities may have short and long term lending. Later in this article we look at long term lending in detail when analysing the Independent Schools sector. However one can conclude that the idea of using long term debt planning to achieve mission objectives and the ability for charities to receive sound financial advice relating to this is an area for development for both Trustees and Banks. Trustees attitudes toward borrowing Barriers to entry into borrowing for charities are internal and cultural rather than an overall unwillingness of banks to lend to the 3rd sector. Further analysis into this suggests that there are a number of factors that contribute toward explaining the relative lack of borrowing in charities compared to the private sector. Charities believe that Banks would not lend them money as they are not for profit making enterprises. However, banking services and charges, particularly interest rates, make no distinction as to who the customer is. There is also perception by Charity Trustees that banks perceive them as amateurs, hence they are less likely to approach a high street lender for some form of borrowing due to the fear of being sharply turned down. Research by the NCVO also suggests that Trustees believe that banks do not understand the bureaucratic and slower decision making process in the 3rd sector. Importantly Trustees worry about personal liability and are therefore less likely to take on debt. In this case they should be encouraged to take legal advice regarding the governing structure of the charity rather than dismissing the possibility of borrowing altogether. More generally Trustees may have a natural adversity to borrowing following the events of the 2008 financial crisis and the subsequent negativity surrounding the concept of leverage. They would not want to bear the burden of presiding over an insolvent charity which has taken on far more risk than was needed. The ultimate effects would be felt by the beneficiaries of such charities. Borrowing for mission specific projects will raise concerns amongst risk adverse Trustees. They also worry that an overrun of initial costs on capital projects will undermine the financial facility as will overly optimistic business plans which fail to meet targets. The lack of a proven track record and technical knowledge in running a new venture may also lead to fears of rising costs. Finally the lack of available expertise in the charities and the cost of obtaining external advice mean that attitudes toward borrowing may be negative.
29
4. Charities & borrowing
Secured Lending Secured lending is a relatively new concept in the charity sector that Investment Managers with a banking operation may be able to offer. Furthermore it can be seen as an example where large banks can be better than their smaller rivals in providing choice and innovative effective investment solutions to the often complex issues faced by a number of charities and foundations. As secured lending is an unfamiliar idea to Trustees, this section starts by outlining the key features and benefits of such a facility. Portfolio lending can be used as a source of liquidity for a variety of purposes, i.e. investment in infrastructure. The assets charities hold at a Bank will be pledged in favour of the Bank as collateral for the loan so are at risk if payments are not maintained. Liquid assets may be eligible for a lending value, which is subject to changes at a Banks discretion. A typically diversified investment portfolio may be able to borrow up to 70% of the assets value. The lending value of the collateral must exceed a charitys liabilities at all times, for example the portfolio value should not fall below the lending value. Quick and easy access to liquidity for a multitude of purposes Tailor-made solution avoids the need to liquidate assets and investments at depressed vales to fund new projects Secured lending is potentially among the least expensive sources of credit available The credit facility can be used as and when you need it; interest is payable only on the amount you actually draw down No arrangement fee for standard facilities No distortion of a charitys overall asset allocation Loans are available in different currencies and tenors However as the lending is secured against the assets of an investment portfolio, it is worth highlighting the risks of such an idea The value of an investment portfolio can go down as well as up; hence in times of market volatility lending values may decrease. Trustees are advised to maintain sufficient headroom between lending and portfolio values to reduce such a risk. If the value of investments do fall and approach the lending value, it may result in additional margin call. Past performance of investment portfolios is not a reliable indicator of future results. In 2012, the UBS Charity Team analysed a specific sector of the charity universe. The details required to carry out the analysis were extracted by looking through the respective reports and accounts for 2010 on the Charity Commission website. It was found that many of the most successful charities in this sector had an investment portfolio managed by an investment management firm, along with a lending facility at a high street bank. As a result the Trustees, in most cases, seemed to be incurring higher fees than would otherwise be the case if the lending facility was with an Investment Manager who offered banking capabilities. By choosing such a single provider of both services it should be possible to save costs. The overall lack of awareness by Trustees within the sector of the benefits of secured portfolio lending is an example of the need for more detailed and wider discussion within the charity sector between Trustees and their financial advisers. Responsible lending using liquid investments rather than pledging illiquid assets, such as commercial property, may be a more viable solution for some Trustees. Of course, this is dependent upon Trustees investment knowledge, objectives, and the suitability of such a secured lending facility along with sufficient confidence amongst Trustees to take such a decision.
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Charity Commission guidelines to borrowing According to the Charity Commission, charities are generally allowed to borrow money to help them do their work, but there are some things that should be checked first 1. Will the money that is borrowed help carry out one of that charitys purposes? 2. Have the charity Trustees considered other options for raising the money that the charity needs? 3. Has the charity looked at the range of loan deals to help decide which is the most suitable? 4. Has the charity got a realistic budget that shows if the charity can afford the repayments on the loan? 5. Is the charity getting professional help with checking the legal papers such as the trust Deed and the loan documents? A study by DG Raye developed the approach that a charity should take a planned approach to borrowing. Raye devised a conceptual framework based upon Brinckerhoffs business development process for charities, which stated the following necessary steps: Review your mission Establish the risk and willingness of your organisation Establish the mission outcome of the business Generate ideas Undertake feasibility studies Formulate a business plan including the financials Prepare an implementation plan with accountability
Conclusions Research has found that rather than there being a market failure instead there was a cultural misunderstanding and a failure to apply normal business processes. Statistics on some parts of the charity sector suggest that perceptions that organisations do not borrow or cannot borrow are wrong. Importantly clarity on legal liability is required and banks need to develop a deeper understanding of charity finances, operations and structures. With the correct education and planning, charities may be more bullish about using loans in an ever more complex funding landscape and as external funding pressures increase charities may have to become entrepreneurial in identifying and taking opportunities. References Wilding K et all (2012), The UK Voluntary Sector Almanac 2012, NCVO Dermine, J and D Schoenmaker (2010), In Banking, Is Small Beautiful? DSF Policy Paper No 2. Economist (3/3/2012), Companies and productivity, small is not beautiful, Vol. 402, Issue 8774, p16. Palmer P (2009), Banking on the third sector Brinckerhoff, P (2000), Social Entrepreneurship Rajani Y (2012), Resource Management Assignment for CASS Business School Rickey B et all (2011) Best to Borrow? New Philanthropy Capital Crunching down on Loans? (2008) The Charity Times online article Borrowing (2012) - The Charity Commission website
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topic 3. Asset allocation in the presence of liabilities
Pension Fund Indicators 2011
Equities
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5. Equities
Introduction
This chapter covers equities. It looks at the characteristics of equities and the key influences on the valuation and performance of shares as a whole. In 2011, the key driver of equity markets was macro news flow and the ensuing gyration between risk on and risk off behaviour. The eurozone sovereign debt crisis dominated headlines while investors shunned risk assets, such as equities, in favour of perceived safe havens. In this extremely volatile environment, world equity markets returned -6.2% (as measured by the MSCI AC World index in sterling terms) despite a strong finish to the year. Charities remain firmly focused on liabilities and risk appetites are low in the UK and elsewhere. However, Trustees should bear in mind that equities typically offer superior long-term returns, and play a crucial role in enabling charities to fund their objectives.
Equity characteristics
What is an equity?
An equity is a share in a company. The company is owned by the shareholders. They have the right to the income and capital of the companys business after it has satisfied its obligations to creditors. Shareholders usually have voting rights allowing them to influence the management of the company. Practically all companies enjoy limited liability. Should a company become insolvent, shareholders are not liable to creditors for any payments beyond their previous subscriptions of capital. Shareholders, therefore, have the benefit of potentially unlimited gains from their investment combined with limited losses. This compensates them for the higher risks inherent in equity investment arising from the fact that shareholders rank last behind other creditors in their claim on the companys assets. Most larger companies have their shares listed on one or more stock exchanges i.e. they are publicly quoted. This facilitates the buying and selling of shares and usually makes it easier for the company to raise new equity capital. Almost all trading and settlement of shares is now done electronically. This has allowed stock exchanges to compete with each other and with new trading systems. Whilst most large companies remain publicly quoted, in recent years the private equity industry has grown significantly. Private ownership may improve management incentivisation and control, and offer greater flexibility in the use of tax-advantaged debt finance. As will be seen in a later chapter, private equity generally provides better returns than publicly listed securities, which is needed to compensate for the relative lack of liquidity and higher risk.
Uncertain long-term returns

Equity owners participate directly in the profits of the companies they own. Profits fluctuate from year to year and are subject to increasing uncertainty as projections are made further into the future. Equities usually offer a higher return than bonds to compensate for this greater uncertainty. Long-term capital appreciation of equities is strongly related to growth in corporate earnings and dividends. Figure 5 .1 shows how, in the UK, earnings and dividends have grown at about the same rate as wages and prices as a whole over the long-term. However, progress has not always been smooth and there have been some periods when real earnings and dividends have declined. 2008 and 2009 saw one of the steepest cyclical declines in earnings as the global financial crisis took hold, with earnings across developed markets falling by almost half. In stark contrast, 2010 saw a strong recovery in the UK of +57% while data for 2011 (IBES, consensus bottom-up) indicate robust earnings growth in the region of +16%.
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5. Equities
The fluctuations over the past few years have been particularly extreme and have made forecasting difficult. When it comes to predicting stock market returns, there is the additional complication that the markets capitalisation rate for earnings (the price-earnings ratio) also fluctuates (see Figure 5.7 later in this chapter).
Figure 5.1 Growth in UK equity earnings, dividends, wages and prices 10,000
If companies continue in future to generate similar returns and apply similar retention policies, a nominal growth rate of about 5% p.a. would be sustainable in the long-term. Long-term inflation in the UK will probably average between 2% and 2.5% p.a. (assuming that the Bank of England steers a successful course between deflationary forces and inflationary pressures). This would imply that real growth would be about 2.5% p.a. With a starting yield for equities in the UK of around 3.5%, this once again implies a long-term real return of about 5 to 6% p.a. The final methodology used to highlight to estimate prospective returns is that of equity risk premia. The theory is that the extra return derived from a risky asset, such as equities, should reflect the volatility it displays relative to a lower risk asset, such as cash. Estimating future volatility and risk premia is not a precise science but most academic estimates suggest the risk premia for equities relative to bonds should be between 2% and 4% p.a. However, the main problem with this approach is that it assumes real yields on bonds are fair at the outset, which is not always the case. Given the exceptionally low real yields for 10 year indexlinked bonds in the UK, which have now turned negative at -0.5%, and an equity risk premium of 3%, this would imply a real return of only 2.5%; much lower than other methods. However, we believe that real yields for sovereign bonds are at artificially low levels. Using a long-term yield of 2-2.5%, added to the equity risk premium, this method would suggest a return for equities of 5-5.5% p.a. The conclusion that can be drawn from these various approaches is that it is reasonable to expect a long-term trend real return from equities of about 5 to 6% p.a. This is consistent both with the historical long-term trend and the prospective returns implied, using a range of methodologies. Ultimately, however, this is not a surprising result since most of the methods used above derive their future expectations for economic growth, return on capital or risk premia, from observations in the past. In addition to the difficulties involved in making simple arithmetically-based return projections against a background of stable economic growth, the vulnerability of equity values to economic disruption, such as recessions, nationalisation and wars needs to be considered. This factor is hard to quantify and might sometimes be underestimated because equity markets that have completely collapsed in earlier periods, such as the pre-Second World War German market, tend to be dropped from historic return series. Figure 5.2 shows how UK real earnings and dividends have not shown a smooth progression but have tended to come under pressure during recessions and periods of rising inflation. However, significant changes in the composition of the FTSE All-Share Index over time make it difficult to be
1,000
100 1962
1969
1976
Equity earnings per share Prices
1983 1990 1997 Year ends Equity dividend Wages
2004
2011
Source: Datastream, rebased wealth series Past performance is not an indication of future returns.
Despite the difficulties, long-term projections of equity returns are necessary, particularly for calculating the funding requirements of charities. There are several possible methods. One rough method is simply to project long-term historic returns into the future. Depending on the historic period chosen, this typically gives a return of around 6 to 7% p.a., in real terms, for developed markets. Is this historic trend return realistic for the future? One way to assess this is to combine the current income yield on global developed equities with the potential future growth in dividends, which, in turn, is linked to the rate of economic growth. While the economic outlook for the next year or two remains challenging, in the long-term, it is likely that the world economy will grow at 3 to 4% p.a. in real terms, with emerging economies delivering higher than average growth and developed markets rather less. In practice, dividend growth usually lags economic growth by between 1% and 2% p.a., so it is probably fair to assume real dividend growth in the long-term will be between 2% and 3% p.a. Combining the 2.8% current yield on global equities with the long-term real dividend growth rate above, suggests it is not unreasonable to expect a long-term prospective real return from equities to be between 5% and 6% p.a. broadly in line with the historic long-term trend. An alternative approach is to look at the return on equity (a companys accounting profit divided by the net asset value). In the UK, for example, this has averaged about 10% p.a. over the long-term. Historically, companies have retained approximately half their profits to finance future growth.
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precise about earnings and dividend trends. For example, the relevance of comparing a UK stock market of one hundred years ago, dominated by railways and textile companies, to one today, with the biggest sectors being oil and gas, and basic resources, is questionable. Indeed, the UK market bears little relationship with the UK economy, with nearly 75% of sales coming from overseas markets.
Figure 5.2 UK real earnings and dividends
400 300 200 100 0 1962
The volatility of the real value of UK equities, as shown in Figure 5.3, casts some doubt on their ability to match inflation-linked liabilities, especially in the short-term.
Figure 5.3 FTSE All-Share Index adjusted for inflation 300 250 200 150 100 50 0 1962 1969 1976 1983 1990 Year ends 1997 2004 2011
1969
1976
1983 1990 Year ends
1997
2004
2011
Real prices
Real earnings
Volatility
Individual equity prices are generally much more volatile than fixed income security prices because assessments of the value of future profits from a company are continually changing. Equity markets as a whole are less volatile than individual equities but are still subject to fluctuation as overall economic prospects change. Volatility is a disadvantage to Trustees who might need to realise assets at unfavourable times or who wish to cover fixed liabilities. It can be an advantage if it allows purchases and sales at attractive prices but patience is required to benefit from market fluctuations. For example, conventional valuation indicators showed equities as overvalued for many years before the turn of the millennium. Maintaining a cautious approach would have led to significant underperformance until the market peaked, yet relative performance would have been recouped over the subsequent three years. However, charities with a short term time horizon might have been tempted to abandon this strategy long before it paid off. Similarly, the difference between investing at the peak of the MSCI World market in July 2007 and the trough in March 2009, would have made an enormous difference to returns, even over long time horizons.
Volatility can be measured. Past volatility can be calculated from data on previous market price movements. Expected volatility can be calculated using option prices to derive the implied volatility that makes the option price fair. These calculations tend to be complicated by the fact that volatility changes over time and sometimes spikes up dramatically during periods of market turmoil. The most commonly used measure of volatility is the VIX, or Volatility Index, a measure of option-implied volatility of the US S&P 500 Index. The VIX provides a snapshot over time as to what extent the market is expected at the time to fluctuate on an annual basis. As can be seen in Figure 5.4, the VIX has typically suggested the equity market might move up or down by around 20% p.a. However, following the financial crisis in 2007/8, the VIX spiked up to an extraordinarily high level of 80%. After a volatile 2010, market turbulence continued into 2011 with the VIX reaching over 40% (as measured in USD) during the summer malaise. Indeed, despite a return to more normal levels of volatility towards year-end, the VIX averaged more than 30 throughout the second half of 2011. Interestingly, Figure 5.5 shows that, in the past, high levels of the VIX tend to be followed by strong periods of equity market performance. In the words of Warren Buffett, be fearful when others are greedy, and be greedy when others are fearful... What is likely is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.
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5. Equities
Figure 5.4 VIX implied Volatility Index 100 80 Volatility (%) 60 40 20 0
1990
1993
1996
1999 2002 Year ends
2005
2008
2011
Source: Datastream, December 2011 Past performance is not an indication of future returns.
Figure 5.5 VIX Index versus next 12 months S&P 500 return 30 25 S&P 500 return (%) 20 15 10 5 0 <15% <20% 20% - 30% Whole Sample VIX index >30% >40%
Over the long-run, the case for diversification is clear. In 2011, however, some of the benefits of diversification were reduced due to the high correlations between share price movements. Correlations quantify the relationship between changes in asset prices. As markets have been driven by macro concerns and not company fundamentals, investors have either bought or sold equities en masse rather than differentiating between companies. In the US, correlations reached more than 65% during Q3 2011. This meant that stocks moved in the same direction 65% of the time, thus reducing the benefits of diversification in the short-term. To put this into context, correlations spiked to 63% after the collapse of Lehman Brothers in 2008 and have averaged 27% over the long-term (see Figure 5.6 ). While having recently fallen from such heightened levels, the return of investors focus to company fundamentals and an improvement in the global macro-economic outlook are likely to see correlations fall to more normal levels.
Figure 5.6 US Large cap stocks: Average cross-sectional return correlation, 1926-2012
Average cross-sectional return correlation (%) 70 60 50 40 30 20 10 0 1926 Average 1943 1960 1977 Year ends 1994 2012
Source: Bloomberg, RBS, Datastream. December 2011 Past performance is not an indication of future returns.
Diversification
Volatility of returns may be mitigated by diversification the spreading of investments within and across different equity markets or between equities and other asset classes. Within individual markets, most of the volatility reduction benefits of diversification can be achieved by investing in a surprisingly small number of holdings, such as 10 or 20 equally weighted positions spread across different industries. However, in practice, the performance of charity investment portfolios is usually measured against an index benchmark comprising several hundred different shares. In order to avoid the risk of underperforming the benchmark significantly, it is necessary to hold highly diversified portfolios, typically with more than 50 holdings. Inevitably, this also limits the scope for outperformance reducing the risk of underperformance must also reduce the potential to outperform.
Source: Empirical Research Partners Analysis Note: US Equity Large Cap Universe consists of 750 largest market cap companies Past performance is not an indication of future returns.
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Sensitivity to interest rates and inflation

Long-run returns on equities are heavily influenced by longterm trends in corporate earnings and dividends. However, equity market levels are also sensitive to interest rates and inflation. High interest and inflation rates tend to be associated with low levels for equity markets. For example, Figure 5.7 shows the inverse correlation between inflation and the price-earnings (P/E) ratio of UK equities. Academic studies suggest that, in the short-term, inflation and equity returns are negatively correlated in the US and UK.
Figure 5.7 UK P/E ratios and inflation
of ~2% p.a., such recent and coordinated intervention across the globe has provided a clear signal to markets that policymakers would rather take inflation risks in ensuring they deliver a robust recovery in growth and avoid a debt-deflationary spiral. Furthermore, the high debt levels in most developed economies give an added incentive to reflate, which is generally positive for equities, and negative for bonds.
Equity valuation
In principle, equities can be valued, like any other asset, on a Discounted Cash Flow (DCF) basis. The cashflows accruing to shareholders over the lifetime of a company can be forecast and then discounted at an appropriate rate of interest to reflect the time value of money and the risk of those cash flows. In practice, there are significant difficulties in both forecasting future cashflows and choosing appropriate discount rates. Therefore, whilst many investors use DCF valuations, they typically also use more simple valuation yardsticks combined with judgement about future prospects. Some common yardsticks are described in Figure 5.8. Most can be used for either individual equities or equity markets as a whole. These common yardsticks can be related to valuation criteria for other assets. For example, the earnings yield on equities can be compared to bond yields or real estate yields to see which asset offers the highest rate of accrual in the short-term. Some charity investors are moving towards more sophisticated valuation methods in order to gain greater insight and accuracy. These methods are generally closer to explicit cashflow forecasting and discounting than the simple rules of thumb presented in the table. Forecasts can involve future dividend payments which are then discounted at the required rate of return. For example, a share paying a dividend of 5 pence per year, growing at 5% p.a. indefinitely, would be worth 100 pence if the required rate of return was 10% p.a. Changing the assumptions can make big differences to discounted dividend valuations. For example, raising the growth rate from 5% p.a. to 8% p.a. increases the value of the share in this example to 250 pence. This does not mean that this valuation method is wrong, it simply highlights the difficulties in equity valuation and the high sensitivity of DCF valuations to moderate changes in discount or growth rates. Whilst dividend discounting is still used as a valuation technique, it is most useful for high yielding shares with very predictable future prospects. However, the majority of shares fall outside this category. In some cases analysts set up detailed models which forecast future profits, cashflows and balance sheets for a few years ahead. The company is then valued as the sum of discounted cashflows for the forecast period plus a terminal value at the end of the period. The terminal value is often determined by conventional criteria such as price-earnings ratios.
35 30 25 20 15 10 5 0 -5 1962 1983 1990 1997 Year ends Ination (%) FTSE Non Financial P/E ratio 1969 1976 2004 2011
Source: Datastream Past performance is not an indication of future returns.
When inflation is high, interest rates on cash and bonds tend to be high because holders of fixed income investments require a real return and because macro-economic policies designed to contain and reduce inflation usually involve higher than normal interest rates. Equity holders tend to suffer in these situations for two reasons. Firstly, prospects for economic growth tend to deteriorate as a period of austerity is required to dampen inflation, impacting corporates earnings potential. Secondly, in practice, companies find it hard to raise their nominal return on capital fast enough to compensate for the erosion of their real profits by inflation. In the longer run, over periods of five years or more, there is more of a positive correlation between equity returns and inflation, possibly because corporate behaviour eventually adjusts to cope with the new environment. Equities therefore, appear to provide some protection against inflation for charities with a long term investment outlook. Nevertheless, their chief attraction as an asset class is their superior expected rate of return versus other traditional asset classes such as bonds, rather than their uncertain ability to match liabilities related to inflation. Current historically low level of interest rates, both long-term and short-term, should be positive for equities as long as economies do not fall into the abyss of depression and deflation, an unlikely scenario in our view. The harsh lessons of the great depression in the 1930s, and more recently Japan, have weighed heavily on central bankers. With central banks targeting positive inflation
37
5. Equities
Figure 5.8 Common equity valuation methods Price earnings ratio (P/E) Calculated by dividing a companys current share price by its earnings per share. The earnings figure depends heavily on accounting conventions so the P/E is not always useful for international comparisons. The reciprocal of the P/E. The annual dividend of a share in relation to the current share price. Calculated by dividing the annual dividend per share by the current market price. Formerly popular in the UK when companies had stable or progressive dividend policies, but arguably less useful now that many companies vary their dividends for tax or other reasons. The ratio of equity market value to the accounting value of shareholders funds. Sometimes an indicator of value in relation to assets, but depends heavily on accounting methods. It is open to debate whether goodwill arising from acquisitions should be included in shareholders funds. Enterprise value (market value of equity plus net debt of the company) divided by earnings before interest, tax, depreciation and amortisation. A measure that attempts to assess short-term cash generation in relation to market valuation. It can be used for international comparisons, because it is not heavily influenced by different accounting methods. Furthermore, it is fairly independent of the capital structure of companies. However, by ignoring depreciation it is a rather crude measure. Economic Value Added. This approach is patented by Stern Stewart, although rivals have similar metrics, such as cash return on capital invested (CROCI) from Deutsche Bank or the system developed by HOLT Value Associates. Generally, they attempt to quantify the value of a company by assessing the returns it makes on the capital it employs compared to the cost of that capital. The difference between the two is the value added and the sum of these differences in the future is the value of the company above its book value. It is a sophisticated approach that is useful in judging the performance of a company in the past, but suffers from the uncertainties of forecasts of the future in the same way as discounted cashflows. The ratio of the market value of equities to the replacement cost of the companies net assets. This ratio is mostly used when looking at an entire market rather than individual companies. In purely competitive markets, arbitrage between the price of assets and the price of equities should ensure the value of Q converges towards one. In practice, competition is far from perfect so many companies with strong market positions consistently trade at multiples of the value of their underlying assets. Similarly, some industries are chronically unprofitable and trade at discounts to replacement cost asset value because it is difficult to realise the assets.
Earnings yield Dividend yield
For example, a start-up company might be expected to lose GBP 10 million a year for three years, break even for two years, and subsequently make GBP 5 million p.a. The GBP 5 million p.a. profits might justify a terminal value of GBP 50 million, but the total discounted value of the cashflows at 10% p.a. is only GBP 4 million because of the start-up losses and the time taken to achieve profits. A variation on discounting future cashflows is calculating returns net of the cost of capital. This is known as economic value added (EVA). EVA is negative if returns are less than the cost of capital. The cost of capital is a discount rate deemed to be the appropriate return for equity holders and is normally calculated by adding a risk premium on top of cash or bond yields. Where the future is highly uncertain, detailed financial modelling is not always worthwhile. Here, comparative valuations can sometimes be made. In the late 90s, for example, mobile telephone and internet companies were sometimes compared on an Enterprise Value (EV) per subscriber basis. The rationale was that companies with profitable and loyal subscribers and good prospects for subscriber growth, should enjoy a premium to other companies on an EV per subscriber basis. New valuation techniques are often, quite rightly, treated with suspicion as they must ultimately be related to long-term cash generation. For example, in early 2012, social networking company Facebook stated they would look to raise USD 5 billion in an initial public offering, or IPO. Total valuation estimates for Facebook ranged from USD 75-100 billion, yet the company had neither indicated how many shares it would sell nor confirmed at what price. It could be argued that the use of a simple price multiple measure based on only a small proportion of total shares and the assumed validity of valuations seen at the last point of investment, raise questions over the companys proposed worth. Similarly, in 2005-06 private equity valuation techniques became commonplace, leading to a boom in M&A activity. Here, acquisition targets were spotted by focusing on businesses that could be more highly leveraged, based on a boom in real estate values and a cornucopia of cheap debt. A large number of deals were focused within the consumer related area. The repercussions of a combination of a consumer downturn and tighter credit conditions has started to feed through to substantial write-downs in valuations and, in turn, potential returns. Whilst forecasting can be subject to wide margins of error, statistical studies of corporate growth can be used to check the plausibility of growth assumptions. There is a tendency for high growth rates to fade to the average as the forces of competition and the difficulty of growing from a larger base, have an effect over time. Investors with a growth style try to identify companies with a competitive advantage which will enable them to overcome the fade effect. Value investors often seek to exploit the fade effect by investing in lowly valued shares where prospects might improve (fade upwards towards the norm). A more detailed discussion on styles and approaches can be found later in this chapter.
Price to book value (P/B)
Enterprise Value (EV/EBITDA)
Economic Value Added (EVA)
Tobins Q
Source: UBS Global Asset Management
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Equity markets
The global equity market
The total value of the worlds equity markets, represented by the MSCI World Index, stood at USD 25.9 trillion at end December 2011 - roughly USD 3,700 per head of global population. Equities represent over one third of the global investible capital market (which also includes bonds and real estate). The total capitalisations of some major equity markets are shown in Figure 5.9. The US economy is the largest in the world and has the biggest equity market, accounting for about half the global total. However, there is no simple link between the size of the stock market and the size of the underlying economy. The UK market, for example, is around three times the size of Germanys, despite the German economy being considerably larger. Note also that in 1989 the Japanese equity market was the biggest in the world, but is now about a sixth of the size of the US market. A number of factors affect the size of stock markets compared to their underlying economies. The most obvious is that countries will have different proportions of privately-owned companies compared to publicly-owned and quoted companies. The UK in particular has relatively few government-owned companies after a sustained period of privatisation during the 1980s. Therefore, a higher proportion of the countrys Gross Domestic Product (GDP) may be quoted rather than unquoted. The UK also has fewer mutually-owned or familyowned businesses than other European countries.
Figure 5.9 Capitalisation of major equity markets at end 2011 Market capitalisation1 USD trillion US UK Japan Germany China
1
particularly high proportion of these multi-national companies such as BP, HSBC and Vodafone. Indeed, as Figure 5.10 shows, the sensitivity of the UK stock market to the UK economy overall is relatively modest, with around three quarters of revenues of the FTSE 100 coming from outside the UK. Given the majority of those revenues and profits are gained outside the home currency, a decline in sterling actually increases the value of the profits to shareholders. This helps to explain the apparent disconnect with the economic environment being experienced in the local economy.
Figure 5.10 Percentage of overseas sales, by region
80 70 60 50 (%) 40 30 20 10 UK Europe ex-UK US Emerging markets Non-domestic developed

Source: Citigroup, December 2011
Japan
GDP USD trillion 15.1 2.3 6.1 3.3 7.5
Capitalisation/ GDP 0.8 0.9 0.3 0.2 0.1
Stock exchanges are also businesses in their own right and have differing listing criteria and regulatory environments. More developed markets, such as the UK and US, provide greater potential for capital raisings as an added incentive. The combination of these factors helps to explain the preponderance of Eastern European companies that listed on the London Stock Exchange over the past few years. Stock market ratings also vary widely across countries. A company may be large in terms of output but if its prospects are unattractive or domestic interest rates are high, the value placed on it by the stock market may be low. Thus the output of an economy is not necessarily directly related to the value of its stock market. The benefits of diversification between equity markets, discussed earlier, are illustrated in Figure 5.11 where the variation in returns between markets can be seen. Figures 5.12 and 5.13 show the cumulative total returns for four major equity markets and a world index in local currency and sterling terms.
11.9 2.2 2.0 0.7 0.6
SCI standard index market capitalisation, including foreign inclusion factors M as applicable. Source: Rimes and Datastream
Another reason is the presence of large multi-national companies. These are fully represented in the indices but not necessarily exposed economically to the country where the shares are listed. Many such companies are also dual-listed, such as mining giants Rio Tinto and BHP Billiton, which are listed in the UK and Australia. The UK market has a
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5. Equities
Figure 5.11 Equities annual returns converted into sterling % p.a. Global US Japan UK Germany Switzerland France Netherlands Italy Sweden Spain Belgium Denmark Norway Austria Canada Australia Singapore Hong Kong 2002 -26.8 -29.9 -18.1 -22.7 -38.6 -19.5 -26.3 -28.1 -17.8 -35.5 -23.8 -20.6 -20.9 -15.1 10.8 -21.2 -9.2 -19.6 -27.1 2003 21.1 15.1 22.8 20.9 47.2 20.2 27.5 15.0 25.6 50.6 42.1 25.6 33.8 32.4 43.7 40.1 34.7 24.1 25.7 2004 7.9 3.3 7.8 12.8 7.5 7.2 11.5 6.3 23.3 27.8 19.9 37.0 20.5 40.7 55.4 14.8 23.3 14.1 15.1 2005 24.6 18.7 39.6 22.0 22.3 30.6 23.7 28.3 13.5 24.1 17.0 21.8 36.1 39.3 37.9 44.8 30.8 30.0 25.1 2006 6.6 1.5 -7.4 16.8 19.9 12.1 19.6 16.3 18.2 27.9 31.4 19.8 15.7 29.4 21.9 5.1 15.5 29.1 23.1 2007 10.3 4.2 -6.5 5.3 33.4 3.9 12.9 15.3 6.3 -1.6 20.3 -1.0 24.7 33.6 2.7 28.8 27.3 29.1 50.0 2008 -19.5 -12.5 -1.3 -29.9 -23.8 -3.2 -21.9 -33.2 -28.8 -32.4 -17.4 -46.0 -28.0 -48.3 -56.1 -24.7 -32.4 -29.0 -30.5 2009 20.6 13.2 -5.9 30.1 13.2 13.0 16.6 32.6 11.3 51.5 24.0 45.9 30.3 73.3 45.7 38.1 56.1 56.4 45.3 2010 16.8 18.8 18.9 14.5 12.4 16.4 0.1 1.9 -12.8 40.0 -18.2 2.9 37.9 15.7 16.8 22.0 18.5 27.9 22.6 2011 -6.2 2.5 -13.1 -3.5 -17.8 -6.1 -15.0 -17.2 -22.8 -16.4 -10.5 -8.0 -14.7 -9.5 -37.4 -11.7 -10.1 -17.1 -16.7 10 yrs (% p.a.) 2011 4.1 2.4 2.3 4.8 4.2 6.6 3.1 1.2 -0.3 8.8 6.1 4.0 10.7 13.6 7.2 10.8 12.5 11.2 9.6
Source: All returns are sourced from Mellon (formerly MAS, formerly CAPS) and are quoted net of non-recoverable withholding tax Past performance is not an indication of future returns.
Figure 5.12 Total cumulative equity returns local currency
Figure 5.13 Total cumulative equity returns sterling
10,000
10,000
1,000
1,000
100 1975 UK
1981 Germany
1987 US
1993 Year ends Japan
1999 World
2005
2011
100 1975 UK
1981 Germany
1987 US
1993 Year ends Japan
1999 World
2005
2011
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Emerging market equities

Definitions There is no official definition of an emerging equity market. Of the roughly 200 sovereign states in the world, about 100 have a stock market. Around 24 markets are generally considered to be mature and the rest are frequently put together under the single classification of Global Emerging Markets (GEMs). The emerging market equity indices with the largest investor following, those of S&P and MSCI, use different selection criteria but overlap in their definition of the emerging market investment universe and both comprise approximately 20 countries. The MSCI Emerging Markets Index had a total market capitalisation at end 2011 of USD 3.2 trillion compared to USD 3.9 trillion quoted at the end of 2010. Given the very large variations in the constituents of emerging markets as an asset class, it is difficult to make any generalisations. Nevertheless, relative to the mature markets, most GEMs usually exhibit at least one of the following characteristics: Higher potential economic growth The development phase of an emerging market usually involves a period during which the country undergoes very strong economic growth as it catches up with the more developed economies. This convergence can be triggered by events such as the privatisation of key state assets (with subsequent productivity and efficiency improvements); the liberalisation of trade, the transfer of industrial know-how from developed to the developing world, technological gains and better access to international capital and falling interest rates. For example, after increased industrialisation and 20 years of real GDP growth averaging +10.2% p.a., China has risen to become the worlds second largest economy. To put this into context, real economic growth rates in advanced economies have averaged +2.2% p.a. over this same period, a very meaningful difference. Dynamic demographic structure Many GEMs have a population structure that is rather different from that prevailing in developed economies. Advances in public health during the second half of the twentieth century significantly reduced infant mortality rates, initially resulting in a rapid increase in infant dependents in many developing countries. As behavioural patterns changed, birth rates subsequently fell and female participation rates in the labour force increased rapidly. The typical developing country today has a demographic structure with a higher proportion of economically active people and with a median age well below that of developed economies. The relatively low dependency ratio, whether young or old, is typically associated with higher savings rates and higher levels of household formation. Where appropriate levels of education are available, productive capacity is growing, average incomes are rising and there is a growing domestic consumer base. However, this demographic characterisation of developing countries is not universally applicable. Those
countries that might be better described as re-emerging, i.e. the transition economies in the European region and Latin America, face problems of ageing populations that are comparable with the situation in developed economies. Cheaper factors of production On the whole, labour costs in developing economies are a fraction of the labour costs in the developed world. Many GEMs are also endowed with abundant natural resources such as oil and minerals. This not only gives them a natural price advantage when it comes to international trade but also encourages the relocation of labour and commodity-intensive industries from mature markets to the developing economies. In turn, this brings in foreign capital and technical know-how that further boost their economic growth. Higher reliance on external capital Global capital flows into emerging markets are attracted by their higher growth potential. The fact that emerging markets can attract such capital, when investors inevitably demand higher hurdle rates to compensate them for the extra risks, implies that rates of return on investments in emerging markets are relatively high. The reason for these higher rates of return arises from the fact that so many emerging market business opportunities remain unexploited or very risky as a result of these countries history of restricted market access; poor technological endowment, policy mistakes or political instability. Emerging markets are attractive precisely because they are trying to redress this legacy. Their policymakers are anxious to promote rapid GDP growth in order to tackle poverty and social tensions. Even though domestic savings rates in some emerging markets are relatively high, the investment demand tends to be even higher. The result is a marked tendency for emerging markets to import capital. It is this reliance on external capital that gives emerging markets their reputation for being liquidity-driven and riskier than developed markets; they tend to have shorter economic and stock market cycles. In liquidity-driven stock market booms, GEMs usually rise once liquidity spills over from the developed markets and they are also among the first to fall when this liquidity dries up, as was once again seen in 2011. Higher uncertainty While several emerging markets have stock exchanges that date back to before the Second World War, the majority are much more embryonic and have only been open to foreign investors since the late 1980s or early 1990s. The short period over which these markets have operated poses a challenge for emerging market fund managers that clearly distinguishes them from their mature market counterparts: most of the historic data on stock price movements, valuations, macro-economic and company specific variables are over too short a time period to be much help in analysing trends. In addition, there can be significant settlement risks.
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5. Equities
In developed markets, forecasting assumptions can be quantified in terms of past relationships. In emerging markets the fund manager has to cope with greater uncertainty, whereas in developed markets there is a tendency towards long-term reversion to the mean. At this stage in emerging markets the mean is only just beginning to form history is being made. Until economic variables find their stable long-term trend, many of the financial, political and economic forecasts have to be made on an educated best guess basis. Higher volatility The uncertainty element, together with the reliance on external capital (much of it speculative and short-term) and less developed political, legal and financial infrastructures, make GEMs generally more volatile and subject to swings in investor sentiment which create much larger price movements than in mature markets. Figure 5.14 shows the returns of the best and worst performing emerging equity markets each year over the last 10 years.
Figure 5.14 Best and worst performing emerging market equities Year 2002 2003 2004 2005 2006 2007 2008* 2009** 2010** 2011** best market Pakistan Thailand Colombia Egypt Peru Nigeria Morocco Indonesia Sri Lanka Indonesia usd worst return % market 112.0 143.2 115.4 158.0 82.5 108.3 -17.0 132.7 84.6 0.6 Argentina Zimbabwe Zimbabwe Malaysia Zimbabwe Sri Lanka Russia Nigeria Hungary Egypt usd return % -49.6 -74.8 -66.6 -2.9 -91.6 -3.4 -73.4 -35.4 -10.7 -49.8
valuations, usually translate into higher returns that can be very attractive for charities prepared to take the long-term view. However, in the short-run, there can be significant underperformance, as illustrated in Figure 5.15 which shows the superior returns available from US equities during the late 1990s. Higher Volatility Financial theory stipulates that higher risk should be compensated by higher returns. For actively managed funds, this greater volatility in stock prices can be an opportunity to obtain higher returns (at higher risk) than can be achieved in developed markets. Figure 5.15 clearly shows the boom bust cycles. Asset bubbles (driven by sentiment, liquidity or commodity prices) can create spectacular price appreciation over very short periods of time. They often end in sharp corrections (as witnessed in Asia, Russia and Latin America) as large quantities of short-term speculative (so called hot) capital initially pour into the emerging stock market and then rush out when the sentiment turns sour, and everyone bolts for the exit at the same time.
Figure 5.15 Emerging markets versus S&P 500 Index 1,400 1,200 1,000 Price Index 800 600 400 200 0 1987 1991 1999 2003 Year ends MSCI EMF USD Index 1995 2007 2011
S&P 500 Index
* Zimbabwe and Venezuela indices are discontinued and no data available ** In addition to Zimbabwe and Venezuela, Argentina indices are discontinued and no data are available Source: DataStream from 2007, S&P Emerging Stock Markets Review prior to this. As at end December 2011 Past performance is not an indication of future returns.
Why invest in emerging market equities? Many reasons are cited to justify investing in emerging market equities. The most common arguments are: Higher growth and potentially higher capital appreciation Conventional wisdom suggests that investors in capital hungry and vibrant emerging markets are able to access economic growth rates that are not available in more mature markets. This has been particularly true over the past few years. While Latin America and Eastern Europe, along with developed markets, suffered a pronounced downturn after the 2008 global financial crisis, emerging Asia continued to grow impressively with China, the powerhouse of the region, growing at 9.2% in 2009, 10.4% in 2010 and 9.2% in 2011. These growth rates, together with cheaper company
When such bubbles burst, sellers can drive down prices to low levels, creating tremendous money making opportunities for the active fund manager who is prepared to follow a patient counter-cyclical strategy. However, it should be remembered that while the upside in GEMs can be great, so can the downside and such opportunities should be considered in light of greater volatility. For example, Figure 5.15 above shows both the more marked downturn and subsequent stronger recovery for GEMs vs the US following the global financial crisis in 2008. The best way to reap the benefits of their volatility without incurring unacceptable risk is to invest in GEMs as part of a diversified portfolio. Portfolio diversification GEMs represent a fragmented asset class whose constituents are driven by factors that are often different from those which move developed markets. This feature can be useful in multi-asset portfolio management. By splitting the
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portfolio between mature and developing markets, a charity investment portfolio can obtain an optimal risk/reward mix that maximises return for any given level of risk, thus increasing portfolio efficiency. However, the benefits arising from diversification can be overstated. History shows that the correlations between large and liquid global emerging market companies and their counterparts in mature markets can, at times, be high. These large companies dominate the GEM indices, so the asset class as a whole does not necessarily offer true diversification benefits at all times. How to invest in emerging market equities Most emerging market funds are actively managed. Indexation does not seem appropriate for this asset class, given that the exploitable characteristic is volatility. As a simple example, revisit Figure 5.14 and observe the huge variations in performance of the best and worst markets each year. The core argument for indexation - the Efficient Market Hypothesis - has only a weak basis in the GEM universe. There are a number of reasons why pricing anomalies can persist for long periods in emerging markets: Residual capital controls exist at the national level and create pools of locked-in capital GEM companies are less heavily researched than their developed market counterparts Fewer hedge funds and other arbitrageurs exist to exploit market inefficiencies Accounting standards are of variable quality and future variables are difficult to forecast Furthermore, the components of market indices can vary dramatically within a short time period in these countries. Those that are undertaking structural reforms and privatisation typically see very large step increases in their total market capitalisation as big utilities, such as telecom companies, are privatised. For example, Chinas weight in the MSCI Emerging Markets (Free) Index jumped from less than 0.5% to 6.5% in June 2000 in order to accommodate newly privatised companies such as China Telecom. Conversely, merger and acquisition activity by multi-national companies has, on occasion, dramatically reduced the listed market capitalisation in some markets recent examples include Argentina and Peru. One way of defining an emerging market is as one where the country factor still plays a significant role in determining stock prices. Given the less globally diversified nature of many listed emerging market companies, it is not surprising to find that their stock prices are more closely correlated to their countrys overall economic performance (especially with regard to currencies and interest rates) than their developed market counterparts. Nevertheless, in certain sectors, including information
technology, telecommunications and natural resources, the risk/return calculation is also subject to the growing influence of global sector factors. In emerging markets, the investment methodology adopted by fund managers needs to incorporate both top-down and bottom-up approaches. Indeed, the two processes need to run simultaneously, for three principal reasons: Macro-economic views have stock/sector selection implications. This is especially the case with cost of capital issues and exchange rate assumptions, which impact the balance sheet Because of the forecasting uncertainties referred to above, any assumptions made for a sustainable cash earnings level and growth rate must be iterative. Initially constructed on a purely bottom-up basis, such assumptions must be tested for credibility by cross-country comparison and by comparing return on investment with costs of capital The countrys approach to issues of transparency, accounting standards and minority shareholder rights has major implications for active management. The active manager seeks qualitative insights into pricing anomalies, but latent value can only be realised within the appropriate environment. Who invests in emerging market equities? Virtually all classes of investor are present in emerging markets. Historically, the first entrants were almost always the countrys government and employees of formerly state-owned enterprises who were given equity during the privatisation process. Frequently, in parallel, came foreign strategic investors (like multi-national oil companies) expanding through acquisitions abroad. Foreign retail investors invested heavily into emerging markets in the late 1980s when a myriad of US and some UK emerging market closed-ended funds were launched and marketed to the public. Also, around this time, hedge funds willing to take high risks for high returns established a significant presence and in several cases made fortunes from speculating in this asset class. In so doing, they increased the volatility of the developing currency, bond and equity markets. Charity portfolios investing in emerging markets is now firmly established.
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5. Equities
Equity management
Approaches
There are two broad approaches to equity management, active and passive. Historically, active investment funds have been tasked with outperforming a well-known index such as the FTSE All-World Index. At the other end of the spectrum, passive management attempts to match the performance of an appropriate index by holding shares in direct proportion to the index weightings. Increasingly, active investment funds are developing more absolute return strategies rather than relative returns. This so-called separation of alpha (gains made from active stock selection) and beta (gains made from market rising or falling) enables much clearer delineation of asset allocation and stock selection. There are many variants of active and passive approaches, some of which are outlined below. who was ranked the third richest man in the world in The Forbes Rich List, March 2012. Value investing can be broadly defined as a fundamental long-term approach that seeks to invest in undervalued companies. However, in practice it is often defined more narrowly as an investment style that concentrates on investing in shares with certain characteristics, such as low price-earnings ratios and high dividend yields. In principle, value investors aim to exploit valuation anomalies. As anomalies get bigger due to price falls, the typical value manager will increase his position. In periods of high momentum, investors chase stocks that are performing well can lead to the price mis-valuations getting larger and hence this result in periods of underperformance for value-based investors who have not held these shares. The past few years have presented a difficult period for value-based investors, with this style of investment underperforming growth and momentum factors. However, statistical studies show that over the long-term, value-based strategies tend to outperform, as illustrated in Figure 5.16, and the best returns tend to come to value managers after a period of poor performance.
Figure 5.16 Cumulative return from size and book-to-market portfolios, 1955-2011 100,000 10,000 1,000 100
Active management
Active managers can use a number of techniques to attempt to beat the market. One approach is for investors to make their own assessment of the valuation of a companys share price, and buy and sell shares according to the premium or discount to their perceived fair value. This is known as fundamental investing. In essence, the approach is straightforward although in practice, many fundamental investors fail as identifying mispriced shares is harder than it may appear. Alternative approaches include momentum investing, which aims to take advantage of trends in share price movements. However, this approach tends to incur heavy transaction costs as it often involves holding shares for quite short periods. Many managers aim to combine fundamental investing with momentum and monitor closely both earnings and price trends.
Style
Statistical studies of active portfolio manager behaviour suggest that many managers stick to a particular style of investing. Indeed, many managers are hired on the understanding that they follow a particular style in which they have expertise. Fundamental investing styles can be roughly divided into value and growth. In addition, small company and large company performance can also diverge significantly. It is important to be aware of both style and size effects on performance.
10 1 1955
1963
1971
Small-Value (19.0% p.a.) Big-Value (15.3% p.a.)
1979 1987 1995 2003 Start of year Small-Growth (12.8% p.a.) Big-Growth (10.3% p.a.)
2011
Source: Credit Suisse Global Investment Returns Sourcebook 2011, Copyright 2011 Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns, Princeton University Press, 2002 Note: Index value (mid - 1955 = 1.0; log scale) Past performance is not an indication of future returns.
Value
The concept of Value investing dates back to the teachings of Benjamin Graham at Columbia Business School in the 1930s and the publication of Graham and Dodds influential Security Analysis in 1934. The fundamental concepts of valuing companies and seeking a margin of safety have been the cornerstone for some of the worlds most successful investors, notably Grahams most famous student, Warren Buffett,
Growth
Growth investors seek to identify companies with good prospects for sales and earnings growth which is faster than average rates. Typically, growth stocks enjoy a higher market rating, as measured for example by the price-earnings ratio, than value stocks because they are perceived to have better prospects. The key to successful growth investment is identifying companies with superior long-term prospects which are not already discounted in the share prices of
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Annualised returns from 1955 to 2011 (%)
the companies. Some investors aim to combine a growth approach with a valuation discipline and refer to their style as growth at a reasonable price (GARP). Growth is typically seen to be a complementary strategy to value and many investors seek to blend the two. The combination of a successful value manager and growth manager can help reduce the volatility of returns. While it is generally accepted in academic studies that value strategies work best over the long-term, growth strategies can work extremely well in certain market environments. In 2010, for example in the US, the Russell 1000 Growth Index delivered a return of 15.1% versus 12.8% for the Russell 1000 Value Index and in 2011 the returns were 1.1% and -2.1% respectively (all in USD terms).
Figure 5.17 The small company effect in the UK

20 18 16 14 12 10
FTSE All Share
HGSC
HG Micro Caps
Source: UBS Global Asset Management, Dimson and Marsh Past performance is not an indication of future returns.
Momentum
Momentum investors focus on companies that have a combination of stronger than average earnings and/or price momentum, in the expectation that this trend will continue. Momentum trends can be very strong and are typical of the latter stages of bull markets. The bull market at the end of the 1990s saw very pronounced momentum trends, driven by the dot.com bubble. Similarly, the tail end of the bull market that ended with the beginning of the financial crisis in summer 2007, saw one of the strongest momentum markets in history. Momentum strategies can struggle when a trend is broken. Generally, managers following a momentum approach performed poorly through 2009, but very strongly in 2010. While Momentum outperformed Value in 2011, this style of investment underperformed the broad market, where High Quality was the strongest performing factor.
Underpinning the long-term outperformance of small caps has been faster growth. Investors in small caps can often capture the early stages of new industries as they develop and benefit from the dynamism and entrepreneurial management that is more likely to reside in smaller companies. By definition, it is much easier for a business to grow from USD 5 billion of sales than USD 50 billion. Another key influence on long-term faster growth rates is the different structure of indices; large cap indices are dominated by energy and consumer staples stocks, whereas small cap indices tend to be populated more by consumer discretionary and industrial stocks. However, it is also worth noting a number of potential issues with small cap investing. By their very nature, small company stocks at an individual level can be more volatile and domestically focused. They are typically less liquid and usually more expensive to trade. Small caps also typically have a higher beta so usually suffer more in a falling market, as seen during 2011s downturn. Small caps also have more variable corporate governance with smaller boards and typically, management with a higher financial stake in the business.
Small company equity

Most markets now have small company indices going back many years. The Hoare Govett Small Companies Index, for example, covers the smallest tenth by equity market capitalisation of the UK market, whereas the FTSE All-Share Index covers the vast majority by value of the entire market. There have been many academic studies conducted on the size effect. Pioneering work by Dimson and Marsh in the UK, as shown in Figure 5.17, highlights the substantial long-term premium experienced by small cap investors. Over a unique 57-year history, the data suggest a small cap premium of +2.5% p.a. over large caps; a very meaningful amount when compounded over such a period. To put this into context, an investment in 1955 of GBP 1,000 in the RBS Hoare Govett Small Cap (HGSC) Index (with dividends reinvested) would now be worth GBP 2.9 million, against a total of GBP 0.8 million for an equivalent investment in the FTSE All-Share Index. The data also show that the smaller tier of micro caps performs even better, though liquidity constraints prevent most institutions from exploiting this.
Unconstrained equity investment

One topic that has attracted a high degree of attention over the past few years is that of unconstrained investment. The term can cover a range of concepts but generally embraces approaches that give the fund manager more latitude in choosing investments, either in asset allocation or in stock selection. At the asset allocation level, such approaches usually require managers to achieve a greater degree of strategic diversification and take larger tactical asset allocation views. At the stock selection level, unconstrained investment can mean a variety of approaches. Some seek to address issues of stock concentration within UK equities, for example, by setting either equally weighted or other non-market value weighted equity indices. Others combine the stock selection and asset allocation concepts by looking to achieve positive
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5. Equities
real returns in effect, measuring an equity portfolio against cash. The common thread tends to be an expectation that managers hold a smaller number of stocks and thereby concentrate the portfolio in their most favoured holdings.
Active quantitative techniques

Continued advances in computer technology, statistical investment and trading techniques and databases, have made it increasingly possible to manage funds actively using solely quantitative (i.e. statistics-based) techniques. These can be applied to both asset allocation and stock selection. Since most quantitative techniques, rely to a large extent on an analysis of historic market data to develop profitable strategies, their success is dependent on past features being repeated in the future or, at least, stock behaviour being predictable to a satisfactory degree. As recent experience shows, previously reliable valuation indicators can be misleading if investment fundamentals change permanently or speculative enthusiasm lasts for prolonged periods. This was particularly evident in the summer of 2007 when a sudden change in momentum trends led to an unprecedented collapse in the performance of many active quant funds. This created a shock wave in the confidence of many investors who had hitherto been under the impression that moderate outperformance was almost a given with such funds. Many more traditional UK fund managers are also refining their techniques and are embracing quantitative methods in order to improve the rigour of their investment processes.
For UK equities, a good example of a benchmark used by UK charities is the FTSE All Share Index. This index is often divided into its three major components, based on company size: the FTSE 100, FTSE 250 and FTSE Small Company Index. In addition to its dominant position in the UK, FTSE is also one of the two major providers of global equity indices, along with MSCI. These mainstream indices are generally constructed based on the market capitalisation of the constituents included. Indices are typically adjusted on a free-float basis which means that shares not directly available to the investing public (e.g. those owned by the business founder or held by other companies) are excluded from the index series. Many view indexation as principally a buy and hold strategy. Index funds are largely self-rebalancing until changes in the constituents occur. The growing proportion of shares held by index funds can result in distortions to market prices around the time stocks move into and out of indices because of abnormally high trading volumes. Index tracking funds, in particular, have needed to acquire holdings in new constituents that closely match the benchmark weight and sell holdings in stocks that are leaving the index. Due to an increase in these distortions, index funds now tend to be run on a more pragmatic basis, phasing purchases over a period of time so as to reduce the impact on the share price. Nevertheless, the growth of index funds has had a noticeable short-term impact on market prices in some cases. In recent times, there has been a significant move away from the mainstream indices to non-market capitalisation weighted and other alternative indices as clients and their investment consultants search for superior or less volatile returns. Two of the most popular types of alternative indices are fundamental indices and minimum volatility indices. Proponents of the fundamental indexing approach argue that there is a flaw in market capitalisation weighted indices in that they systematically overweight all stocks trading above fair value and underweight all stocks trading below fair value. Fundamental indexing strategies respond to this perceived construction deficiency by weighting securities by their fundamentals or economic footprint rather than simple market capitalisation. Market prices, which can be prone to speculation, are not components of these indices. This means that the index constituent weights are less affected by market bubbles that can over-expose a passive investor to individual companies, sectors or countries. This, we believe, is a key reason for charities interest in using this type of index. Similarly, minimum volatility strategies have stimulated interest. The attraction is that minimum volatility strategies offer market (eta) exposure but with reduced volatility or limited downside portfolio risk.
Passive equity
Since active funds in aggregate represent a wide crosssection of the universe of investible securities, it is perhaps not surprising that, over most extended time periods, active managers have not, on average, succeeded in outperforming market indices. It has, therefore, been possible to achieve at least average performance simply by investing in the securities that comprise an index. This is known as passive management or indexation and has grown in popularity in recent years. The main advantages are transparency, low costs and predictable relative performance. A number of techniques can be used to run a passive fund. The most straightforward is full replication, which means buying and holding all the shares in the index in the appropriate proportions. Another approach is to hold only a sample of shares that is designed to track the index quite closely. The level of tracking accuracy will reflect the number of stocks held and how closely the sampled fund matches the characteristics of the benchmark index.
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Exchange traded funds Pooled funds have been popular in passive management for many years because of the cost savings inherent in aggregating portfolios with similar objectives. However, the past few years have seen the growth of a new form of commingled vehicle for passive investment such as Exchange Traded Funds (ETFs). These are similar in many respects to open-ended pooled funds, except that the units are traded on a stock exchange in a similar way to shares. Rather than buy units from the manager of the fund, the investor makes purchases in the market at the prevailing price. Investors (and market makers) are assisted by the publication on a daily basis of the net asset value (NAV) of the fund share, which is also updated, on an indicative basis, in real time during trading hours. Unlike most traded shares whose prices can be distorted by imbalances between supply and demand, ETFs have a unique process whereby market makers can create or redeem shares at NAV on a daily basis by in-specie transfers of stock matching the index structure. This ensures that fund shares generally trade close to asset value at all times when the underlying market is open and liquidity in the fund shares is closely linked to the liquidity of the underlying market. For private investors, ETFs provide a viable alternative to index-tracking pooled funds as charges are generally lower. For charities, ETFs represent a flexible and cost effective form of tactical investment, giving the ability to take short positions by borrowing shares and then selling them. The first funds tracked mainly broad-based indices such as the S&P 500 Index in the US. However, most new funds have been of a specialist nature, often providing exposure to specific industry sectors within countries or regions. ETFs therefore, provide a flexible means of undertaking portfolio switching and hedging using listed products without the counterparty risk of the unquoted market or the cost and complexity of undertaking individual stock purchases and sales.
Enhanced indexation In addition to the strong growth in the use of index tracking strategies among charity investment portfolios, there has also been increased interest in enhanced indexation. In enhanced indexation, managers seek to add incremental performance to the index return through a wide range of techniques. The different strategies used by enhanced index managers include seeking to add performance in managing index constituent changes; arbitrage between stocks with similar characteristics; the use of technical analysis to seek to capitalise on recognisable trading patterns; low risk active management based on fundamental analysis, or a combination of some or all of these methods. Enhanced indexation has been a powerful tool in the business models of the giant global passive managers to move clients on very low fees into a higher added-value product, while seemingly giving them the comfort that higher risk still leads to stable returns. Whilst a lucrative development for the managers, the benefit to clients is arguably less clear.
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topic
Pension Fund Indicators 2011 UBS Charity Compendium 2012
Bonds
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6. Bonds
What is a bond?
A bond is a debt instrument requiring the issuer (the borrower) to repay the lender (the investor) the amount borrowed plus interest over a specific period of time.
Figure 6.2 Increasing divergence of peripheral European sovereign yield spreads

1,500 1,200
Basis points
Who issues bonds?

Central governments have been major issuers of bonds, normally in their own currencies, to finance shortfalls in current revenues against current spending and also to finance investment projects. During the 1980s, chronic deficit financing in many countries created a sharp increase in bonds outstanding. With the notable exception of Japan, the 1990s saw a marked reversal of attitudes on the part of governments of developed economies. In recent years, many developed world governments have run increasingly high budget deficits leading to increasing bond issuance; credit rating downgrades, widening yield spreads and increasing levels of debt to GDP (see Figure 6.1). Over the last couple of years there have been many rating downgrades of developed markets sovereigns a trend that is likely to continue over the medium term. This contrasts with relatively robust corporate credit quality, outside the financial sector. Figure 6.2 shows the development of yield spreads for four European peripheral sovereigns since the start of 2010. For certain peripheral European sovereigns this trend has developed to such an extent that they are no longer able to finance themselves independently and have required both financing support and bailouts.
Figure 6.1 Gross government debt to GDP ratio 200
900 600 300 0
Jan-10
May-10
Oct-10
Mar-11
Aug-11
Jan-12
Spain
Portugal
Ireland
Italy
France
Source: Bloomberg Past performance is not an indication of future returns.
As can be seen from Figure 6.3, the UK benefits from a significantly longer average debt maturity profile than many other European sovereigns. This is a result of the well developed long-dated gilt market.
Figure 6.3 Debt maturity profile
100
Debt maturity (% of total)
80 60 40 20 Germany France Italy Belgium Spain Portugal Ireland Greece <10 yr 10yr20yr >20yr 0 UK
150
Source: Bloomberg, UBS Global Asset Management Past performance is not an indication of future returns.
(%)
100
50
0 2009
UK Germany France Italy Belgium Spain Portugal Ireland Greece 2010 2011
Bonds issued by central governments are normally but not always, considered the highest credit quality in each country. Government agencies may also issue bonds. State and local governments also have some power to raise funds via bond issues, again to cover shortfalls in revenue against expenditure but more commonly, to finance capital expenditure. Credit quality can vary widely. Bond issues, other than those by governments issuing in their own currency, are non-government issues, often referred to as credit or corporates. True corporate bonds are those issued by companies. The key feature that distinguishes nongovernment debt from central government debt is a higher level of default risk. The riskiness of the bond is dependent on the issuers ability to pay the coupons and the principal at the agreed times.
Source: Eurostat, OECD Past performance is not an indication of future returns.
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6. Bonds
Credit ratings, assigned by agencies such as Standard & Poors (S&P), Moodys and Fitch, measure the relative probability of an issuer defaulting. These ratings range from AAA through BBB (which are all regarded as investment grade or high quality) and then below this from BB to C (often referred to as sub-investment grade or high yield). Supranational institutions, such as the World Bank, are important issuers across many currencies and, typically, are regarded as very high quality credits.
Credit risk and the growing importance of non-government bonds

Credit risk is a function of the credit quality of the issuer. The key factor distinguishing domestic government bonds from bonds issued by agencies or corporates is that the outright default risk of the former is typically low. Governments have the ability to raise cash to pay coupons and principal either by printing money or by raising taxation. Other issuers, or governments issuing in currencies other than their own, vary widely in their ability to make payments and this is recognised in the credit ratings assigned by the rating agencies. Essentially, the credit ratings provided by agencies such as Standard & Poors, Moodys and Fitch are designed to capture the probability and severity of loss. They provide a relative ranking for the loss probability for a given debt investment in comparison with other rated instruments. The most visible form of loss default is defined as any missed or delayed payments of interest and/or principal, or exchange into a new package of securities. The lower the credit quality of a bond, the greater the premium investors require in terms of a yield spread over the equivalent risk-free (government) bond. Whether this premium is sufficient at the general level can be assessed by looking at historical experience with default, adjusted according to the perceived outlook for the economy and the health of the corporate sector. Default risk is not the only factor for which investors require compensation. Non-government bonds are typically less liquid than government issues, meaning that buying and selling is more expensive. In certain market conditions there may also be a risk that selling bonds in a hurry may be difficult or expensive, or both. Market perceptions of risk may also change, pushing yield spreads tighter or wider with the consequent impact on the current market value of holdings, compared with risk-free assets. Unlike default risk, these more general risks associated with the asset class as a whole are not susceptible to reduction through diversification. .
When looking at non-government bonds as a separate asset class, rather than as an alternative to government bonds, the relevant comparator becomes a non-government bond benchmark. In this situation, holding the universe of nongovernment bonds removes any stock-specific risk. However, full diversification is rarely achievable or desirable, making careful sector and stock selection an important activity. This is pertinent as the risk of default on a bond is actually less than the probability of a rating downgrade, for example, from AA to A. A downgrade can adversely affect the marketto-market value of the bond and the portfolio (although the return if held to maturity is unaffected), unless the market has already factored in such a deterioration in credit quality. Conducting independent internal credit research can be used to reduce the credit migration risk. Within the market, the general pricing of credit risk compared with the government benchmark is typically measured by the swap spread. This indicates the extra yield over a government bond that a good quality bank has to pay to borrow in a specified maturity. It is called the swap spread because it relates to a swap transaction in which a bank pays (or receives) a fixed rate of interest to receive (or pay) the current short-term floating rate. The wider the swap spread, the greater the credit yield premium. Figure 6.4 shows the impact of the rally in developed market bond yields during 2011 on total returns on varying fixed income asset classes. However, to some extent this was reversed in early 2012 as both High yield and investment grade yields spreads rallied following the European Central Banks announcement of funding support for the European banking system.
Figure 6.4 Total bond returns, year to 31 December 2011 Total returns (%) Global government bonds * Global investment grade corporate bonds** Euro high yield***
* Citigroup WGBI ** Barclays Capital Global Aggregate Corporate (USD, EUR, GBP) *** Merrill Lynch Euro High Yield 3% constrained Source: Citigroup, Bank of America Merrill Lynch and Barclays Capital
6.35 4.20 -2.53
Swap spreads have increasingly come to be preferred as a generic indicator of credit conditions. They are not affected by changes to an individual borrowers credit status, as is the case if an actual single bond is used as an indicator. Nor are they affected by changes to average maturity or credit quality, as is the case if a Composite Index of bonds is used. This has led to an increasing use of the swap rate itself as an indicator of the general level of yields and the basis for analysis of value. A BBB- rated corporate bringing a bond issue, for example, might look not at the yield premium over government bonds as the relative cost of borrowing but at the yield premium over swaps.
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The global bond market

Bond markets in developed economies have more than doubled in size over the last ten years. However, until recently, government bond markets have grown more slowly. After very rapid growth of borrowing in the 1980s, most governments in developed economies moved towards a more prudent fiscal policy in the 1990s, operating with lower budget deficits or, in some cases, moving into budgetary surplus. This has now changed given the need by governments to fund the recent extraordinary measures taken to support the global economy. Greater issuance of non-government debt has been spurred by factors such as: Disintermediation whereby borrowers gain direct access to savers through debt instruments, cutting out middlemen such as the banks Securitisation whereby finance for new activities can be raised by asset-backed bonds Privatisation whereby previously government run and funded enterprises are transferred into the private sector Globalisation the increasing openness of capital markets has allowed borrowers wider access to savers across markets Index qualifying securities are bonds that meet the requirements set by providers of bond indices that fund managers are typically measured against. Figure 6.5 shows the size of index qualifying fixed income securities by asset
Figure 6.5 Size of the global bond market (USD bn) 60,000 50,000 40,000 30,000 20,000 10,000 1999 Government 0 2000 2001 Securitised 2002 Corporate 2003 2004 High yield
class from 1999 to 2011, demonstrating how the global bond market has grown over the period. The long-term growth in the non-government sectors is particularly notable. Global bond benchmarks are already coming under close scrutiny as the increasing importance of credit makes inclusive aggregate and corporate benchmarks more appropriate for many clients. Both the USD and EUR high Yield markets have shown substantial growth over recent years, interrupted only during the credit crisis, when high yield bond issuance stopped. In particular the EUR High Yield market has demonstrated a substantial increase in diversification of issuance by companies from different industries and now accounts for approximately 15% of the global high yield market (as at end 2011). As the economic outlook deteriorated during 2008, the yield spreads reached record levels, especially following the Lehman bankruptcy in September 2008. However, from Q2 2009 onwards through early 2011, corporate bond yield spreads rallied dramatically (with yields narrowing as prices increased) resulting in high total returns for both investment grade and high yield bonds. From Q2 2011 onwards the corporate bond market experienced higher levels of volatility, especially in Financials, largely as a result of the continued uncertainty surrounding European sovereigns. Figure 6.6 and Figure 6.7 show yield spreads for investment grade corporate bonds and high yield bonds.
2005 2006 2007 Emerging market debt
2008
2009
2010
2011
Source: Bank of America Merrill Lynch. Amounts outstanding at year ends
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6. Bonds
Figure 6.6 Global corporate bond spreads by industry sector
700
Option-adjusted spreads
600 500 400 300 200 100 0

2007 2008 2009 2010 2011
Despite the increase in the number of countries that can access global capital markets (and therefore, reduce their cost of funding), government bond markets globally are still dominated by a few currencies. Figure 6.9 shows that in 2011 over 80% of the index qualifying government fixed income market was accounted for by issuance in US Dollars, Euro and Yen.
Figure 6.9 Size of the global bond market, developed economies, end 2011 Government bonds* USD billion US Eurozone Japan UK Other Total 12,284 8,372 10,394 1,836 4,773 37,659 % 32.6 22.2 27.6 4.9 12.7 100 Non-government bonds** USD billion 10,353 3,426 548 567 411 15,305 % 67.6 22.4 3.6 3.7 2.7 100
Corporate
Financial
Utility
Industrial
Option-adjusted spread over treasuries for global bond indices Source: Bank of America Merrill Lynch. To end Decembber 2011
Figure 6.7 High yield spreads have seen historic wides
2,500
Option-adjusted spreads
Slowing economy. Default expectations rise Collapse of European telecom market
2,000 1,500 1,000 500

Russian default
Accounting scandals. Possible Iraq invasion. Economic uncertainty
Sub-prime, nancial writedowns
Source: Bank of America Merrill Lynch * Includes inflation-linked securities ** Includes corporates, foreign bonds, FRNs and eurobonds issued by non residents in the domestic country
0 1997 1999 2001 2003 US high yield European high yield
The growth of global capital markets has meant that the governments of many developing countries have also established bond markets. These may be in local or foreign currency, typically US Dollars. The growth of emerging bond markets is discussed later in this chapter.
2005 2007 2009 2011
Source: Bank of America Merrill Lynch. As at end December 2011
During Q4 of 2008, the market for new issues of corporate bonds practically closed down as a result of unprecedented risk aversion by bond investors. However, since then the corporate bond new issue market has reopened with high levels of bond issuance during 2009, 2010 and 2011 across different industrial sectors. For Financials, there was very little appetite for bond issuance in 2011, especially during the second half of the year. Throughout 2011 the primary dealer bond inventory levels further reduced (Figure 6.8). This resulted in liquidity being affected and bid offer spreads being wider compared to previous years.
Figure 6.8 Primary Dealer Positions Corp. Securities due greater than 1 year 250,000 200,000 Value (USD m) 150,000 100,000 50,000 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: Federal Reserve Bank of New York. As at end December 2011
Bond market structures are not uniform. In the US, for example, government bond markets are relatively liquid up to maturities of 30 years while the liquidity in some other markets has been limited to bonds of ten years or less. The price convention, settlement convention and the method of calculating interest, varies from market to market but perhaps more importantly, yields are expressed on a different basis: semi-annual in the US and the UK, annual in many European markets, and on a simple interest basis in Japan. Fortunately, there is little problem in converting yields to show them on a consistent basis.
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Some important bond terminology

Plain vanilla Plain vanilla bonds specify the principal, coupon dates, coupon amount and the redemption date. See Figure 6.10 for definitions. Provided the issuer does not default, the holder of a plain vanilla bond is assured of both the size and the timing of cash flows. Beyond this, there are many other types of bonds with a variety of characteristics.
Figure 6.10 Bond terminology Principal The amount that is borrowed and the value at which a bond is redeemed. This is also called face value or par value. The date on which the principal will be repaid. Fixed amounts of interest payable on pre-set dates. A coupon is usually a fixed percentage of the principal. Dates on which coupons are paid. The price at which bonds are traded after the issue date.
date. Generally, convertibles issued by a government are convertible into another bond with different characteristics after a specified date. Companies may issue bonds that can later be converted into equity. Asset-backed bonds The cash flows of an asset-backed bond are determined and secured by the cash flows of an underlying asset. An example is the mortgage-backed bond; mortgage interest payments made by homeowners are used to pay the coupon on a bond. The structure of such bonds may allow for early repayment, in part or in full, if underlying assets change for example, if borrowers repay their mortgages early. Gross redemption yield A bond is typically valued in terms of its gross redemption yield. This is the rate of interest at which the price of the bond is equal to the total discounted present value of the coupon and principal payments. Yield curve One way of assessing relative value between different bonds is to compare their gross redemption yields, either across issuers and markets or across maturities. If we take bonds issued by the same issuer, then the different yields for bonds of different maturities stem both from investor preferences for different maturities and their expectations for inflation and interest rates over time. A plot of the relationship between yield and maturity is called a yield curve. Upward sloping yield curves have typically been deemed normal. There are several possible explanations for this. Some academics have argued that it is investors preference for liquidity (Liquidity Preference Theory) that has resulted in lower yields for shorter-dated bonds. The Expectations Theory argues that it is actually investors expectations for interest rates that determine yields. The greater the uncertainty in forecasting future inflation and credit risk, the higher the yield demanded by investors as the term increases. The Segmentation Theory states that different investor classes have different preferences and it is the relative demand and supply of bonds in each maturity range that determines yields. Yield curves are not always upward sloping. They may invert (slope downwards) to reflect a situation where short-term interest rates have been set at a level that is perceived to be above the neutral level, in order, for example, to slow economic activity and bear down on inflation. Under these circumstances, investors in longer-dated bonds may be prepared to accept a lower yield because they believe that such a policy will be successful in leading to a lower level of short-term interest rates in the future. Duration Generally, the longer the bond, the higher its duration and the greater the change in price for a given change in interest rates. Duration is expressed in two ways. Macaulays duration
Redemption date Coupon
Coupon dates Price
Variations to plain vanilla Two common variations on the standard plain vanilla bond described above are Floating Rate Notes (FRNs) and Zero Coupon Bonds (ZCBs). An FRN pays a coupon that is re-set at predetermined intervals according to a set formula (for example, the three month interest rate set each quarter). A Zero Coupon Bond does not pay any coupon at all but is issued at a discount to its face value. It is particularly suited to matching liabilities precisely because the risk associated with reinvesting coupon is eliminated. In some markets these can be created from plain vanilla bonds by stripping: a bonds coupon and principal payments are stripped into individual payments so that an investor can buy, for example, just the coupon payment for December 2011. Callable bonds The issuer has the option to redeem a callable bond at par prior to its redemption date. This bond disadvantages the investor and typically pays a higher coupon than the equivalent plain vanilla bond. Puttable bonds The investor has the option to demand the redemption of a puttable bond at par prior to expiry or at a specified date depending on the contract. This is an advantage to the investor and these bonds generally pay a lower coupon than plain vanilla bonds. Convertible bonds Convertible bonds give the investor the right to convert the bonds into something else in the future at a specified
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6. Bonds
is expressed in years and is a measure of the present value of the cash flows of a bond, weighted by the life of each of the cash flows. Macaulays duration, adjusted for the current yield on the bond, gives the modified duration. This measures the percentage change in the price of a bond for a given small change in yield. Figure 6.11 compares the Macaulays duration and the modified duration for two hypothetical bonds. Figure 6.12 shows the sensitivity of the prices of the same two bonds to changes in yield. Note that the price of the bond increases faster when yields fall than it decreases when yields rise. This is called convexity and can be an important feature of bond investment, particularly when yields move significantly. Duration is a key concept because expectations of yield changes will cause investors to select the maturity of their bond holdings accordingly.
Figure 6.11 Macaulays duration and modified duration Bond 1 Coupon Frequency of coupon (per year) Price Redemption value Number of years Internal Rate of Return (IRR) Macaulays duration Modified duration
generally referred to as the credit spread. It follows that the general level of bond yields changes for three reasons. First, as investor expectations for inflation move. Second, as concerns about uncertainties vary. Third, as investors are willing to, or are forced to, accept different levels of real yield. Determining whether yields are at an appropriate level or are likely to move in either direction is, therefore, dependent on an evaluation of the appropriate levels of: Real yields The inflation outlook and inflation expectations, and Risk premia Interest rate risk This is critical for bonds that pay fixed coupons. If general interest rates (and therefore, yields) rise, investors are worse off as they have fixed interest receipts at a lower rate than is now available. Different types of bonds and borrowers have varying sensitivities to changes in interest rates, as measured using duration, which was discussed earlier in this chapter. Exchange rate risk Factors, such as inflationary trends, budgets and monetary policy affect all bond markets but do not operate uniformly across different countries. This was amply demonstrated during 1992 when the US and UK were easing monetary policy at the same time as Germany was pursuing a continued tight monetary policy in the aftermath of unification. The performance of bonds varies over time from country to country because economies worldwide tend, at any time, to be at different stages of the economic cycle. The desire to invest beyond an investors domestic base needs to be carefully considered, particularly as two separate decisions need to be addressed: the bond decision and the currency decision. For the bond decision, the selection of the individual bond is frequently less important than the market or country. There are a variety of factors that influence the level of long-term interest rates and hence bond yields. In different economies, it does not follow that the highest nominal yield represents the best value. By adjusting the nominal yield by the prospective inflation rate to produce a real yield, a useful first step is provided in evaluating international bond markets. While this method of valuing markets is useful, it cannot be the final determinant of whether to invest or not. There must be a full analysis of the country in question to determine whether the economic and monetary fundamentals, and hence the risk, are matched by the yield. Having made the decision to invest in an international bond market, a separate decision then needs to be made regarding the currency position. Essentially, there are two choices. First, to hedge the total cost of the international asset back into the investors base currency through the forward foreign exchange
Bond 2 5 1 100 100 30 5% 16.12 15.35
5 1 100 100 5 5% 4.55 4.33
Figure 6.12 Bond price sensitivity to changes in yield Change in price Change in yield +3% +2% +1% +0.5% 0% -0.5% -1% -2% -3%
Bond 1 -12.0% -8.2% -4.2% -2.1% 0.0% +2.2% +4.5% +9.2% +14.1%
Bond 2 -33.8% -24.8% -13.8% -7.3% 0.0% +8.1% +17.3% +39.2% +67.2%
Value in bonds Charities concerns with the real return on their assets mean that nominal bond yields include compensation for expected inflation and an expected real return. There is also likely to be some form of risk premium. This allows for the uncertainty about the future, typically in respect of inflation on government bonds. It also allows for default and event or liquidity risk on corporate bonds. This latter element is
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market (i.e. cover the currency risk). Second, to leave the international asset unhedged. The decision will be influenced by the outlook for the currency. Inflation risk Conventional bond coupon and principal payments are fixed in nominal terms. Inflation erodes the real value of these payments and represents the most serious threat, other than default, to the value of bond investments. Governments that allow inflation to develop can be regarded as defaulting by stealth, even where they honour the actual payment schedule on their bonds. Inflation risk can be significantly reduced by investing in inflation-linked bonds (index-linked in the UK, Treasury Inflation Protected Securities in the US) which have their coupons and final redemption amount fixed in real terms. In other words, the coupon and redemption amount are increased by a specified measure of inflation experienced during the bonds term. Figure 6.13 sets out a comparison with a hypothetical conventional bond. Both governments and corporates have issued inflation-linked bonds but the corporate market is small and liquidity can, therefore, be difficult. The motivation to issue bonds that protect investors from inflation stemmed from the 1970s experience of very high inflation. This had led investors to demand exceptionally large risk premia against the risks of future inflation.
Figure 6.13 Comparison of inflation-linked and nominal bonds Inflation-linked bond Assumptions Fixed coupon Inflation per annum Life of the bond Coupon frequency Face value Internal rate of return (IRR) Modified duration Cash flows/periods 0 1 2 (coupon) 2 (principal)
Risk premia Compared to conventional bonds, inflation-linked bonds do not require a risk premium for inflation exceeding expectations. However, risk premia for default risk or rising real yields are still relevant. Liquidity premia can also be significant when markets are newly established or very small compared with their fixed interest equivalents. Break-even inflation When comparing a conventional bond with an inflationlinked bond of similar redemption date, the rate of inflation that equalises the return on the two securities can be calculated. This is known as the break-even inflation rate and should provide an indication of the level of inflation expected by the market. It is most unlikely that inflation will turn out exactly at the rate implied by market levels. If inflation proves to be higher than the break-even rate, the inflation-linked bond provides the better return; if inflation is lower, the conventional bond outperforms. Inflation-linked bonds have been issued in the UK since the early 1980s. Other governments notably Australia in 1985, Canada in 1991, Sweden in 1994 and France in 1998 have issued inflation-linked securities but as Figure 6.14 demonstrates, only the US and France have come to rival the UK market in size. The US established a market in Treasury Inflation Protected Securities (TIPS) in January 1997, the equivalent of UK index-linked gilts. Since then, there have been several auctions and new issues, covering a wide range of maturities.
Figure 6.14 Size of inflation-linked bond markets Market value (USD billion) Canada France Germany Greece Italy Japan Sweden US (TIPS) UK (Index-Linked gilts)
Source: Barclays Capital as at 31 December 2011
Nominal bond 5.1% 2 years annual 100 5.1% 1.86 -100 5.1 5.1 100
2.5% 2.5% 2 years annual 100 5.1% 1.88 -100 2.56 2.63 105.07
Number of issues 6 12 4 0 9 16 6 31 19
61.7 213.0 72.1 0.0 113.3 54.0 35.6 718.1 520.9
Inflation-linked bonds reduce the risk of unanticipated inflation to an investor. This has two important consequences. First, investors are confident of maintaining the real value of their investment and lock in a real return. Second, there is no risk premium for unanticipated inflation and, therefore, the cost of borrowing for the issuer may be lower. However, the issuer does give up the potential for inflation to erode the real value of its obligations.
The development of the TIPS market was accompanied by the opening of a substantial yield premium over index-linked gilts although actually TIPS were issued initially at a yield discount. This highlighted the new opportunities for actively managing inflation-linked securities in an international context. Volatility in the real yield spread means such opportunities will continue to ebb and flow.
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6. Bonds
Emerging market bonds

Definitions International investors can access bonds from over 50 countries that are classed as emerging markets. Many of these countries have liquid markets for bonds denominated in US Dollars or another international currency such as the Euro or Yen. A smaller number, around 30 countries, also has growing local currency bond markets through which investors can get exposure to both local yields and currencies. Due to the longer history of USD bonds, the majority of investment is still in US Dollar-denominated emerging market bonds. Despite this, investors are becoming increasingly focused on domestic market investments. This shift in interest is partly based on historic performance that exhibits a low correlation to other asset classes and attractive risk-return profiles. In addition, access to the markets became easier due to the ongoing improvement in liquidity and transparency as well as a better developed capital market infrastructure. The emerging market universe covers a broad range of countries in terms of economic and market development. The most widely used USD denominated emerging bond index is the JP Morgan Emerging Markets Bond Index Global (EMBI Global). The EMBI Global contains the most liquid US Dollar denominated sovereign and quasi-sovereign securities; the total market value of the EMBI Global was around USD 417 billion at the end of 2011. The EMBI Global index includes countries with a low or medium per capita income (as defined by the World Bank), as well as those countries that have restructured their debt within the past 10 years or have outstanding restructured debt. As such, the country inclusion methodology used by the EMBI Global is income-based and risk-based rather than rating-based. The underlying principle for this is that emerging countries, irrespective of their credit rating, share similar risks. In contrast, other index providers, such as Merrill and Barclays Capital, have created emerging debt benchmarks that include countries strictly on the basis of credit rating (BBB-\Baa3 or lower). Given the large number of countries, it is useful to think of the emerging world in regions. These are Latin America, Eastern Europe, Asia, the Middle East and Africa. Among them, Latin America boasts around 45% of the total market capitalisation and is one of the largest and most liquid bond markets. In 2006, JP Morgan created a new local Currency Index family for the domestic markets, which includes bond, denominated in local currency. These indices are calculated in the same format as the JP Morgan Global Bond Indices for developed markets. The most diversified index includes 19 countries/currencies with a market capitalisation of approximately USD 1,383 billion, at the end of 2011. So this market value is already more than three times larger than the EMBI Global Index and underlines the importance of this still young market segment.
Who issues emerging market bonds? Governments are usually the biggest issuers. Quasigovernment institutions, like PEMEX in Mexico, are also major players in many countries. Corporate issuers, albeit on a smaller scale, complete the group of bond issuers in emerging markets. There are some important points to be made with regard to these bond issuers. The creditworthiness of emerging countries governments is less uniform than that of developed countries. Rating agencies such as Moodys and Standard & Poors play an important role as they assign credit ratings to the local and foreign currency bonds of emerging market governments. With regard to corporate issuers, their debt tends to be denominated in US Dollars. Those with an international presence have been able to tap international capital markets and access cheaper and more regular funding than that available through traditional bank borrowing. This sector is still relatively young but fast growing, and offers exciting opportunities for investors who are willing to spend time identifying value. Types of emerging market bonds There has been investor interest in emerging market bonds for decades, although concerns about structural and debt problems among the issuers in emerging markets kept these securities outside the mainstream. This changed with the Brady Plan, where the resulting bonds were an important catalyst for the acceptance of emerging market debt in more traditional portfolios. The Brady Plan, created by US Treasury Secretary Nicholas Brady, was a response to a series of bank loan defaults by developing countries in the 1980s. These defaults had negatively affected the global financial system, as they had forced a number of US and foreign commercial banks to write down the value of their assets. The Brady Plan, narrowly defined, was an innovative debt renegotiation format, whereby defaulted sovereign bank loans were written down and converted into bonds. More broadly, however, the Brady Plan also encompassed an entire set of economic policy prescriptions that developing countries adopted in order to receive additional international aid. This aid, in turn, allowed the participating countries to meet their obligations under the Plan. The Brady Plan differed from previous approaches in a number of respects, among other things the underlying structural problems of the debtor countries (such as protected markets and controlled prices), were addressed for the first time. Also, the commercial banks loans to private and sovereign entities were transformed into sovereign bonds, which thus enhanced their appeal to investors. Another important feature of the plan is that the terms of Brady bonds vary. Most bonds were issued with a final maturity of between 10 and 30 years and have semi-annual coupons, and many have amortising principal payments. Coupons may be
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fixed, floating, step-up or a hybrid combination. Moreover, unique characteristics, such as principal collateral, rolling interest guarantees and value recovery rights, were added to Brady bonds in order to improve creditworthiness and attract investors. As of today, the majority of Brady bonds have matured. Therefore, the importance and weight of Brady bonds in Emerging Markets debt indices went down over time and is now at around 6% only. Eurobonds are the other major type of emerging market bonds. Eurobonds are internationally issued securities denominated in hard or to a lesser extent- local currencies. Most eurobonds have a fixed coupon and a defined single maturity. As a portion of trading volume, euro bonds now make up the largest portion of the US Dollar denominated emerging debt market. The importance of euro bonds will continue to be high because new debt is raised as euro bonds, and, because countries have been opportunistically exchanging Brady debt for euro bonds. Exchanging Brady bonds for euro bonds is attractive if a country can issue euro bonds at lower yields than those of existing Brady bonds, thereby reducing the cost of servicing the outstanding debt. In some cases, countries have chosen to exchange Brady bonds for euro bonds simply to receive shortterm cash flow savings through lower coupons/amortisations, or to release the treasury collateral backing certain Brady bonds. Outstanding volume and trading volume of euro bonds have been increasing significantly over the last few years. Local currency denominated bonds are mainly issued under domestic law. These bonds often provide the most attractive financing source for the issuers for two reasons: Risk premia mainly depends on domestic yield developments As these bonds are issued in their own local currency, currency risk is eliminated from the issuers point of view Due to strong fundamental improvements over the last 4-5 years, many emerging market countries used their reserves to buy back USD denominated debt while issuing domestic bonds. This was only possible as these governments were able to raise cash mainly from domestic investors, i.e. pension funds, insurance companies etc. Given the attractiveness of the markets also for foreign investors, an increasing amount of capital has been flowing into local currency bonds from abroad as well.
Performance of emerging market bonds Emerging market bonds do not have a long return history. However, to get an indication of the returns we have created an Emerging Market Debt Index (EMD Index) by using the JP Morgan EMBI Index returns from 1991 to 1993, and the JP Morgan EMBI Global index returns from 1994 to 2010. The Emerging Markets Bond Index (EMBI) was the predecessor of the EMBI Global Index. Since 1991, emerging market bonds (adjusted for defaulted securities) have shown a return of 14% p.a. This compares with an average annual return for US treasury bonds of 8.25% p.a. over the same period. The excess return in the bonds comes with higher volatility because of the inherent risks associated within investing in emerging market bonds have an average volatility of 11.2% p.a. (for the period 1991 to 2011), compared to US Treasury bonds at 5.75% p.a. Figure 6.15 shows how the Tequila Crisis in Mexico in 1994, and the Russian and Brazilian crises in 1998, resulted in negative returns in those years. At times the market is more resilient and, despite the Argentine crisis in 2001, the return of the overall market in 2001 was positive. The last negative return in 2008 was due to the global financial crisis. Whilst this crisis was not triggered by any country specific credit event, emerging market bonds were hit hard by increasing investor risk aversion. However, 2009 posted a significant return due to a stronger economic environment in Emerging Markets countries and a significant recovery.
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6. Bonds
Figure 6.15 Emerging market USD denominated bond return history Annual return % 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Average 1991-2011 % p.a. 38.8 7.0 44.2 -18.3 26.4 35.2 11.9 -11.5 24.2 14.4 1.4 13.1 25.7 11.7 10.7 9.9 6.3 -10.9 28.2 12.0 8.5 13.7 Volatility % 8.6 6.4 8.9 21.9 16.8 12.2 14.6 32.0 12.4 10.2 10.2 13.5 8.2 8.6 5.5 5.7 4.5 19.1 7.1 6.8 4.7 11.2 Spread (bps) 751 635 687 751 1209 724 438 795 861 651 792 629 454 346 343 171 255 724 294 289 426 567
Figure 6.17 shows the yields and sovereign spreads for some key emerging market bonds. The spreads vary, thus providing opportunities to outperform indices through active management. The term spread is a measure of the yield on a bond expressed in excess basis points (100ths of one percent) above the yield on a benchmark bond, such as a US Treasury. For example, at the end of December 2011, the yield of the Brazilian Government bond (due to 2040) was 8.04%, giving it a spread of 567 basis points (bps) over a similar-maturity US Treasury bond yield of 2.37%. This spread can be interpreted as a measure of compensation for accepting the higher risks and, by extension, value, which exists between the Brazilian Governments 2040 bond and an equivalent US Treasury security.
Figure 6.17 Emerging market bond spreads at end 2011 Bond* Argentina Discount Brazil Euro Colombia Euro Indonesia Euro Mexico Euro Panama Euro Peru Euro Philippine Euro Russia Euro Turkey Euro Venezuela Euro 8.28% 2033 11% 2040 11.75% 2020 7.75% 2038 8.3% 2031 9.375% 2029 8.75% 2033 9.5% 2030 5% 2030 6% 2041 9.375% 2034 Spread (bps) 973 567 205 263 205 209 236 267 309 379 1,179
As at end December 2011 Past performance is not an indication of future returns.
Figure 6.16 Emerging market local currency denominated bond return history Annual return 2003 2004 2005 2006 2007 2008 2009 2010 2011 Average 2003-2011 % p.a. 16.9 23.0 6.3 15.2 18.1 -5.2 22.0 15.7 -1.8 12.2 Volatility 7.2 8.6 7.0 10.4 8.2 20.4 14.9 11.4 14.0 11.3 Yield (%) 6.9 6.9 6.7 6.7 7.6 7.4 7.3 6.7 6.6 7.0
Source: JP Morgan * For bonds with variable coupons, the table shows only the most recent coupon
Finding value in emerging market bonds Value in emerging market government bonds can be identified through a quantitative and qualitative analysis. Therefore, the countrys ability and willingness to pay back its debt is monitored constantly. Historically, a variety of factors have been responsible for both crises and recoveries. The Mexican crisis, for example, was precipitated by a highly indebted government sector, while the crisis in Asia was triggered by poor regulation and problems within the private sector. Among bonds denominated in US Dollars, or other hard currencies, investors are interested in the governments ability to service external debt, which also requires the ability to generate foreign exchange. The capacity to do so will eventually be reflected in the spread.
As at end December 2011 Past performance is not an indication of future returns.
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Some of the key items that are useful in valuing external debt are: The level of external indebtedness, both in the private and public sector. This should be compared to exports and the ability to continue to raise debt in international capital markets The level of overall government debt The openness of the economy competitiveness of exchange rates, the development of the export sector and the level of import competition Politics The size of the economy and access to international agencies such as the IMF The state of the world economy and the demand/supply balance for commodities The investment decision making process in domestic markets requires not only the detailed fundamental analysis of the issuer but also additional factors have to be taken into account. Expectations for local interest rates, domestic inflation or the valuation of the currency itself can be important drivers of the overall total return. In general, local rates in emerging countries are determined by the same factors and data as for developed markets and will be analysed in the same way. The local currency can be seen as an additional source of return and should, therefore, be analysed as an asset class in its own right. The challenge in evaluating emerging market currencies is the result of their relatively short history as, in the past, many of these currencies were managed, linked or pegged to another currency. Long-term currency models, such as Purchasing Power Parity (PPP), have only limited expressiveness. Other factors for emerging market currencies include the value of a currency, carry to risk, basic balance or expected real rate. All of these factors should be taken into account.
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topic
Real estate
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7. Real estate
What is real estate?
For charity investment purposes, real estate usually refers to the commercial sectors of office, retail and industrial (including logistics) and the leased (rather than owner occupied) residential real estate sector. The types of real estate that constitute the investable market vary from country to country as do their financial characteristics. In most countries, investment in the three main commercial sectors can be found. Investment in the residential sector is less common, but where available it serves as a critical sector. In the UK, investment in the residential sector is very low but in the Netherlands, the US and Switzerland, for example, it is relatively high. Owning real estate not only buys the physical asset and the rights which have been granted to the land on which that asset is developed, but also it buys a right to the future income stream from that land and/or building. As a landlord, the right to these future income streams is governed by a lease with a tenant. The value of an asset reflects a number of key factors: Expected income growth The risk related to income growth Tenant default risk Liquidity risk Management costs Real estate valuers, or appraisers, typically reflect these factors in a yield, or capitalisation rate (cap rate), which is used to capitalise the current and expected future income streams. In the UK, real estate valuers are usually members of the Royal Institution of Chartered Surveyors (RICS). In the US, an external appraisal is performed by a Member of the Appraisal Institute (MAI). Other countries also have similarly qualified professionals to undertake valuations. Looking at the factors above, real estate can offer a range of investment characteristics with different risk levels. At the lower end of the risk spectrum is core real estate investment which is focused on predictable income streams available from high quality tenants. Risk is reduced when a building is already operational and generating income. Riskier strategies that aim to improve existing properties are commonly referred to as value-added and opportunistic. Often, with these types of strategies, lease lengths are shorter and tenant covenants less secure than those of core properties. The most risky investment strategies include real estate development, which involves new buildings being delivered to the market, and purchasing distressed property or debt at discounted values. As is evidenced by the range of investment styles available, real estate income streams can also be cut in many ways, offering investors a wide spectrum of risk/return possibilities.
Gaining exposure to real estate

Private and public equity real estate There are two broad ways to gain exposure to real estate: Through the private market by direct investment or by indirect investment in unlisted funds or a fund of funds. Through the public market by indirect investment via real estate company shares or Real Estate Investment Trusts (REITs). It is important to note one major distinction between these two routes; price and valuation. Publicly traded real estate company shares and REITs can be traded instantaneously on a stock exchange. While the underlying assets are properties, the shares do not typically trade at prices which are the sum of the individual properties prices, net of liabilities (e.g. debt), known as Net Asset Value (NAV). Share prices can reflect substantial discounts or premia to NAV since investors are not only buying the properties but also the management teams abilities and strategy, and will independently assess the value of the assets in the company. In contrast, the private market operates on valuations of assets. Valuations are estimates of the price at which an asset might trade and can be above or below a realised price. In commercial real estate markets, the lack of information available on transaction prices has led to the construction of indices based on regular valuation of a sample of properties. The price of units in unlisted funds is based on these valuations and trading takes place at NAV (often with a bid/offer spread to reflect the cost of acquiring and disposing of the underlying assets). Accessing commercial real estate markets via private and public routes each brings with it advantages and disadvantages. These are summarised in Figure 7.1. The decision on which way to invest is a series of trade-offs. For example, direct investment in properties brings with it control and undiluted income (in the sense that there are no fees to be paid to a third-party manager) but because the sums involved in buying real estate are large, the formation of a diversified portfolio requires a large allocation and significant management time. In contrast, gaining exposure via real estate company shares or REITs can be a low cost option to acquire diversified real estate exposure, access expert management and benefit from the divisibility of the sum invested by owning shares. However, shares in real estate companies can often mean exposure to debt via leverage in the company and volatility more akin to the wider stock market than the underlying property assets. However, it has been shown that holding publicly traded shares over the long term can deliver a similar return profile to holding direct real estate, after accounting for public versusprivate pricing issues and leverage. Somewhere in the middle of direct investment and public markets lies the unlisted fund route.
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Figure 7.1 Gaining exposure to real estate Example investing GBP 250m Private Unlisted Funds Route Direct Single Fund Manager / Fund of Funds Public Listed Securities
Number of properties
1 to 50
10 to 500 Trade-os
100 to 5,000
30,000+
High
Income Control Specic risk Management time Cost Liquidity Divisibility Diversication Leverage Volatility High
Source: UBS Global Asset Management, Global Real Estate Research and Strategy
Unlisted funds may be close-ended or open-ended. Openended funds raise and redeem capital on a regular basis, providing some liquidity to investors. Open-ended funds typically have an infinite life. In contrast, close-ended funds raise capital, close and then invest. Close-ended funds typically have a limited life. In some markets, there is an active secondary market for buyers and sellers of interests in close-ended funds to arrive at effective and transparent pricing. The platforms to facilitate this are most developed in the US and UK with Europe and Asia lagging behind. Unlisted real estate funds offer a balance between volatility and liquidity, though not all investors may be eligible to invest in them or find them tax efficient, especially when investing cross-border. Nonetheless, they can enable an investor to access unitised real estate vehicles which come in many shapes and sizes; from those investing in a single asset to multi-billion dollar funds investing globally. In this way, charities can choose a single fund with broad exposure, or can concentrate their portfolio in specific funds allocated to particular sectors or styles of investment. As discussed above in general terms about real estate investing across the risk spectrum, the style of an unlisted fund can also be classified as core, value-added or opportunistic. While these styles have been defined by various market participants, there is no single global definition of what constitutes a core, value added or opportunistic fund. Broadly, styles relate to the classification of a funds risks. There are effectively three layers to a funds risk profile: the risk related to the individual assets (specific risk); the geographical and sector diversification within the fund (market risk), and the level of leverage (debt as a percentage of gross asset value) used. Taken together, these layers combine to determine a funds style, so not all funds with zero leverage can be considered core.
Some examples are useful here. A GBP 5 billion fund which invested in stabilised assets across the retail, office and industrial sectors, in a mix of core European countries with no leverage, would be widely considered a core fund. At the other extreme might be a fund developing five office properties in Moscow, with leverage of 75% this would commonly be viewed as opportunistic. In the middle are value-added funds which may take leasing and refurbishment risk but typically would not undertake ground-up development or at least would seek to limit such exposure. Another investment route is via fund-of-funds, or multimanager investments. Here, rather than investing directly, a portfolio of unlisted funds is selected by a manager and actively (re-)positioned. This removes the risk of being exposed to a single fund (or manager) but typically adds a layer of fees in recognition of the managers ability (and direct time costs) to select and carry out due diligence on funds which are assessed to offer good risk-adjusted returns for a particular strategy. The fund-of-funds approach has grown in popularity in the last five years such that individual unlisted funds may have a high proportion of their investors from such fund-of-funds. Outcome-oriented funds Outcome-oriented funds are relatively new to real estate investment but are growing in popularity as investors focus on liability matching. These funds typically target inflation, for example, plus x% or government bond yield plus y%, whereas typical real estate benchmarks are market based, similar to those for equity markets. These types of funds rely upon extracting specific elements of value from the various components (capital return and income return) which contribute to an assets total return.
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Real estate derivatives

A recent development in the UK real estate market, following several false dawns dating back to the 1990s, is the availability and use of derivatives, usually in the form of a total return swap or forward contract. These derivative contracts are written against published real estate indices (IPD) and should give investors the ability to sell or buy exposure to markets. Derivatives can also adopt a funded format where the real estate derivative is embedded into a bond or note structure called a Property Index Note (PIN). The cash flows of these bonds are structured in a way that is designed to be similar to a transaction in the physical asset. Figure 7.2 shows that the volume of trades averaged around GBP 1.2 billion per quarter between 2004 and 2009 with the UK dominating activity. Since 2009 though, the volume of trades has fallen back to around a third of these levels as investors have become cautious over pricing, volatility and limited liquidity in the market. A limited number of sector level swaps have also taken place, where one party may wish to decrease office exposure in favour of the retail sector for instance and the other take the counterparty position. The UK has the most established real estate swap market but Investment Property Databank (IPD) indices are also used in a number of other countries such as Australia, France, Germany, Italy, Japan and Switzerland as the basis for commercial real estate derivatives. A variety of indices are used in other markets, such as the US.
Figure 7.2 Total notional trades by the IPD total returns market by country (GBP m) 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500
2004 Q1 2005 Q2 2005 Q3 2005 Q4 2005 Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009 Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011
as smoothing. Smoothing bias those statistics which are of use to asset allocators in real estates favour, including the average return (mean), the volatility of that return (standard deviation), the relationship of these returns between sectors and countries, and the relationship of these returns with the returns from other asset classes (correlation). Whilst this bias is almost certainly present, those who have used adjusted data to account for the smoothed valuations find that the resulting allocation to real estate, whilst diminished, is still not trivial and that the same benefits remain but the extent of these benefits is lessened. That said, real estate is typically combined into a multi-asset portfolio for the following reasons: Diversification Using data from the UK, Figure 7.3 provides some historic data on the correlations across the main asset classes. With correlations well below one, and negative for the relationship between UK real estate and UK gilts, the addition of real estate to a portfolio of equities or bonds can lower the portfolios volatility and provide a potential higher return per unit of risk.
Figure 7.3 Correlation between UK real estate, equities and bonds, 1997 -2010 UK property UK property UK equities UK govt bonds UK inflation 1.00 UK equities 0.62 1.00 UK govt bonds -0.19 -0.34 1.00 UK inflation -0.11 -0.19 0.53 1.00
Source: IPD, NCREIF, UBS Global Asset Management, Global Real Estate Research and Strategy Correlation: Statistical measure of the linear relationship between two series of figures (e.g. performance of a security and the overall market). A positive correlation means that as one variable increases, the other also increases. A negative correlation means that as one variable increases, the other decreases. By definition, the scale of correlation ranges from +1 (perfectly positive) to -1 (perfectly negative). A correlation of 0 indicates that there is no linear relationship between the two variables.
UK
Source: IPD
France
Germany
The level of diversification available depends upon the route used to gain exposure to real estate. The public real estate markets are more correlated with the performance of the wider stock market than private, unlisted vehicles and so offer lower levels of diversification (at least over short holding periods). The addition of leverage to a portfolio will also increase potential volatility. Relatively high and stable income return capital return linked to economic growth A particular feature of real estate, and of particular significance to charities, is the high proportion of total return which is derived from income return (i.e. contractual rental payments) over the long-term. As shown in Figure 7.4, the expectation is that over the long-term core real estate will deliver the majority of its total return (80%) from income return with the minority share (20%) attributable to capital growth. This reliance on income return, which is far more
Key benefits and challenges of investing in real estate

Benefits In order to assess the merits of investing in real estate, it is necessary to conduct analysis using published real estate indices. This brings with it various issues related to the way in which real estate indices are compiled from valuations rather than prices taken together these issues are known
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stable and predictable in terms of cash flow expectations than capital growth, is attractive to income focused charities. It can be shown that investments which are less reliant on capital return are generally less volatile than those which are more reliant on capital return.
Figure 7.4 Proportion of total return from income expected in long-term
US
result in exceptionally large hypothetical allocations to real estate due to the issues of smoothing discussed above, which should be viewed with caution. To compensate, estimates of real estates volatility are often adjusted upwards in an asset liability model (ALM) framework. The resulting hypothetical real estate weight in the multi asset portfolio falls but to a range of around 12% to 20%, depending on the assumption used for liabilities. Real estate companies securities and REITs tend to display a far higher degree of volatility than the published private real estate indices, not least because they are publicly-priced. Challenges of investing in real estate The main concern for those investing in real estate is the lack of liquidity of the sector; the ability to turn an asset into cash or the ability to turn cash into the asset. For assets which are relatively illiquid, investors tend to demand an illiquidity premium for holding that asset. This means that holding real estate, potentially, should deliver a higher return than cash, if only because of the inability to convert real estate instantaneously into cash (and by implication into other asset classes), and vice versa. Real estate tends to suffer from two sources of illiquidity. First, is that induced by a mismatch between price and value and, second, the delays inherent in the purchase and sale process. Fundamentally, liquidity is a function of price. In a market which relies upon valuations as a proxy for price and in periods where values and prices depart from one another considerably, liquidity is likely to be impaired. This issue is particularly prominent in a downturn, where valuations may lag prices due to a lack of transactional evidence and investors may be reluctant to sell at prices that differ significantly from the last valuation. In markets where prices and values do not depart considerably, trading can take place in a reasonable time frame. In periods of market stress or dysfunction, it will typically take longer for investors to buy/sell an asset or to enter/exit a fund. Real estates lack of liquidity is most often mentioned during periods of credit stress when investors are looking to reduce their exposure to the sector. However, as compensation, an illiquidity premium should be earned for money being locked up. As discussed previously, listed REITs or real estate companies can offer far higher levels of liquidity but at the expense of greater volatility and a closer correlation to the wider stock market.
UK
Eurozone
Australia 0 20 40 60 80 Percentage of total return from income return 100
Source: UBS Global Asset Management, Global Real Estate Research and Strategy. Chart is for illustrative purposes only and refers to long-term equilibrium assumptions for core, unlevered real estate. As at e nd December 2010
Nonetheless, as economies expand, the accompanying increase in the demand for real estate space drives rental levels higher, which is partially reflected in capital return. Figure 7.5 shows the contemporaneous and positive relationship between real estate capital returns and GDP growth across the developed economies.
Figure 7.5 Real estate returns and GDP Growth (%), 2001-2010 10 5 Total return (% p.a.) 0 -5 -10 5 3 1 -1 -3 GDP Growth (%p.a.)
-15 -5 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Global real estate capital returns (LHS) Developed economies GDP growth (RHS)
Source: IPD, UBS Investment Bank
Global real estate investment

Across the globe, the conventional practice of real estate investment has been to first invest in the domestic real estate market. This by no means implies that investment has been exclusively domestic but there has been an exceptionally high home-bias for the majority of real estate investors. Real estate is different across the globe and subject to different
Relatively low volatility Looking at the published private real estate indices, such as those created by IPD and the National Council of Real Estate Investment Fiduciaries (NCREIF), the volatility of real estate appears low compared to that of equities and bonds. Using unadjusted historic estimates of real estates volatility can
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risks and local practices. This has created a deterrent to those wishing to invest in non-domestic markets (beyond just currency risk and tax issues). The starting point for those investing outside their domestic market has been to demand a premium over their domestic market, whether this is appropriate or not. Typically, this has resulted in those wishing to invest out of their domestic market accepting risks that they might not choose to take on locally. This approach is changing, as global real estate investment is now more accessible and better understood. Benefits of global real estate investment Investing globally in real estate opens up a set of opportunities at four key levels. Wider opportunity set For smaller countries, the available domestic investable stock, by definition, is limited. This can result in a strong under writing of demand supporting valuations, often putting the market at risk of over valuation. For such investors, by investing non-domestically, the size of the investible market can be increased considerably. For example, the size of the global real estate market is approximately USD 12 trillion with Europe and the Americas markets representing 35% and 36% of the invested universe, respectively, and Asia at 29%. Non-domestic investment opportunities of the same style as might be invested in domestic markets can usually be found elsewhere across the globe with a similar risk/return profile. Broadening the investment horizon for real estate investment can open up a wide set of opportunities beyond simply investing in other countries and expands the stock of properties available for investment. The most apparent of these opportunities is that, in a number of countries, charity investment in the residential sector is not only possible but can form the main part of a countrys real estate market. Other such sector opportunities might be hotels, retirement homes and student accommodation. Beyond the sectors available for investment, styles of investment can be different in different markets. For example, developed market investors are increasingly attracted to the higher growth prospects available in many emerging market countries. Diversification Beyond simply widening the opportunity set, investing on a global basis can provide powerful diversification benefits. This is shown in Figures 7.6 and 7.7 where, whilst a global real estate cycle can still be identified, the correlation between the main regions is relatively low but the correlation between the sectors within a single country is relatively high. It is possible that the relatively low levels of inter-regional correlations are flattered by the use of indices. These are constructed by using individual real estate valuations which are on a different basis from one another.
Figure 7.6 Total real estate returns by region, 1995 -2010 (% p.a.)
25 20 15 10 5 0 -5 -10 -15 -20 -25 1995 UK
1998 Eurozone
2001 US
2004 Australia
2007 Global1
2010
Source: IPD, KTI, NCREIF, UBS Global Asset Management, Global Real Estate Research and Strategy 1 Global portfolio rebalanced each year: US 45%, Eurozone 40%; UK 10%; Australia 5% Past performance is not an indication of future returns.
Figure 7.7 Correlations between main real estate markets, 1995-2010 US US Eurozone UK Australia 1.00 Eurozone 0.68 1.00 UK 0.62 0.41 1.00 Australia 0.90 0.62 0.54 1.00
Source: IPD, NCREIF, UBS Global Asset Management, Global Real Estate Research and Strategy
Greater opportunities to enhance returns For those seeking higher returns, there is a wide range of possibilities. Figure 7.8 shows, from a set of 82 country / sector combinations (for example, French retail and German office), the historical range of returns generated since 1990. The range in 2008 approached almost 60% before narrowing in both 2009 and 2010. The range has averaged around 30% since the mid 1990s. However, due to the illiquidity factors described above, it is not always possible to tactically switch between countries and sectors as quickly as might be desired, although with the increasing availability of derivatives, this may become possible.
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Figure 7.8 The range of returns available at the country/sector levels (% p.a.), 1990-2010
50 40 30 20 10 0 -10 -20 -30 -40 -50
Risks of global real estate investment With such straightforward potential benefits to investing globally, the orthodoxy of real estate as a local investment is being challenged. However, investing globally in real estate is not without its issues. Some of these are discussed briefly here. Currency risk This is a risk which relates to all asset classes where investment is made non-domestically, outside the domestic currency zone or outside a fixed exchange rate regime. For real estate, the tendency to hedge appears greater than for equities but less than that for bonds. This relates to the proportion of total risk that is attributable to currency risk, which for real estate is relatively high. Tax It is important to look at the post tax, net returns available from non-domestic real estate. Most market analysis is conducted gross of tax given that the tax position of each investor differs so it is important to identify the potential tax leakages which may be experienced. Benchmarking performance Whilst real estate performance benchmarking in some countries has a long history, benchmarking at a global or even the regional level is in its infancy but growing rapidly. This is driven by IPD, its partners and its alliances with other national benchmark providers, NCREIF in the US. Similarly, fund level performance benchmarking is in its infancy though in some countries it has been long established. Despite the limited nature of global real estate benchmarks, investors have found suitable solutions depending on their risk tolerance and investment goals. Some of the most commonly used indicators for benchmarking performance include cash on cash return, internal rate of return and, increasingly, absolute return targets. A positive step in the European real estate market is the development of the IPD Pan-European Property Funds Index, which tracks the quarterly performance of open-ended funds with a RICS valuation methodology. Although the index is still only in its consultative stage, its formal release should generate more interest in Pan-European property funds from those investors that have concerns about the lack of a suitable benchmark for European real estate allocations.
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
Range of returns
Source: IPD, KTI, NCREIF, UBS Global Asset Management, Global Real Estate Research and Strategy Past performance is not an indication of future returns.
Inflation hedging characteristics For investors seeking real income protection and real wealth preservation, commercial real estate has delivered strong real returns over long run investment horizons. For the Australian, Canadian, UK and US markets, nominal real estate returns have significantly outstripped domestic inflation over 10, 20 and 30 year periods (Figure 7.9). However, over shorter time horizons, real estate does not necessarily move at the same time as inflation nor even in the same direction. For example, global real estate returns turned negative across many markets in 2008 and 2009 but headline inflation rates remained elevated because of rising oil prices. In fact, the contemporaneous correlation between real estate performance and inflation is generally low, or even negative, for these markets. So even though returns have outstripped inflation on an ex-post basis, the sector only provides a partial hedge against inflation as income and values cannot adjust quickly enough to protect against unexpected shocks to inflation, at least in the short run.
Figure 7.9 Real estate returns and inflation (% p.a.), 1991-2010 10 8 6 4 2 0
Australia Real estate total returns
Canada Ination
UK
US
Source: Thomson Reuters Datastream, IPD, NCREIF, UBS Global Asset Management, Global Real Estate Research and Strategy Past performance is not an indication of future returns.
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The UK and European real estate markets

Market performance
The UK is commonly described as the most transparent real estate market in Europe and ranks only behind the Australian and Canadian markets on an international scale. IPD provides detailed information about the UK real estate market and the performance history dates back to the beginning of the 1970s. The UK is the only European market to provide a monthly index, allowing investors to make better-informed and more timely decisions. Outside the UK, IPD and its partners provide limited performance data in Europe; limited in terms of the number of countries covered; the representativeness of the properties included in the measured sample; the data collected, the period of measurement and the delay between year end and the publication of results. Based on the data available from IPD it is possible to analyse the performance of European markets, albeit bearing in mind the limitations outlined earlier. Compared to other asset classes, as shown in Figure 7.10 (in local currency terms), European real estate has delivered a total return that has exceeded bonds and equities over 5 year and 10 year periods. This differs from our long-term expectations where we believe that the returns from the sector should fall between those of bonds and equities owing to the combination of bond and equity-like characteristics of real estate.
Figure 7.10 Returns for real estate, bonds and equities in Europe (% p.a.) to end 2010 8 6 4 2 0 -2 -4 -6 1 year Equities Bonds 3 years Real estate 5 years 10 years Figure 7.11 Total returns from UK and eurozone real estate (% p.a.), in local currency terms, 1995-2010
At the aggregated level, eurozone real estate has outperformed the UK market only three times in the last ten years. Figure 7.11 demonstrates the level of total returns in the eurozone compared with the UK. However, the average return for real estate in Europe conceals a wide range of country/sector level performance, offering significant diversification benefits to investors. In 2010 the performance ranged from Irish retail delivering -3% to 16% for UK retail. The gap between the best and the worst performing segment has averaged 28% over the last ten years, from a low of 12% in 2001 to a peak of 50% in 2008 when global credit markets froze. At the asset level, total returns have seen an even wider range than at the market level, creating further opportunities to investors. For UK based investors, what may also be appealing is the relatively low correlation between a diversified UK real estate portfolio and a diversified eurozone portfolio. We estimate that the correlation between the two markets has been just 0.43 over the last ten years (in local currency terms). While the economies of the UK and Continental Europe are closely linked in terms of performance, real estate market performance at the IPD level can often reflect outcomes that show less of a correspondence. As a consequence, a portfolio combining UK and eurozone real estate should provide higher risk-adjusted returns to investors. The correlation between the Swiss and the eurozone real estate market has been 0.41 over the same ten-year period, while the correlation between the Swedish and the eurozone real estate market has been relatively high at 0.80 over the same period.
20 15 10 5 0 -5 -10 -15 -20 -25 1995 UK

1998 2001 Eurozone 2004 2007 2008 2010
Source: Thomson Reuters Datastream, IPD, UBS Global Asset Management, Global Real Estate Research and Strategy (in local currency terms) Past performance is not an indication of future returns.
Generally, achieving diversification benefits within one country through simple three-way sector bets (retail/office/industrial) is difficult, as these sectors are typically highly correlated. For example, the correlation between each of these sectors for the UK is around 0.85 between 1981 and 2010. Diversifying across 15 countries and 3 sectors has provided powerful risk reduction. For example, total returns for Irish retail show a standard deviation of 23.1% over the last ten years but the IPD European Index has shown a standard deviation of just 4.6% over the same period. As previously discussed, this figure is subject to downward bias due to valuation smoothing.
Source: IPD, UBS Global Asset Management, Global Real Estate Research and Strategy Past performance is not an indication of future returns.
Differences in market practices

The eurozone is an aggregate of individually defined real estate markets with varying market practices. Most notably, lease structures vary widely across Europe. Leases are typically shorter in Continental Europe than in the UK, although shortening lease lengths and break clauses in the
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UK are making lease lengths similar. The upward-only lease review, which is prevalent in the UK, is only compulsory in Ireland. In other countries, income is indexed, typically to inflation, and, at review, the ability to achieve full open market rent levels is limited. In the UK, the tenant is typically liable for the majority of building costs (repairs, insurance, heating, lighting, etc) but in continental Europe, there is a range of varied relationships whereby the income paid to the landlord can be eroded by liabilities for these costs. Transaction costs vary widely across Europe, but average out at around 6% to buy and around 1.5% to sell. They may also vary locally, e.g. within Belgium or Switzerland.
even in times of poor relative performance, the wide dispersion of returns at the individual asset level means that selecting the right offices can prove to be a fruitful strategy, albeit one which relies upon stock selection and asset management skills. Retail The retail sector is broadly categorised into unit shops (or high street shops), shopping centres and retail warehouses. Unit shops typically offer little physical obsolescence but some micro-locational risk as town centres can shift with new development. Shopping centres carry greater depreciation but less locational risk, although they are still not immune from new town centre schemes shifting shoppers focus. Retail warehousing has been an expanding market that has been reaching a degree of maturity in the last few years although the shift towards online shopping continues to support the sector. With the exception of Ireland and the UK, the European retail sector is less integrated than the office sector. Investors have just started to discover the characteristics and benefits of investment in the retail sector. There have been some major local players but cross-border investing has been less prevalent. Unlike the office sector, there are fewer Pan-European retailers than Pan-European office occupiers. Retail brands are often unheard of outside of their home country and so making an investment in the retail sector, on a cross-border basis, requires greater due diligence than investing locally. The biggest benefit of investing cross-border in the retail sector has not only been higher returns compared to offices but also low correlation between countries. Retail sales are typically less influenced by global factors and more driven by domestic factors. Industrial The industrial sector is a relatively immature investment sector in Europe but is developing. In the UK, logistics represent only 15% of the industrial sector. In contrast, since most European manufacturers are owner occupiers, logistics dominate the industrial sector across much of the Continent. With the exception of France and the Netherlands, multi-let industrial parks are virtually nonexistent in Europe. The concentration of logistics asset exposure bears some risks, especially obsolescence. Logistics companies require good transport access but the relatively flexible supply of land in locations where it is optimal to have logistics properties give distribution companies flexibility and negotiation power. Furthermore, the logistics business sector is very competitive and contracts have become much shorter. While ten years ago ten-year contracts were common, industrial and retail companies have often shortened the contracts with their logistics companies to five years or even less. This results in specific
Commercial real estate sectors

The European commercial real estate market can be split into three different sectors: offices, retail and industrial. Offices Of all of the main real estate sectors, offices, particularly those with an occupier base tied to the financial services sector, tend to be the most cyclical. Offices represent a little over a third of the estimated commercial real estate market as measured by IPD. Major markets in Europe include Amsterdam, Frankfurt, London, Madrid and Paris. As part of highly centralised countries, London, Madrid and Paris dominate their national markets. In contrast, Amsterdam and Frankfurt are part of polycentric countries, and they do not dominate their national office markets. The size of the London office market means that it is worth providing more detail. The London office market is the most liquid market in Europe with investment volumes representing 13% of the total European real estate turnover in 2011. Londons liquidity helps to attract significant interest from foreign investors, who have represented around 50% of the market since 1993. But the citys exposure to the cyclical financial services sector means that its performance is more volatile than other European cities. For example, total returns in the City office market turned from 25% in 2006 to -24.1% in 2008 before seeing a rebound of 22.6% in 2010. For investors, London offices present a trade-off between greater liquidity but also greater volatility. The major office markets across Europe are driven by employment in the finance and business service sectors. As a consequence, the major European office markets tend to be highly correlated following similar development cycles. Geographic diversification, therefore, does not automatically mean that economic and real estate market diversification can be achieved. Therefore, it is often appropriate to include regional cities in an office portfolio since these typically have a more diversified economic structure and are, therefore, less reliant on the fortunes of one volatile sector of the economy. On the other hand,
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The US real estate market

business risks in the European industrial sector. Exceptions to this are locations where logistics need to compete with other land uses, for example at airports, ports or last mile distribution points. In these locations, distributors are willing to take on longer leases to secure a scarce resource and land value is often underpinned by an alternative use. In other more general distribution locations, the next best use might be agricultural land. The attraction of investing in industrial/logistics assets in Europe has traditionally been the relatively high income return compared to other sectors and low correlation between individual European countries.
Market performance
Over the past five years the US market has been characterisedby a considerable degree of volatility with strong performance leading up to the peak of the market in 2007 followed by two negative years and a strong rebound in 2010/2011. This wide swing in returns was significantly influenced by distress in the credit markets, which forced equity markets beyond normal boundaries, as can be seen in Figure 7.12. Despite extraordinary volatility, core real estate equity returns have still managed to average 3.1% p.a. over the period 2006-2011. Values have appreciated in each of the quarters of 2010 and 2011. Fundamental performance is now gradually improving in most office and industrial markets but vacancy rates remain elevated relative to historical averages, limiting the extent of any rental growth. Vacancy rates are expected to edge down further in 2012 but the process will remain slow and uneven. In contrast, vacancy rates in national retail markets only stabilised towards the end of 2011. Despite the weak recovery in fundamentals, core pricing has recovered on the back of low yields on other assets such as cash, government bonds and investment grade corporate debt. In markets with strong competition, pricing is at, or approaching, peak pricing levels, suggesting investors once again feel confident about future rental growth. Whether this growth comes on line depends crucially on the strength in the recovery in the US labour market.
Figure 7.12 US equity, bond and real estate returns to end 2011 (% p.a.)
15 12 9 6 3 0 -3 1 year NCREIF NPI 3 years S&P500 Stock Index 5 years 10 years
Bar-Cap Govt/Credit Bond Index
Source: Thomson Reuters Datastream, NCREIF, UBS Global Asset Management, Global Real Estate Research and Strategy Past performance is not an indication of future returns.
Since the inception of the NCREIF Property Index (NPI) over 30 years ago, the total return for real estate has been 7.9% p.a. in nominal terms. Figure 7.13 shows the annual income return and total return for the NPI over the past 30 years, with capital return being the difference between the two lines. The appraisal process typically establishes value in relation to income so the income component of the
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7. Real estate
return remains relatively consistent while market changes are embedded in capital return. Thus, the rise and fall of the income return is an indication of relative pricing over time and can be crudely equated to a yield or cap rate. The gradual decline in this component during the middle of the decade confirms pricing was on the rise. 2009 marked a reversal of this trend with seven consecutive quarters of rising income returns, followed by a levelling of the income return towards the end of 2010. The income return (i.e. yield) has since fallen in each of the four quarters of 2011 as pricing recovered somewhat from the trough.
Figure 7.13 NCREIF Property Index total return and income return (% p.a.), 1979-2011 30 20 10 0 -10 -20 -30 1979 1983 Income return 1987 1991 Total return 1995 1999 2003 2007 2011
Given the high level of vacancy across the majority of key markets, tenants have been able to use high sector vacancy to their advantage in lease negotiations. Demand for office space has recovered faster than office employment. Firms are taking advantage of todays lower rents, expanding their offices and locking in cheaper overhead costs. Retail Retail is the most highly segmented of the four major US commercial real estate sectors. Most of the data available are for community and neighbourhood shopping centres, including grocery-anchored strip centres. Investors also compete to acquire regional malls, lifestyle centres, and power centres. Within a typical power centre, pads may be sold to occupiers, and big box retailers may construct freestanding stores. High street retail tends to be difficult for investors to add to their portfolios. Given the headwinds facing the US consumer over recent years, it is not surprising that the retail sector remains under pressure. By many measures, it is a laggard sector in the recovery of core commercial real estate. Consumer spending represents two-thirds of the US GDP and retail sales account for approximately half of all consumption. While the liabilities of the average American household has decreased since the depths of the financial crisis, income growth remains sluggish. With unemployment a key concern, demand for retail goods is likely to remain uneven and cautious; thereby limiting the pace of recovery for retail rental levels. However, as is the case in many other markets globally, the supply side story is more favourable and supportive of potential future rental growth. New construction of neighbourhood and community shopping centres reached the lowest level on record during 2010 and 2011. Retail development is expected to remain below long-term levels over the next several years, allowing tenants to absorb some of the excess vacancy in the market. Industrial In the US, investors in the industrial sector primarily focus on distribution or warehouse space with limited investment in light manufacturing properties, and research and development labs (R&D). Coastal cities with strong port activity and gateway markets proximate to Canada and Mexico tend to attract the bulk of investment. Following the 2008-2009 recession, US industrial propertiessuffered historically high rates of availability. With a slow but positive economic recovery underway, the US industrial space market is responding accordingly. Growth in US Gross Domestic Product correlates highly with industrial net absorption. Whilst an overall lack of confidence has generated an atmosphere of caution in the near-term, improvements in the economy should lead to increased manufacturing production, with positive knock-on effects for real estate demand. While demand is not expected to reach pre-recession levels before year end; absorption should
Source: Thomson Reuters Datastream, NCREIF, UBS Global Asset Management, Global Real Estate Research and Strategy Past performance is not an indication of future returns.
During the peak of the market, real estate investors became increasingly aggressive, requiring low or no risk premium. During 2009, the relationship shifted dramatically as investors and lenders demanded excessive risk premiums bringing equity and debt transactions to a virtual standstill. Whilst risk premia have fallen from 2009 highs, they remain attractive relative to historical averages reflecting heightened risks but also encouraging investors to the sector.
Commercial real estate sectors

The US commercial real estate market can be split into four different sectors: offices, retail, industrial and multifamily apartments. Offices As measured by the NCREIF Property Index, offices comprise the majority of institutionally-held private commercial real estate investment in the US, with 35% as of December 2011. The office sector is highly cyclical but seems to be past the low point of the current business cycle. The market for downtown office space is tighter than the market for suburban office space. Downtown office rent growth typically outperforms suburban office rent during expansionary periods. Suburban rents do not fall as quickly nor far as downtown rents during contractions.
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The Asia Pacific real estate market

continue to slowly improve. Reinforcing the positive trajectory of the sector, all primary industrial sectors added jobs during 2011 for the first time since 1998. Multi-family apartments Institutional-grade apartments comprise 26% of the NCREIF Property Index, the second largest concentration of investment after the office sector (December 2011). Generally, these are large apartment complexes with a minimum of 40 market-rate units, clubhouses, amenities, and on-site leasing offices. In practice, it is common for an institutional-grade apartment development to have several hundred units. There are three primary types of multi-family developments garden, mid-rise and high-rise. Nich investments may by placed in properties marketed as senior or student housing. Even after two years of growth, the multi-family sector continues to report strengthening revenue, with rising occupancies and above-inflationary rent growth. With dozens, or possibly hundreds, of leases per property, the majority of which renew annually, landlords can take advantage of frequent expirations to capture market improvements. The factors that support apartment sector growth are improving, albeit to varying degrees. Even though US unemployment remains high, the rate is declining steadily as the pace of hiring has shown signs of improvement. Despite rising home affordability, the US home ownership rate fell from 69% in 2005 to 66% in 2011. As new households form, they are increasingly likely to choose renting over ownership. It is expected that srong developer interest in this attractive investment will soon begin to reverse the dramatic drop-off in new supply that began two years ago. However, multifamily construction permit approvals remain historically low. New development of institutional-grade apartments is not expected to increase fast enough to reverse the sectors positive revenue trend, although individual markets are at varying stages of the development cycle.
Market performance
The Asia Pacific (APAC) region is expected to continue to grow materially faster than the rest of the world over the short, medium and long-term. However, from an charity investment perspective, with limited performance indices available, it is often difficult to give an overview of performance in the region as a whole. Many of the markets lack globally comparative market information, which limits the relevance of standard statistical techniques in understanding relative performance. Figure 7.14 shows the total return of the four markets in the APAC region where published IPD indices are available: Australia, Japan, New Zealand and South Korea. These markets are considered developed amongst the APAC region and returns are increasingly in the range of those experienced by other mature economies markets.
7.14 Total returns in APAC (% p.a.), 1985-2010
30 25 20 15 10 5 0 -5 -10 1985 Australia 1990 Japan 1995 New Zealand 2000 Korea 2005 2010
Source: IPD Note: Korea is a consultative index Past performance is not an indication of future returns.
Whilst many global investors are attracted by the opportunities available in the markets of APAC region, transparency varies markedly across the region. In terms of transparency, the region can be broadly split into three different groups: Developed economies with high levels of transparency such as Australia, New Zealand, Singapore and Hong Kong. These markets rank on a par with most European countries and offer clear opportunities for core investors Developed economies that show low levels of transparency relative to their economic maturity. This group includes Japan and Korea where lack of market information, especially in the retail and industrial sectors, holds back transparency in these countries. The lack of data availability tends to be related to the concentrated ownership base and leasing structures that heavily favour landlords Emerging economies with low levels of transparency. At the other extreme, the region has some of the worlds least transparent markets including China and India. These markets tend to attract value added and opportunistic capital 71
7. Real estate
South Korea
Hong Kong
Malaysia
An early step forward in improving transparency across the region is the extension of IPDs coverage of the region. Having started with Japan and South Korea nine years ago, they are now also tracking China, Hong Kong, Indonesia, Malaysia, Singapore, Taiwan and Thailand using a combination of private and public real estate data. Whilst the data and coverage are limited for the latter group of countries and not comparable with other IPD indices, on going efforts like this and others, such as the Asian Association for Investors in non-listed Real Estate Vehicles (ANREV), will help boost transparency in the regions emerging markets. Whilst the IPD performance data for the APAC region are limited to core strategies in developed markets, the region as a whole appears to have considerable investment opportunities in the value-added and opportunistic strategies. Owner occupier levels remain high in the regions emerging markets at around 80%. With economic expansion likely to continue to outstrip developed markets, owner occupiers will eventually begin realising this cheap source of capital to fund their expansion plans, providing opportunities to investors. The regions stock is biased towards the industrial sector, representing around 40% of the market. In the export orientated countries and emerging markets this figure is much higher. For example, 60% of Chinas institutional real estate stock is in the industrial sector. Figure 7.15 shows the breakdown by sector across the region. This bias is not surprising given the industrial make-up of many regional economies centres around manufacturing and trade. The near-term outlook is still largely dependent on this industrial base but domestic sources of growth-particularly private consumption are likely to play a growing role in coming years. As this gradual rebalancing takes place, the retail sector is likely to benefit, providing significant opportunities to investors. Higher wages, growing populations and increasing urbanisation, particularly in China, will also continue to underpin demand for residential accommodation.
Industrial
Ofces
Retail
Other
Source: DTZ, UBS Global Asset Management, Global Real Estate Research and Strategy
Within-region diversification benefits

For the APAC region, the within-region diversification potential is probably the highest of any of the global real estate regions, ranging from the highly transparent Australian Listed Property Trust (LPT) market through to the dynamic but relatively opaque Chinese and Indian markets. This is difficult to prove given the lack of available real estate market data but we can use, as a proxy, for instance correlations between GDP growth within the region compared to the correlations with the eurozone countries. Figure 7.16 shows the average for the correlation of each countrys GDP growth with four other countries within the region. It demonstrates the within-region diversification possibilities, if we assume that GDP growth is ultimately linked to capital growth in the real estate markets.
7.16 Real GDP growth average correlations, 1996-2011 Asia Pacific Australia China Hong Kong Japan Singapore Eurozone Germany France Italy Spain Netherlands 0.78 0.92 0.89 0.86 0.86 0.40 0.46 0.69 0.67 0.65
Source: Thomson Reuters Datastream, UBS Global Asset Management, Global Real Estate Research and Strategy
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Singapore
Australia
Thailand
Taiwan
This lack of transparency tends to make foreign investors cautious in approaching the regions emerging markets. Unsurprisingly then, domestic players have tended to dominate the region in recent years with foreign investors representing less than 10% of the transactions in 2009 and 2010. Nonetheless, the region is heading in the right direction with most markets maturing and transparency improving. China and India have seen the largest improvements in transparency between 2008-2010 due to increased data availability and ongoing regulatory changes. Greater transparency should eventually feed through to higher levels of liquidity and a less concentrated investor base in the future, helping to attract more longer term core capital to the regions emerging markets.
7.15 APAC real estate stock breakdown, 2010 100 90 80 70 60 50 40 30 20 10 0
China
Japan
India
Growth of Asia Pacific real estate markets

The APAC region has seen the fastest growth in value of investable stock (i.e. stock of sufficient quality to become institutional product) over the period 2005-2010, growing at an estimated 10% p.a. This represents a combination of capital growth, refurbishments of old buildings and new developments coming to the market. This compares with 4.3% p.a. growth in the Americas region and a decline of 1.8% p.a. in the EMEA region. The decline in the EMEA region reflects the sharp decline in values since the peak of the market in 2007 combined with a limited amount of new supply coming to the market over this period. Breaking down the analysis even further, emerging Asia has seen the strongest growth at 16% p.a. against 4.8% p.a. in Emerging EMEA and 8.7% p.a. in Emerging Americas (Figure 7.17 ). The growth in emerging Asia has been very much led by China (20.5% p.a.) and India (14.1% p.a.) but Thailand (9.4% p.a.) and Malaysia (9.2% p.a.) have also seen strong growth. Given the stronger economic growth prospects of the emerging Asia region, this trend is expected to continue as growing demand puts further pressure on rents and new stock is delivered to the market. Already the office development pipeline across most Asian cities as a proportion of current stock is significantly higher than all other markets, creating significant opportunities for new entrants into the market.
7.17 Global investable real estate stock 7 6 5 USD Trillions 4 3 2 1 0 Developed Developed Developed Emerging Emerging Emerging Americas Europe Asia Asia Europe Americas 2010 % change (RHS) 120 100 80 60 40 20 0 -20
2005
Source: DTZ, UBS Global Asset Management, Global Real Estate Research and Strategy
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topic
Alternative sources of return
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8. Alternative sources of return

What are suitable alternative investments?
For many years, the bulk of UK charity portfolios were allocated to either equities or bonds. In some cases, there would also be a small allocation to cash. However, more recently, charity portfolios have been allocating a larger portion of their assets to new investments. These include both new asset classes and capabilities that rely on gaitning exposure to existing asset classes in different ways. Collectively, these investments are sometimes referred to as alternatives, in the sense that they are alternatives to equities and bonds. However, a clear definition is needed. So for a charity portfolio trying to define a list of alternative investments, what characteristics should they consider? We would propose that any new class of investments could usefully combine some or all of the following characteristics: Preserve the real value of the charitys assets Provide a claim on future cash flows. This makes it easier to model the assets fundamental risk and return characteristics, and their ability to hedge liabilities that often take the form of cash outflows Improve the efficiency of the portfolio. This means the portfolio can obtain a higher ratio of return to risk Cost effective. It should be possible to hold and manage the assets without incurring punitive costs This can be illustrated with reference to the two largest traditional charity portfolios investments equities and government bonds. Both of these asset classes have claims over future cash flows. In the case of equities, these cash flows are related to corporate profits and, in the case of government bonds, they are related to a coupon guaranteed by the governments ability to raise taxes. The different nature of these cash flows means that equities and bonds have fundamentally different characteristics and, therefore, the correlation between the returns from equities and bonds is relatively low. This implies that their risks are well diversified when they are held in combination, leading to a more efficient portfolio. Profits generally grow in line with general economic growth, therefore equities should help preserve the real value of assets. Conventional bonds do this less well because their value is fixed in nominal terms. However, investing in both equities and bonds is relatively cheap. This combination of attributes helps to explain why these two assets have historically been so popular. Some of the alternative asset classes that charity portfolios have been considering would also appear to have many of the same attributes as equities and bonds. Private equity, for example, is also a claim on future cash flows derived from corporate profits. The difference is that, unlike traditional equity investments, these companies are not publicly listed and so the investment is relatively illiquid. Historically, investment in private equity has also been considered a good risk diversifier because the companies differed in nature from
publicly quoted ones. However, there is some concern that this distinction may recently have become blurred as large public companies have reverted to private ownership. Charities have not restricted themselves to investing only in financial assets. For example, many charities have made significant allocations to real estate. Real estate is another asset class that derives a significant part of its value from cash flows. In this case, the relevant cash flow is the rent at which it can be let. Rents tend to grow in line with inflation, which has meant that real estate has been seen as a useful inflation hedge. In addition, the distinct nature of these cash flows means that real estate can help to diversify a portfolio although, in practice, rents are likely to be influenced by some of the same factors as the profits that underpin equities. However, unlike equities and bonds, real estate is a physical rather than financial asset, and this has important implications. In particular, it is subject to depreciation in the form of both wear and tear, and obsolescence. It, therefore, requires capital expenditure to maintain its real value and this makes it quite a costly investment. The physical nature of real estate also means that it is relatively illiquid and makes it difficult to obtain passive exposure to it. High cost probably helps to explain why other physical assets that could be rented out to generate a cash flow are not normally included in charity portfolios. For example, cars, planes and tuxedos are all physical assets that are commonly leased to generate a cash flow. It is easier to gain diversified exposure to these cash flows indirectly through the financial assets of companies that are already engaged in these operations. There are a number of physical assets that are becoming of increased interest to charity portfolios which do not have any obvious claim over a cash flow. For example, commodities have increasingly been seen as a useful addition to a charity portfolios armoury. However, they do not necessarily entitle the owner to any future cash flow beyond a risk-free rate of return. Commodities are relatively cheap investments via derivative markets and have a relatively low correlation with equities and bonds, which implies they should be good portfolio diversifiers. However, this lack of correlation also explains why commodities are unlikely to deliver a return above cash in equilibrium if they are managed on a passive basis. Also, historically, they have been a poor hedge against inflation. Other physical assets that are sometimes considered as alternatives include works of art, wine and other collectables. However, they too are not generally underpinned by a cash flow. It may be possible to earn a yield on a piece of artwork, for example, by lending it to a museum but that would not be possible with wine, since nobody would want to borrow it without consuming it. Nevertheless, their value should generally rise through time as wealth increases. This should help to preserve the
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real value of the investment but may also imply that they are exposed to some of the same risks as equities, thus reducing their ability to diversify a portfolio. They may also be expensive to store and maintain. Another set of investments that have been considered as alternatives are strategies that are used to gain exposure to existing asset classes. These investments include hedge funds, currency funds and Global Tactical Asset Allocation (GTAA) funds. These funds cover a wide range of different investment strategies which makes it difficult to generalise their characteristics. What links them together is their ability to use leverage and to take both long and short positions. Whilst they are not asset classes, such investments may benefit portfolios because the strategies they employ mean they are not highly correlated with the existing assets. A relatively new addition to the list of alternatives is infrastructure. Infrastructure assets are used to facilitate the orderly operations of an economy. Of course, some of these assets are not new and it has always been possible to get exposure to many of them through equity and bond markets, such as utilities and transport stocks. However, investing in physical assets, such as toll roads
and healthcare facilities, has been more difficult and, like real estate, require the management of contracts and capital reinvestment, which can be expensive. By packaging different forms of infrastructure investments together, investors may be able to gain diversified exposure to assets that share certain desirable characteristics. In particular, the cash flows should be relatively stable and may provide a good hedge against inflation. Charity portfolios are casting their nets ever wider in an attempt to improve their asset mix. In doing so, they are considering assets both financial and physical, liquid and illiquid and those with or without an underlying cash flow. They are also investing in new strategies that are not really separate asset classes at all. What matters most is that charities should consider the underlying characteristics of each potential investment, both in isolation and as part of a portfolio of assets, to ensure that the fund will benefit from an allocation to alternatives. Figure 8.1 summarises the key characteristics of a range of alternatives.
Figure 8.1 Comparison of Alternative Investments Potential returns Private equity - venture capital Private equity - buy-ins/buy-outs Hedge funds Infrastructure Gold Commodities Art & collectables very high high various medium low volatile medium Liquidity low low low/medium low high high low Diversification benefit moderate moderate various moderate high high high Risk very high high various low/medium medium high medium Holding/ management costs high high high high low low high
Source: UBS Global Asset Management assessment of consensus views
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Hedge funds
A hedge fund is a pool of capital where the manager has the ability to use leverage and to take both long and short positions with the aim of achieving an absolute return. A large variety of hedge fund strategies exists and the level of risk taken will vary. Investors looking for a diversified exposure to hedge funds may frequently opt for a fund of hedge funds a fund with underlying investments in several hedge funds that can cover different strategies and geographical areas. of sub-strategies include convertible bond arbitrage (buying the convertible bond and selling short the underlying stock); fixed income and mortgage-backed security arbitrage (involving spread plays between instruments of different credit quality, maturity or other features), statistical arbitrage (using mathematical/ statistical models to buy and sell baskets of securities simultaneously) and merger arbitrage, which seeks to capture the price spread between current market prices and the value of securities upon successful completion of a merger. The width of the spreads typically reflects the markets willingness to take on transaction risk. Trading strategies are generally more top-down in nature and are often driven by views derived from monetary policy, fiscal dynamics, and macroeconomic research. These strategies may utilise financial instruments, such as foreign exchange, equities, interest rates, sovereign debt, currencies, and commodities to express a managers view. In executing different approaches, managers generally may use either fundamental or quantitative models, or a combination of both. The sub-strategies may include global macro, systematic Commodity Trading Advisors (CTA), and commodities. Other strategies include niche or esoteric approaches not classified above. Hedge funds that specialise in life settlements; weather derivatives; catastrophe bonds litigation funding; emissions trading, specialty finance and other, generally illiquid; approaches fit into this category.
Hedge fund strategies

The hedge fund arena can best be dissected via a strategy and sub-strategy terminology, although it should be noted that classifications vary and many funds employ multiple approaches. Equity Hedged is the broadest category in which managers strive for alpha (excess return) through sector allocation and especially, stock selection. These funds typically use fundamental analysis to invest in publicly traded equities. Through fundamental analysis, managers evaluate factors that may affect a securitys value, such as macroeconomic trends, industry specific metrics, and other qualitative and quantitative factors. Equity hedged managers may take both long and short positions to capture the perceived mis-pricing of a given security. Portfolio construction is primarily driven by bottom-up fundamental research although top-down analysis may also be applied. This category can be divided by market exposure (short bias, neutral, conservative, aggressive), sector (technology, energy, financials, healthcare, etc.), or other means, such as capitalisation, geography or style. Credit strategies involve investing long and/or short in debt or debt-linked securities on an opportunistic basis. Portfolio gross and net exposures can vary based on the manager and their view of the opportunity set. This strategy may be directionally long or short and can also include trades to exploit intra-capital structure anomalies as well as long and short trades in debt securities of different companies. Directional credit, for example, may include investments in distressed debt or equity securities of firms that are in the midst of financial restructuring, balance sheet re-capitalisation, or that offer compelling trading opportunities. Relative Value strategies are generally non-fundamental and non-directional, and are often quantitatively-driven. Managers in this strategy typically use arbitrage to exploit mis-pricings and other opportunities in various asset classes, geographies, and time horizons. Managers frequently focus on capturing the spread between two assets while seeking to maintain neutrality to other factors, for example, to geography; changes in interest rates, equity market movement and currencies. Examples
Performance
Hedge funds had a difficult time in 2011 as many faced losses resulting from the European sovereign debt crisis the US credit downgrade; Japans earthquake; global slowdown concerns, high levels of market correlation and Middle East turmoil. On average, both hedge funds and funds of hedge funds produced results similar to equities and finished the year down approximately 5%, according to Hedge Fund Research, Inc. (HFR). Despite bumps in the road, we believe the longterm outlook for hedge funds remains sound. Figure 8.2 shows one of HFRs diversified indices, the HFRI Fund of Funds Composite Index, one of the most frequently used proxies for hedge fund portfolios, net of two layers of fees, compared to equities, bonds and cash (gross of fees). The strong multiyear performance of hedge fund portfolios, relative to more traditional investment alternatives, is important as investors seek compensation for the lower transparency and liquidity, and higher complexity and headline risk. Compound Annual Rate of Return (CARR) of the HFRI Fund of Funds Composite Index was 7.4% p.a. for the period from January 1990 to December 2011. The HFRI Fund Weighted Composite Index compounded at 11.2% p.a. over the same period. Global equities compounded at
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approximately 5.7% p.a. and bonds at 7.0% p.a. Long-term hedge fund absolute performance as well as relative performance, therefore, seems intact.
Figure 8.2 Cumulative fund of hedge funds performance, January 1990 to December 2011
6,000 Performance (1.1.190 = 1,000) 5,000 4,000 5.7% p.a. 3,000 2,000 1,000 0 1990 1993 1996 1999 2002 2005 Bonds 2008 2011 3.8% p.a. 7.4% p.a. 7.0% p.a.
Fund of Hedge Funds
Equities
Cash
Source: A&Q Industry Research, Bloomberg Based on USD total returns of HFRI Fund of Funds Composite Index, MSCI World Total Return Index, Barclays Global Aggregate Index, and BofA Merrill Lynch US T-Bill 3M Index respectively. Figures on the right show CARR (compound annual rate of return). Past performance is not an indication of future returns.
Total Return Index as a proxy for a long-only strategy and the HFRI Fund of Funds Composite Index as a proxy for a hedge fund portfolio, net of two layers of fees. By the end of 2011, world equities were roughly 21% below their previous high, last observed in October 2007. Figure 8.3 also reveals another key attribute of hedge funds: these vehicles tend to offer asymmetric or option-like performance. During bull markets, the average hedge fund can be expected to underperform its long-only counterparts. However, during bear markets, wellpositioned hedge funds might produce flat or even positive returns. Over the period 1990 to 2010, the mean return for the HFRI Fund of Funds Composite was 0.61%, versus 0.57% for the MSCI World Total Return Index. Moreover, looking solely at negative market months, the mean return for equities was -3.63% versus only -0.36% for the HFRI Fund of Funds Composite Index. Considering that 108 out of the past 264 months resulted in negative performance for the MSCI World Total Return Index (versus 79 for HFRI Fund of Funds Composite Index), it stands to reason that hedge funds may offer certain desirable performance characteristics for the more risk-averse investor. Figure 8.4 depicts calendar year returns of the HFRI Fund of Funds Composite Index and the MSCI World Total Returns Index. A key observation is that hedge funds exhibit less extreme behaviour in the tails: while they tend to underperform in the most bullish markets, hedge funds lose only a fraction of what equity markets experience in the most bearish environments. Results for 2011 were rather anomalous as hedge funds slightly underperformed equities in a modest bear market. The hedge fund industry grew in size in 2011, according to HFR, as a result of investor inflows. Total assets stood at USD 2.0 trillion at 31 December 2011, up USD 91 billion from 31 December 2010. Flows into hedge funds were strong in the first half of 2011 (roughly USD 30 billion each quarter) but then tapered off by the latter part of the year. Inflows in 2011 of USD 71 billion were a promising sign and stronger than 2010s USD 55 billion tally. HFR also reports a small outflow from funds of funds in 2011 of USD 8 billion, though this deallocation was smaller in size than in previous years. A policy decision that includes a modest allocation to hedge funds in addition to equities and bonds, seems to have been a rewarding move for long-term investors, certainly over the period 2000 to 2011. 2011 was a difficult year for most asset classes and a disappointing one for many hedge funds. Figure 8.5 shows the performance in 2008 through 2011 for both traditional assets and alternatives. The average hedge fund and fund of hedge funds realised equity-like losses of roughly -5% in 2011, according to the equal-weighted HFR indices. Other sources, such as the Dow Jones Credit Suisse Hedge Fund Index (an asset-weighted index), report slightly lesser losses of -2%, while UBS research points to modest 2011 losses for most institutional-sized hedge funds and funds of hedge
Based on the data in Figure 8.2, a balanced portfolio (60% equities, 40% bonds, monthly rebalanced) compounded at a rate of 6.5% p.a. gross of fees. This means the decision to allocate away from equities and bonds into hedge funds would have added value in the long-term, even after accepting the additional fees from a fund of funds. The argument in favour of hedge funds is strengthened when one looks at inflation-adjusted returns. A hypothetical investment of USD 100 in hedge funds, as measured by the HFRI Fund Weighted Composite Index on 1 January 2000 and adjusted for inflation (using the US Consumer Price Index as a proxy), would have finished at roughly USD 145 at the end of 2011. A hypothetical investment of USD 100 in the MSCI World Total Return Index stood at approximately USD 81, for the same period. This is a substantial difference. Equity markets have incurred drawdowns in excess of 40% twice in the past ten years. This has resulted in many balanced portfolios not keeping up with inflation. The compounding effect of returns means that it can take considerable time to make up for large losses. When the risk management capabilities of hedge funds were criticised after 2008, many managers reduced leverage, improved liquidity and, in general, revamped their firm-wide risk policies to mitigate the effects of tail risk, induced by the financial markets. This dedication to active risk management is a major product differentiator between hedge funds and long-only programs, as the latter in general are more at the mercy of market forces in the determination of overall portfolio risk and the severity of drawdowns. Figure 8.3 illustrates this point it shows the monthly returns of both the MSCI World
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funds. Longer term, only hedge funds and global bonds were positive for the combined period 2008-2011, whereas most other asset classes have yet to recover from their substantial 2008 drawdowns. In an era where investors swing like a pendulum from risk-on to risk-off trades, hedge funds may have certain proprietary advantages that could offer value in the years to come. These unique skills include the ability to accept liquidity risk, assess complex deals and dynamically change exposures to suit changing market conditions. Firstly, as banks balance sheets become ever-increasingly regulated, Relative Value hedge funds, as liquidity providers, can step in and benefit as new risk transfer agents. Secondly, credit-savvy hedge funds may take advantage of depressed prices in the European and US structured products space; few participants but hedge funds
are capable of valuing and participating in such complex, securitised assets. Thirdly, Equity Hedged managers appear to have been gradually increasing their net and gross exposures to take advantage of good beta as markets recover, while at the same time seeking to maintain active hedges against unforeseen market downturns. Hedge funds have seen cycles of great prosperity over the years, and the potential for the industry seems strong. As the hedge fund industry has been experiencing a new wave of recapitalisation, and as individual hedge funds have adapted with new sources of alpha along with refined risk management processes, we believe todays nimble and skilled managers have the potential to prosper and exploit a new paradigm of opportunities in the global markets.
Figure 8.3 Monthly returns of long-only equities and fund of hedge funds
MSCI World Index (USD) HFRI Fund of Funds Composite Index (USD net of fees)
Jan 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 2.3 -4.1 -8.7 -7.6 1.2 4.5 -2.2 1.6 -3.0 -3.0 1.9 -5.7 2.2 2.8 1.2 1.8 -1.5 6.6 0.4 -1.8 3.7 -4.7
Feb 3.5 1.4 -10.2 -0.5 -0.5 -0.1 3.2 1.7 -1.7 -0.8 -8.4 0.3 -2.6 6.8 1.2 0.6 1.5 -1.3 2.4 -1.7 9.3 -4.3
Mar -0.9 6.2 7.6 -0.9 1.9 2.2 -1.9 -0.6 -0.3 4.4 -6.5 6.9 4.2 4.2 -2.0 1.7 4.8 -4.3 5.8 -4.7 -2.9 -6.0
Apr 4.3 0.1 11.3 5.3 4.5 3.1 -2.1 -2.0 8.9 -3.4 7.4 -4.2 4.0 1.0 3.3 2.4 3.5 3.1 4.7 1.4 0.8 -1.4
May -2.0 -9.5 9.2 1.6 2.9 -3.3 1.9 1.0 5.8 0.2 -1.2 -2.5 -3.6 -1.2 6.2 0.1 0.9 0.3 2.3 4.0 2.3 10.5
Jun -1.5 -3.4 -0.4 -7.9 -0.7 0.0 0.9 2.1 1.8 -6.0 -3.1 3.4 4.7 2.4 5.0 0.5 0.0 -0.3 -0.8 -3.3 -6.2 -0.7
Jul -1.8 8.1 8.5 -2.4 -2.2 0.6 3.5 -3.2 2.0 -8.4 -1.3 -2.8 -0.3 -0.1 4.6 -3.5 5.0 1.9 2.1 0.3 4.7 0.9
Aug -7.0 -3.7 4.2 -1.4 0.0 2.6 0.8 0.5 2.2 0.2 -4.8 3.3 -0.2 -13.3 -6.7 1.2 -2.2 3.0 4.6 2.5 -0.3 -9.3
Sep -8.6 9.4 4.0
Oct 10.4 3.7 -1.8
Nov -2.4 -2.1 4.1 -6.4 -4.0 2.5 3.4 5.3 1.5 5.4 5.9 -6.1 2.8 6.0 1.8 5.6 3.5 -4.3 -5.6 1.8 -4.3 -1.6
Dec 0.0 7.4 1.8 3.3 -1.3 2.1 2.2 3.8 6.3 -4.8 0.6 1.6 8.1 4.9 1.2 -1.6 2.9 1.0 4.9 0.8 7.3 2.1
YTD -5.0 12.3 30.8
Jan 0.1 -0.4 0.7
Feb 0.8 0.1 -0.4 1.4 0.8 0.4 1.4 1.1 0.3 -0.3 -0.7 5.2 -0.2 1.9 1.7 -0.6 -0.1 -2.3 2.2 1.2 0.0 1.3
Mar -0.1 1.7 0.0 -2.7 0.8 1.7 -0.6 0.5 0.0 0.8 -0.4 0.2 2.1 4.0 -0.8 1.0 1.4 -2.3 1.5 0.8 3.5 2.1
Apr 1.2 0.9 1.1 1.0 1.7 1.8 -1.4 -0.9 1.2 0.6 0.7 -3.4 3.3 0.9 0.4 3.1 1.5 -1.1 2.3 0.1 -0.8 0.9
May -1.1 -2.6 3.3 1.7 2.1 -1.9 0.2 -0.9 2.1 0.4 0.9 -1.6 0.8 -0.9 1.8 1.5 0.9 0.4 2.1 0.3 0.8 0.5
Jun -1.3 -0.9 0.4 -0.8 0.7 -0.6 1.4 0.2 0.7 -0.9 -0.1 2.8 2.8 -0.6 2.5 0.4 0.6 0.8 2.8 0.4 1.2 2.2
Jul 0.4 0.8 1.5 -2.7 0.3 -0.2 1.7 -0.6 0.2 -1.3 -0.4 -0.2 0.7 -0.2 4.6 -1.9 1.7 0.2 2.4 0.8 0.5 3.1
Aug -2.6 0.1 1.1 -1.5 -2.2 0.7 0.8 0.0 0.8 0.3 0.2 2.0 0.1 -7.5 -0.3 1.5 2.3 1.3 1.8 0.5 1.3 1.6
Sep -2.8 2.4 1.7 -6.5 2.2 0.1 1.5 0.9 1.2 -0.5 -1.6 -1.2 -0.1 -2.6 2.8 1.3 0.8 0.8 0.3 2.5 1.8 2.8
Oct 1.1 1.5 -0.1 -6.2 3.1 1.7 -1.4 0.8 1.5 -0.2 0.9 -1.0 1.3 -2.0 -1.4 1.6 -0.5 -1.0 2.3 1.7 0.6 1.6
Nov -1.0 -0.1 0.8 -2.6 -1.5 1.9 1.7 2.6 0.6 0.8 0.4 -1.5 4.9 1.4 1.1 2.3 1.2 -1.0 0.4 0.3 0.1 0.0
Dec -0.5 2.2 0.8
YTD -5.7 5.7 11.5
-11.9 -18.9 4.8 1.2 2.6 1.9 0.6 -11.0 -8.8 -5.3 -1.0 1.8 5.4 3.9 2.9 -2.6 -1.8 -0.9 2.6 -10.5 3.1 3.7 -2.4 2.5 6.0 7.4 1.9 -1.7 5.2 9.1 -5.2 0.7 -1.6 2.9 2.8 -2.7 1.6 9.4
-40.3 -2.9 9.6 20.7 10.0 15.2 33.8 -19.5 -16.5 -12.9 25.3 24.8 16.2 14.0 21.3 5.6 23.1 -4.7 19.0 -16.5 1.3 2.9 0.0 1.6 0.8 0.5 1.9 1.5 1.4 -1.0 3.6 2.7 -1.3 1.3 0.9 1.3 0.4 0.1
-1.5 -21.4 0.5 1.7 2.0 1.5 1.6 0.7 1.1 1.4 6.9 1.6 1.1 0.7 2.2 -0.5 4.8 1.8 4.5 0.1 10.3 10.4 7.5 6.9 11.6 1.0 2.8 4.1 26.5 -5.1 16.2 14.4 11.1 -3.5 26.3 12.3 14.5 17.5
Return below -15% Return between -15% and -10% Return between -10% and -5%
Source: A&Q Industry Research, Bloomberg Past performance is not an indication of future returns.
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Figure 8.4 Fund of hedge funds versus MSCI World, January 1990 to December 2011
40 30 Total returns in USD (%) 20 10 0 -10 -20 -30 -40 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 MSCI World (5.7% p.a.) HFRI Fund of Funds Composite (7.4% p.a.)
Source: A&Q Industry Research, Bloomberg Past performance is not an indication of future returns.
-50
Figure 8.5 Performance of various asset classes, 2008-2011
40 30 Total returns in USD (%) 20 10 0 -10 -20 -30 -40 -50 2008 Hedge Funds 2009 2010 Fund of Hedge Funds 2011 Global Bonds -19.0 -5.2 -21.4 -40.3 -5.7 20.0 10.3 11.5 5.7 4.8 6.9 5.5 5.6
30.8 12.3 13.5 9.0 -1.2
28.6 18.9
-5.0
-3.2
Global Equities
-46.5 Commodities
-45.1
Real Estate
Source: A&Q Industry Research, Bloomberg, Hedge Fund Research, Barclays Capital Based on USD total returns of HFRI Fund Weighted Composite Index, HFRI Fund of Funds Composite Index, Barclays Global Aggregate Index, MSCI World Total Return Index, S&P GSCI Total Return Index and GPR 250 Property Shares Index World Local Currency. Past performance is not an indication of future returns.
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Private equity
Private equity is a broad term that refers to any type of equity investment in an asset in which the equity is not freely tradeable on a public stock exchange. Private equity investments are generally less interchangeable than publicly traded shares and are usually considered a long-term investment. The private equity market is an important source of capital for start-up and young companies, for firms in financial distress and those seeking growth or buy-out financing. Depending on the point of the companys life cycle, the following are the principal financing stages: Venture capital Venture capital investing generally refers to investments in new and emerging companies. Companies financed by venture capital are generally not cash flow positive at the time of investment and may require several rounds of financing before the company can be sold privately or floated. Venture capital investments can be made into companies at the pre-product and/or pre-revenues stage, or it can be into companies which have just started to generate revenues. Venture capital investors typically acquire a minority ownership position in the company. Expansion/growth Expansion or growth financing are investments which often follow the venture capitalists and comprise investments whereby the company needs capital to grow and expand the business, and, usually, as quickly as possible. Depending on the nature of the business, companies receiving expansion or growth financing are already generating sustainable revenues but might still not yet be profitable. Buy-out Buy-out generally refers to investments seeking to acquire significant or often controlling interests in established, typically cash flow positive, or profitable companies. The use of debt financing, or leverage, is often prevalent in buy-out transactions and debt components of an acquisition financing structure can reach up to 75% of the purchase price. Within the buy-out strategy, there are mega; large; medium, small and micro-sized buy-outs. Special situations Special situations refer to a broad range of private equity investment strategies outside the scope of venture capital expansion and growth, and buy-out investments. Typically, special situations include investment strategies such as turnaround investments; distressed investments, mezzanine capital and lately, a growing segment called secondaries.
Private equity as an asset class

Private equity investing usually refers to an activity of investing in privately owned companies, which are typically acquired, in whole or in part, through privately negotiated transactions. Private equity funds pool capital from investors into strategy specific funds. These are often organised as limited partnerships, which are the most common legal structures for making private equity investments. Investors in such funds usually commit a certain amount of capital upfront to the private equity fund and, when requested by the funds manager or general partner, pay-in the amount (or percentage of the amount) over a period of time, usually over the first three to five years of the funds life. The general partner, i.e. the fund, then makes private equity investments on behalf of the fund on the basis of a pre-defined investment strategy and in accordance with the terms of the offering memorandum. A funds investments are usually realised, or exited after a five to seven year holding period through a private sale, an Initial Public Offering (IPO) or a recapitalisation, and the proceeds are distributed to the fund and the funds investors. The funds themselves are typically wound up after a period of ten to twelve years. Private equity investments are usually categorised according to financing stage, which refers to the stage of development of a company at the time the fund makes its investment. Each investment strategy (i.e. financing stage) carries distinct risk and return characteristics. Accordingly, each financing stage (as shown in Figure 8.6 ) potentially has a different value proposition within a diversified private equity portfolio.
Figure 8.6 Private equity investment activity
Company value
Private equity investment characteristics

Buyout Expansion/growth Venture Time Private IPO Public
Expected performance is medium to high over the longterm. Typically, private equity investors expect a minimum net return between 3% and 5% above publicly quoted indices. Top-quartile private equity fund managers have, historically, outperformed investors return expectations The J-Curve effect means that over the first two to four years, i.e. during the funds investment period, returns are usually negative, as the fund deploys capital (i.e. there is capital outflow)
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Private equity managers hands-on management can support the generation of steady positive cash flows over the long-term, because a proactively managed underlying company in a private equity fund has, historically, provided real returns to its shareholder(s), i.e. the fund Private equity investments earn money for investors through a) dividends paid to investors, b) increasing the business value and c) capital gains on the sale and exit of an investment A private equity manager with sector expertise can add value and optimise exit timing Historically, private equity has a low correlation to other traditional and alternative asset classes. Unlisted businesses have a very low correlation to equities and bonds, primarily because valuation metrics applied to public instruments are not necessarily applicable to private businesses A lower correlation to public traditional investments is also the result of the private equity investors ability to perform extensive due diligence on the investment opportunity before investing and once invested. This has two advantages, namely, they can use the funds value, creating a hands-on strategy to manage the investment, and can time the entry and exit of the investment depending on the industry cycle. (For example, private equity investments typically perform over a three to seven year, or more, period) Private equity investments usually align the interests of the investor and the company, because management of the target company is motivated by ownership in the business Long duration private equity investments provide a good match for long-dated liabilities A considerable amount of risk lies in the inherently illiquid nature of private equity investing. Once the fund commits to a private company, the investment is usually not liquid
increasingly becoming an important component in the asset allocation of charity investors, and numerous institutions around the world have created separate allocations to private equity. In private equity the management fees and holding costs are fairly high as investments are intensively managed and private equity funds have to cover the high costs of research, corporate finance and governance. The fee structures of private equity funds include a fixed management fee plus a performance fee. Some private equity funds also offer a hurdle rate to investors. Generally, the performance fee includes incentive payments based on achieving certain investment targets. Private equity advocates an appropriate incentive mechanism as a good way of attracting management talent and ensuring value-enhancing behaviour.
The private equity industry in 2011

With the global economic situation still very much in the balance, macroeconomic considerations are regarded as the greatest challenge currently facing the private equity industry worldwide. The fall out from the 2008-2009 downturn has also triggered increased attention from national regulators seeking to enforce more transparency from financial institutions. The private equity industry, often characterised as an enigmatic one, has been criticised in some instances, giving momentum to a process that had already begun on the back of concerns about job security and asset stripping (locusts1) as businesses with larger (often politically sensitive) shareholders came under private equity ownership in some markets. Witness also the most recent political debate unleashed in the course of the US presidential primaries, where a Republican front runner candidate is a former Managing Director of Bain Capital. The private equity industry is currently facing a plethora of challenges, some private equity specific, some regulatory and some reputational. Regulatory matters are high on the agenda, not least the introduction of Alternative Investment Fund Managers Directive (AIFMD); Solvency II, Basel III and US Dodd-Frank Act, including the Volcker Rule, etc. AIFMD, in particular, is expected not only to lead to higher levels of bureaucracy and increased costs but also to frustrate the dynamism of the industry by raising the barriers to entry for first time managers and spin-out teams. Moreover, Solvency II may impede the insurance industrys interest in investing in alternative assets in general and private equity in particular, as insurance companies struggle to implement a proprietary risk model or adopt the one provided by the regulator. 2011 was a roller-coaster year from a private equity perspective. The beginning of the year saw a return to conditions similar to pre-Lehman and included multi-billion
1
Increasing investor interest

Over the last few years, charity portfolios, particularly those with long-term time horizons, have shown an increasing interest in private equity investments. The global demographic trend of ageing populations has resulted in the need for longer-term, high-yielding, defensive investments to fund retirement incomes. Due to the lower correlation of private equity investments with traditional and other alternative asset classes, investments in private equity can play an important role when optimising an charitys portfolio, in terms of its risk and return characteristics. As a result, private equity assets are
Attributed to German politician Franz Mntefering
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exits (for example, the USD 8.5 billion sale of Skype to Microsoft), the return of dividend recaps and some of the largest ever private equity IPOs (for example, Kinder Morgan, HCA). But with the unfolding of the sovereign crisis, private equity markets experienced a summer chill and autumn frost and still face new challenges. The largest deal of 2011 was the announced acquisition of oil and gas producer Samson by a consortium led by KKR in November. However, according to data provider Preqin, for the whole of 2011, the value of global private equity investment rose 5% year-on-year to USD 260 billion, despite the number of deals falling 6% over the same period. Whilst there was a gain, the increase in value was not nearly as impressive as that of the previous years, when transactions featuring private equity almost doubled to USD 248 billion from USD 151 billion in 2009. However, values are still far below 2007s USD 900 billion peak. Venture capital staged an impressive comeback in 2011. Record IPOs of Internet and social networking companies, such as Groupon or LinkedIn, and strong demand for shares in unlisted companies, such as Facebook, Twitter or Zynga, made headlines internationally. However, high valuations have raised concerns over another bubble. Remember Microsofts acquisition of a small stake in Facebook in 2007 at a valuation of USD 15 billion? This was the first time people began wondering if there was another internet bubble in the making. As recently seen, Facebook nevertheless went public in 2012 at a valuation of USD 104 billion making the social media company one of the largest IPOs in history.2 The global IPO market produced 338 offerings in 2011, down 29% from 2010. However, despite the dismal backdrop of the downward spiralling eurozone and a moribund US economy and heightened market volatility, the 2011 results are remarkable. In the US, 24 internet companies went public, the most to do so in over a decade, including three of the top five most highly anticipated Internet 2.0 names (Groupon, LinkedIn and Zynga). World-recognised brands, such as Prada; Ferragamo; Samsonite, Glencore and Michael Kors; also completed IPOs during the year. Had it not been for the Greek solvency crisis, which erupted in mid-summer, the US IPO market certainly, and the global IPO market possibly, would have continued the recovery that began in late 2009. Proceeds raised by private equity-backed IPOs more than doubled in 2011 to USD 20.4 billion, the highest level in at least a decade. This was primarily due to HCA, Kinder Morgan and Nielsen, who completed three of the largest US private equity-backed deals of all time. The trio raised a combined USD 8.3 billion. However, despite the record amount raised, with 35 IPOs in 2011, private equity deal flow remained 40% below levels seen from 2004 to 2007, when the average number of private equity-backed IPOs per year was 57. Venture-backed IPO activity also saw a healthy
2
increase, though 2011 proceeds of USD 7.9 billion remained below the 2007 peak of USD 9.7 billion. There were 51 Venture Capital-backed deals in 2011, which remains 41% below 2007 levels (86 deals). Fundraising activity was also skewed, with more activity during the first half of the year than in the second half of 2011. Asian managers raised more capital than European managers, which is a first in the industry. Secondaries had another record year, driven by regulation, more banks are forced to divest certain assets, including private equity. Bank sellers included BNP, HSH Nordbank and Citigroup, while Deutsche Bank and AXA insurance group are still selling some of their illiquid assets. More forced sellers are lying in wait.
The private equity market in 2012

In December 2011 Preqin, an independent research firm focusing exclusively on alternative assets, interviewed 100 leading limited partners (LPs) from around the world and revealed that not only do the majority (85%) of investors intend to at least maintain their exposure to private equity but also 38% actually expect to increase their allocations in the longer term. In terms of their 2012 planned private equity investment activity, 62% expect to make their next commitment in H1 2012 and a further 11% expect to make their next commitment in H2 2012. Some transactions, which were put on hold in Q4 2011, might go through in H1 2012. At the same time, some private equity firms have taken advantage of lower prices in public equity markets and have made offers for companies to revert to private ownership. Four of the five largest deals in H2 2011 were public-to-private transactions. Moreover, the global share of emerging markets private equity deals will increase further. Debt markets, in all likelihood, will remain difficult in 2012, especially in Europe, where banks have limited appetite for new leveraged buy-outs. Luckily, a lot of fund managers have actively addressed upcoming debt maturities and extended the maturity wall towards 2014/2015. Firms that have to refinance in the coming 12 months will probably see more problems. However, the scarcity of debt in Europe can provide private equity firms with attractive deal opportunities to invest in firms looking for capital. The US market should be less affected; there, debt is more readily available although at higher margins. Furthermore, small/mid-cap transactions can rely on club financing and use lower absolute levels of debt. In addition, deals in emerging markets rarely use leverage and should hence be less affected by the global deleveraging. Private equity firms are still sitting on more than USD 900 billion of unspent capital, of which almost USD 200 billion needs to be spent in the next two years before investment periods expire.
Facebook filed its S1 shelf registration on 1 February 2012
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This amount looks manageable as, in 2010 alone a total of USD 240 billion was invested in private equity deals globally. Overall, the combination of willing private equity buyers and still cash-rich corporate buyers will continue to support prices, especially for high-quality, established companies. Prices for small-cap transactions, however, should fall somewhat. Lower public equity markets might also provide some interesting deal opportunities for takeover offers for long-term oriented private equity buyers. Distributions of recent vintage years have clearly been affected by the recent global recession but in some cases, still saw record levels in 2011 and will probably continue, at least, into H1 2012. Performance Figure 8.7 shows the latest available returns for the US and European private equity industry. (Please note, that these private equity figures reflect the total market, using an available sample size, while the figures of the best performing top-quartile funds are significantly higher). The data confirms the attractive performance characteristics of private equity in general, which do compensate, in the long run, for the illiquidity aspect as well as the differing cycles for the individual sub-segments. In the US, looking at the 20 year investment horizon (i.e. including the years 1999 and 2000, which were very beneficial for early stage technology investments), venture capital clearly continues to outperform buy-outs. Over a 5 year investment horizon, the US buy-out strategies slightly outperformed venture capital. Looking at Europe, on the other hand, over a 3, 5, 10 and 20 year investment horizon, buy-out strategies outperformed all other strategies. Generally speaking, the investing environment in Europe is probably less conducive to venture capital than in North America.
Figure 8.7 Private equity returns in the US and Europe European private equity returns to 30 June 2011 (% p.a.) 1 year All Venture All Buy-outs All Private Equity MSCI Europe (TR) 17.01 36.68 34.55 36.02 3 years -5.56 -2.7 -3.26 -2 5 years 0.61 8.39 6.31 2.02 10 years 0.72 13.98 10.17 6.15 20 years 2.75 13.72 11.35 7.52*
Figure 8.8 shows the returns that UK investors have achieved in different parts of the UK private equity arena to end 2011. Results have been volatile and vary greatly between different types of fund. From 2000 to 2002, returns were generally dragged down by factors similar to those affecting the quoted equity markets. From 2003 to 2007, a performance rebound was experienced by most fund types. However, 2008 saw the financial crisis and recession take hold, with private equity suffering alongside other asset classes. Whilst 2009 saw mixed returns after another challenging year, 2010 and 2011 have been periods of strong rebound for private equity. Notably, venture capital funds that had a vintage after the dotcom bubble have seen improvement in the underlying performance, whereas the strongest performance was generated by small MBO with 20.9% over a ten year period. The Annual Internal Rate of Return (IRR) for all UK private equity funds, covered by the BVCA survey, was 14.3% in 2011. The longer term numbers remain fairly static with the survey showing that the long-term net returns being in a narrow band around the 15% mark, on average, over the last ten years. Hence this years since inception returns remain broadly in line with this overall development.
Figure 8.8 UK private equity returns to end 2011 % p.a. All funds by fund vintage: Pre-1996 1996 onwards by location: UK Non-UK by sector: Technology Non-Technology Compared to quoted equities: FTSE All-Share FTSE SmallCap n/a n/a 12.9 17.3 1.2 -4.1 4.8 3.3 130 371 1.2 8.9 1.7 8.4 -0.8 15.4 348 153 4.8 9.0 6.1 8.3 11.0 15.2 153 348 -0.5 8.6 70.2 8.0 16.0 14.3 Number of funds 501 3 years 8.6 5 years 8.0 10 years 14.3
US private equity returns to 30 June 2011 (% p.a.) 1 year All Venture All Buy-outs All Private Equity S&P 500 (TR) 25.32 21.62 22.70 30.69 3 years 1.99 4.46 4.43 3.34 5 years 4.78 5.78 6.17 2.94 10 years 0.94 6.51 5.43 2.72 20 years 19.46 9.82 12.07 8.73
Sources: BVCA Performance Measurement Survey 2011, BVCA/PwC/Capital Dynamics Past performance is not an indication of future returns.
* MSCI Europe (TR) 20 years data is not available. The 7.52% figure shown reflects the period 31 Dec 1995 through 30 June 2011, i.e. 186 months Source: Thomson Reuters, Venture Economics, QASIM, data generated 19 January 2012 Past performance is not an indication of future returns.
In summary, the performance highlights the importance of diversification (by time; strategy, geography and industry) when developing a private equity investment programme. In addition, it shows the outperformance against quoted equities, which is even significantly higher if one gains access to the top performing private equity managers, for example, through fund-of-funds.
The European economies are often built on the back of the SMEs (Small and Medium Enterprises), which are particularly successful for small and medium buy-out investment strategies.
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Infrastructure
A defensive component in portfolios can enhance long-term overall returns
Infrastructure continues to attract attention amongst the investment community in the UK and around the world. Over the past few years in particular, infrastructure has solidified its place as a separate and unique asset class in the alternatives space. Commitments to unlisted infrastructure funds rose from USD 10 billion in 2005 to USD 37 billion in 2008 and, following the adverse impact of the financial crisis, from USD 9 billion in 2009 to USD 32 billion in 2010, and USD 16 billion in 20111. With many investment options available, first time investors may find it difficult to identify the role of infrastructure in their portfolio and match that role to appropriate managers. In the following discussion, we outline some key characteristics of infrastructure and give an overview of the asset class in the current market environment. We also consider expected return for the asset class, the key risks of infrastructure investment and the key attributes of best-in-class infrastructure managers. Globally, only a small fraction of infrastructure assets are listed or under private ownership. Notable examples include the water sector in the UK, the power generation sector in North America and many roads, ports and airports in Australia. There is substantial potential for increased private ownership. Drivers of future growth in the sector include demographic trends, the increasing role of private capital and increasing turnover of already privately held infrastructure. In general, investors who focus on yield and managing longterm liabilities, such as charities, should find infrastructure attractive. In addition to benefiting from enhanced diversification, these investors can use infrastructure to help match their liability profile with a reasonably predictable and partly inflation-linked distribution stream. Given its relatively low correlation with traditional asset classes, infrastructure can also play a valuable role in the risk-return optimisation of a portfolio and, in our view, should be considered in strategic asset allocation decisions.
Infrastructure as an asset class

The increase of infrastructure funds in the market offer investors multiple options from core to development and private equity opportunities. A portfolio of defensive or core infrastructure assets is characterised by the following investment characteristics: low correlation with other asset classes, cash yield and a degree of inflation protection, each of which are considered below. Low correlation: each infrastructure asset typically has unique revenue drivers and risks. This characteristic generally causes a lower correlation between the performance of infrastructure as an asset class and the performance of other asset classes. Some business drivers are more closely related to GDP growth (for example, ports) while others are more closely related to population growth (for example, water utilities). Consequently, there are differing correlations with traditional equities within the infrastructure asset class. Cash yield: infrastructure assets typically require significant initial capital expenditure and have long operational lives, often spanning 30 to 100 years or beyond. Such assets are usually regulated or underpinned by long-term contracts which typically provide a reasonably predictable yield. Development assets generally provide no yield during construction and lower yields during initial operations. However, cash yields usually increase over time as the asset matures and utilisation increases.
Defining infrastructure assets

Infrastructure is defined as the permanent facilities and structures that a society requires to facilitate the orderly operation of its economy. Examples include: Transportation such as toll roads; airports; ports; bridges, tunnels and rail Utility and energy infrastructure such as water and wastewater services; power generation, electricity and gas networks and fuel storage facilities Communications infrastructure such as transmission towers Social infrastructure such as education; recreation, waste management and healthcare facilities. Like real estate, infrastructure is not homogenous. It spans the risk-return spectrum from lower risk Public Private Partnerships (PPP) in developed countries, with availabilitybased revenue streams, to more private equity-like (higher risk) assets, such as single terminal concession ports. The high barriers to entry and the monopoly-like characteristics of typical infrastructure assets mean that their financial performance should not be as sensitive to the economic cycle as many other asset classes. Investments are generally low risk, given the stable and growing demand for the essential services provided together with the regulation of the businesses or long-term contractual protection of revenues or both.
Source: Preqin Ltd Historical Infrastructure Fundraising
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Inflation protection: revenues associated with infrastructure assets are often hedged, or partly hedged, against the impact of inflation either through an inflation element incorporated in the price or revenue formula of the relevant regulatory or contractual arrangements, or through the pricing power of the business based on the essential nature of the services provided. It is this combination of characteristics that supports the argument that infrastructure warrants its own allocation within an investment portfolio. These funds are well-suited to charity portfolios seeking steady, reliable returns. The infrastructure fund manager is responsible for the sourcing of deal flow, the execution of transactions (both acquisitions, and later in the life of the fund, divestments) on behalf of the fund, and the ongoing management of those assets held by the fund.
Infrastructure managers employ execution and asset management executives that are comparable to private equity investment teams, albeit with specific skills and experience in relation to the regulatory and market considerations that apply to infrastructure assets.
How does infrastructure compare with other asset classes?

Infrastructure investment shares some of the characteristics of fixed income (long-term predictable cash yield), real estate (investing in physical assets) and private equity (geared investment, albeit with substantial differences in the underlying risk). The similarities and differences between infrastructure and other asset classes are summarised in Figure 8.9.
Figure 8.9 Infrastructure compared with other asset classes Similarities Private equity Management control over investments Converging investment techniques Cash yield is significant part of return Absolute return objective focus Importance of location Equity ownership Upside return potential Long-term, predictable cash yield Long duration asset Low market risk Differences Different risk-return objective; lower exposure to economic cycle Longer investment horizon, return less driven by exit strategy Strong cash yield/lower capital growth Control over operating companies Barriers to entry; less exposure to valuation cycles Longer cash flow predictability, higher gearing Normally larger individual asset size Lower level of securitisation/liquidity Lower correlation with business cycle Relatively predictable and high cash yield Asset ownership Growth/upside potential Inflation hedge features Indirect exposure to interest risk
Real estate
Equities
Fixed income
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In terms of return expectations for infrastructure compared to other asset classes, Figure 8.10 generically depicts the risk/return spectrum across various asset classes and within infrastructure sub-sectors.
Figure 8.10 Infrastructure risk-return expectations compared to other asset classes and within infrastructure sub-sectors
Risks
Whilst infrastructure assets are generally viewed as being relatively low risk, they are exposed to a number of sector specific risks. In our view, investors should never lose sight of the fact that risk always matters and there is no such thing as a risk-free infrastructure investment. Patronage and demand risk Some infrastructure, such as transportation - toll roads, ports or airports - is more exposed to patronage or demand risks than other infrastructure. For such infrastructure, though essential, patronage usually varies in response to economic conditions: business people make more international business trips in a buoyant economy and therefore, airport patronage increases. Transportation infrastructure therefore, tends to be pro-cyclical. This was certainly observed in response to the recent global financial crisis. Consequently, a portfolio which contains a substantial proportion of transportation infrastructure will often correlate more highly with equity markets than a portfolio which contains more utility infrastructure. Regulatory and sovereign risk As infrastructure is often a monopoly or subject to open access, it is often regulated by governments either through systems set by regulators or through long-term concessions. In such circumstances, regulatory independence and consistency, as well as government capacity to unilaterally amend concession terms, are key risk factors. This is closely allied to broader sovereign risks which also need to be considered for example, whether to invest in developed or emerging economies. Contractual and credit risk Along with regulatory protections, contractual protections are key defensive characteristics of infrastructure. For example, a portfolio of electricity generation facilities takes on infrastructure characteristics if its power output is pre-sold under long-term contracts without such contracts, the portfolio would be exposed to the often substantial fluctuations of commodity and spot-market power prices. Such contracts, therefore, provide fundamental protections but the contractual compliance and creditworthiness of the counterparties thus becomes a key risk to assess and manage before and throughout the life of an investment. Operational risk Infrastructure has operational risks. A regulated water and sewage company, for example, may incur sewer flooding during prolonged heavy rainfall where sewage systems reach their hydraulic capacity. While the company can do some forward planning, the full cost of these measures may not be taken into account at the relevant periodic review and the incident could adversely affect the companys results.
Private Equity VC
Expected returns
Private Equity Greeneld mature development buyout Mature Procyclical
Hedge funds
Mature Noncydical
Bonds
Risk
Each investment opportunity must be assessed on its own merits to determine the minimum required return. Some subsectors, such as transport, are exposed to higher risks (hence requiring higher returns), given their pro-cyclical exposure to the economy, than, for example, a utility. Mature assets in contracted and regulated sectors usually generate low double digit returns. Renewable energy infrastructure returns are also typically at that level. Additional risk premia are required for market exposure (for example, patronage and commodity risks) and development and construction risks. A survey conducted in 2011 by Deloitte reveals fund managers return expectation for various asset subclasses. Figure 8.11 shows the lowest returns for Public Private Partnerships/Private Finance Initiative (PFI) and the highest required return is infrastructure services. The required returns reflect the contracted nature of the PPP/PFI revenues versus the demand risk and low barriers to entry of infrastructure services. In the view of the authors, infrastructure services firms do not satisfy the key investor requirements of infrastructure investors.
8.11 Infrastructure IRR comparison across infrastructure subsectors (3 being high and 1 being low)
3.0 2.5 2.0 1.5 1.0 0.5 Other regulated utilities Infrastructure services Water Rail/metro Other transport Renewables Airports Telecoms PPP/PFI Roads Waste Ports 0.0
2007 Average
2010 Average
Source: Deloitte (2011): a fork in the road ahead: An in-depth analysis of the current infrastrucure funds market.
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Construction risk Greenfield projects involve construction risks though such risks can be mitigated through proper structuring, including back-to-back pass down of key construction risks to the contractor; contracting with a credit-worthy contractor, monitoring and managing against timetable and budget during construction and contingency planning. Financing and inflation risk Leverage used in financing infrastructure transactions may expose investors to debt costs and refinancing risks. In most cases, to mitigate the risk, managers will use derivatives to hedge interest rate risks and to better match debt service with the profile of the revenues. Where cost effective and sufficiently flexible, managers will also use longer dated debt to reduce refinancing risk. Cash flow values may also be eroded by inflation where the regulated, or contracted cash flows, do not move in whole or part with inflation, or where the monopolistic market position of the infrastructure does not allow the owner to recoup inflation costs from the asset user. The above risks will have varying degrees of influence on whether an infrastructure investment is appropriate in any risk-return assessment. They highlight the importance of conducting extensive due diligence before making an investment and the need for the investment team to be broadly skilled. A toll road and hospital, for example, have unique characteristics that will influence their distinctive risk profile. Consequently, as is the case with most investing, it is important to ensure that risks are fully understood at the outset and the portfolio, appropriately diversified and balanced. The above risks are not exhaustive and should be read in conjunction with the detailed risk factors set out in the private placement memorandum relating to a fund.
Unlisted funds unlisted funds invest directly in infrastructure on behalf of their limited partners Direct infrastructure investment
Key attributes of best-in-class infrastructure managers

In the case of unlisted investment funds, the investor must first decide on a fund manager. So what should you look for in an infrastructure fund manager? Here are our views: Investment team experience and regional presence Investment team quality is paramount to the success of an infrastructure fund. The team needs to demonstrate in-depth sector know-how, strong transactional capabilities including principal investing, advisory work and capital markets experience - and deep asset-level operational experience. In addition, regional on-the-ground presence is important to understanding the environment in which a company or fund operates. As the asset class matures, fund managers performance is becoming more visible, allowing an investor to assess performance against their stated fund mandate. Opportunity sourcing and investment process With many managers seeking infrastructure investments, access to quality opportunities and a disciplined investment process are crucial. Successful fund managers have a good reputation as transaction counterparties; a broad and deep network to source investment opportunities, a record of remaining within their mandate (i.e. no style drift) and the experience and skill to select the best opportunities. Asset management capabilities Ongoing asset management of infrastructure may be either passive - in the case of smaller stakes in listed investments or active - in the case of significant stakes in either listed or private investments, including direct investments. In the case of active management, a quality manager will seek to add value by pursuing a hands-on asset management approach with a particular focus on areas such as strategic planning, enhancement of operational performance and optimisation of capital management. Conflicts of interest Close alignment of interest between the fund manager and investors is essential; put simply, fund managers should profit if investors profit. Investors increasingly focus on strict governance, transparent conflicts management and transparent fee structures.
Investing in infrastructure
With a recent increase in funds in the infrastructure sector, a growing number of investors are looking to include infrastructure in their investment portfolios. Investment in infrastructure can generally be made in five broad forms - in approximate order of ascending sophistication and difficulty of execution for a prospective infrastructure investor: Listed funds - listed funds invest in direct infrastructure, listed infrastructure or both, and are usually externally managed Listed stocks there is a large universe of listed stocks in the infrastructure sector including utilities Fund of funds - a fund of infrastructure funds invests in a diverse portfolio of infrastructure funds
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Key issues in 2012 and beyond

Even the best infrastructure fund managers are facing new challenges in the changing macroeconomic environment. There is a large number of country, sub-sector specific or short-term issues that go beyond the scope of this document. However, we highlight below some of the globally relevant, medium to long-term key issues: Climate change The impact of potential climate change upon infrastructure should be considered at all stages of investment. Climate change subsidies and other support to the renewable energy sector also provide a good example of the potential impact of policy and associated regulations on investment activity. Over the past decade, the experience of investors in Germany, Spain and some of the North American regions, demonstrated the extent to which subsidies can accelerate the development of the sector but also cause a slowdown in development activity once economic support is reduced and, potentially, substantial losses for those investors excessively reliant upon subsidies. Government finances Deteriorated government finances, especially in many developed countries, represent another important issue for infrastructure investors. Fiscal stress suggests that private capital will increasingly be needed for financing infrastructure capital expenditures. Concern around public finance sustainability will require governments to reduce spending and find alternative infrastructure financing. These drivers should create investment opportunities. Furthermore, the way governments deal with their financial balances will be an important driver of economic growth. Indirectly, this will affect infrastructure projects exposed to demand volatility. Inflation Considering that investors often seek inflation hedging through infrastructure investment, the outlook for inflation is an important consideration. Uncertainty around future inflation was limited for the decade preceding the global financial crisis. However, the current outlook is a lot more uncertain. For the infrastructure sector, this uncertainty could mean an increasing demand for assets that are structured to provide an inflation hedge and a growing focus on differentiating between assets that have explicit inflation links, and those that do not. Investment returns There has been a significant increase in recent years in the number of infrastructure funds and the size of assets under management. However, this does not necessarily reflect a disproportionate supply of capital chasing infrastructure assets. The market expansion reflects the rapid development of the asset class from a low base rather than an oversupply of capital. Partly due to the expansionary monetary policy response to the global financial crisis and also reflecting
a post crisis shift in credit standards (i.e. tolerance for leverage), expected returns have declined across a number of markets and asset classes. However, on a risk-return basis, infrastructure remains a compelling asset class. Debt markets The availability and terms of debt will remain a major driver for overall infrastructure investment activity. While debt markets have strongly recovered since the financial crisis, a number of structural changes arose over the past two years, some of which are likely to persist over the medium term. These include the shift from bank to bond markets as most banks will have to continue to strengthen their capital and liquidity position, as well as reduce their appetite for long-term project debt. The state of debt markets will be important for the financing of new investments and also, critical for the significant refinancing needs of the sector over the next few years. The strength of the corporate bond market, including the re-emergence of the high yield and sub-investment grade market in the past year, is generally seen as a source of funding which will ease some of the pressure around re-financing.
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Global tactical asset allocation

The objective of Tactical Asset Allocation (TAA) is to add value for the charity portfolio by moving away from the strategic asset allocation for periods of time to take advantage of valuation anomalies across the different asset classes comprising the strategic benchmark. Historically, a standard balanced charity portfolio would set its strategic asset allocation in line with a benchmark. The manager of each portfolio would then use their discretion to alter the asset class weightings around this benchmark, within limits defined by the charity Trustees investment policy. Ignoring TAA completely removes a potentially valuable and important additional source of return as well as potential risk reduction. Typically, balanced funds that contain a mix of different asset classes would expect to achieve perhaps about a quarter of their expected long term out-performance of the benchmark from TAA. TAA can thus be seen as another source of return with a low correlation to other elements of potential excess return in the portfolio. Over recent years, new techniques for implementing TAA have evolved which allow charity portfolios to obtain exposure to TAA, even if they employ specialist fund managers for each asset class. In addition, these new techniques remove many of the constraints that traditional methods imposed on TAA, thereby allowing for greater portfolio efficiency through either higher expected returns and/or lower expected risk than could previously have been expected from this capability. These new techniques have become more commonly referred to as Global Tactical Asset Allocation (GTAA) and often involve the creation of a selfcontained GTAA fund that can be used to overlay TAA views onto existing portfolios, regardless of their benchmarks. The GTAA manager can then use derivative products, such as equity and bond market futures and currency forwards, to achieve an investment return from GTAA that aims to replicate the contribution typically expected from traditional TAA techniques, but with greater efficiency. While the fund manager will still be restricted by agreed limits on the level of risk that they can take within the GTAA product, there are a number of major advantages that stem from using this type of approach, meaning that it is more efficient in terms of risk and return than traditional TAA methods. For example: Unlike traditional TAA, these GTAA portfolios can take views on asset classes that lie outside the strategic asset allocation or investment universe of the underlying portfolio. This creates a much larger range of investment opportunities with which to add value invest in a physical asset, in its entirely. This constraint often produces a major inefficiency within traditional portfolios Investing in physical assets can make it difficult to express asset allocation views. For example, a fund manager may decide that bonds in a particular country are cheap but that the currency of that country is expensive. This creates a dilemma and the net result may be that no view is taken. By using derivatives, it is possible to separate these two decisions buying the bonds and selling the currency creating a much wider range of potential investments Using derivatives allows the fund manager to respond more rapidly to valuation discrepancies and avoids any disruption to underlying portfolios of stocks or bonds. Figure 8.12 summarises schematically how an expanded investment universe and increased flexibility enhance the managers ability to add value Utilising derivatives to express asset allocation views can reduce transaction costs that would otherwise be incurred by transacting physical securities The common theme is that newer GTAA techniques tend to remove constraints on the TAA process that have, in the past, restricted the range of investment opportunities available. Removing these restrictions tends to result in a more efficient portfolio and therefore, an improvement in the risk-return trade-off to the benefit of the charity portfolio.
Figure 8.12 Modern GTAA enhances ability to add value Ability to add value Investment exibility
Investment exibility Investment universe Skill
Investment universe
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Modern GTAA
Using derivatives makes it is possible to short an asset class. It means that if the fund manager thinks an asset will fall in value, they can effectively sell that asset and make a gain if its price falls. This is impossible using traditional techniques, since the fund manager can only
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Currency
How does currency affect returns?
An inescapable reality of investing internationally is that a foreign investor cannot earn the local rate of return that is available to domestic investors. For example, a UK investor buying United States government bonds is not able to earn the same returns that a US investor would earn. This is because the UK investor is also faced with the issue of exchange rate exposure, which the US investor is not. Currency exposure does not have to be accepted; it can be hedged. If currency exposure is accepted (hereinafter this is referred to as being unhedged), then the return to the UK investor, in our example from the US government bond, is provided by the combination of the bonds rate of return in the currency of its denomination the US Dollar and the rate of return of the dollar against the British pound. The UK investor experiences both of these returns simultaneously. Hedging currency exposure is sometimes thought of as completely removing the issue of currency from international portfolios, such that the UK investor earns the same rate of return as a domestic investor. In fact, hedging does two things the first being to remove exposure to currency fluctuations, and the second, to replace this with a known gain, or cost, that is equal to the interest rate differential between the two currencies. The latter is known as the impact of hedging, and it is not possible to hedge without incurring this. Hence the choice facing a UK investor buying US bonds is whether to earn unhedged or hedged returns. However, the investor cannot simply earn the local return in dollars that is experienced by domestic US investors. Mechanics of hedged and unhedged returns An unhedged investor buying an international asset first buys the foreign currency in which the asset is denominated (this is known as a spot purchase), and then uses this to purchase the asset. Thus, the UK investor, in the example, initially sells sterling for dollars before using the dollars to pay for the US government bond. The dollar value the investor obtains from the sale of sterling depends on the spot sterling-dollar exchange rate at the time of this transaction. Upon realising this investment, the investor will sell the bond and receive dollars, and will then have to sell the dollars for sterling. The Dollar value that the investor receives on selling the bond is determined by the rate of return that the bond has delivered over the period it was held. The final sterling value the investor realises from the bonds proceeds is determined by the new spot sterling-dollar exchange rate at the time of the sale. Thus, the investors total unhedged return in sterling is the combination of the bonds return in dollars and the return of the dollar against the pound. We refer to these components of the investors unhedged return as the local return and the currency return respectively. Written as an equation: Unhedged return = local return + currency return A hedged investor undertakes a different sequence of transactions. In the same example, when buying the dollars, the investor simultaneously sells the same amount of dollars, again, at an agreed date in the future (a forward sale). The exchange rates for buying and selling the dollars against sterling are known as the spot rate and the forward rate respectively. The forward rate is equal to the spot rate plus an adjustment, known as the forward premium or discount, which reflects the interest rate differential between the two currencies. The adjustment is not necessarily zero, but importantly, it is known in advance, hence the spot rate and the forward rate are both locked in at the time the overseas investment is initiated. From this point in time until the agreed forward date, the investor has the use of the dollars to purchase and hold the bond. If the investor then sells the bond again, receiving dollar proceeds on the forward date, these are then simply paid over in settlement of the forward sale, and sterling is received at the pre-agreed forward rate, and no further transaction is necessary. In this way, irrespective of the movement of the dollar against sterling subsequent to the initial transaction, the investors total hedged return in sterling is the combination of the local return of the bond and the return that is represented by the forward premium or discount. We refer to the latter component of the hedged return as the impact of hedging. Written as an equation: Hedged return = local return + impact of hedging The difference between the return from an unhedged investment and the return from a hedged investment is referred to as the currency effect. With a bit of algebra, it can be shown that this is also equal to the currency return minus the impact of hedging.
Equilibrium risk and return

Currencies are generally not considered to be an asset class in their own right. Rather, currency exposure is a property possessed by all financial assets and represents a component of their risk and return. In the case of cash deposits, risk (from an international perspective) is almost 100% currency related since the interest rate is known with near certainty. It is frequently assumed that the currency exposure of an asset makes little difference to its long run return. Another way of saying this is that currency exposures wash-out over a long horizon or that currency exposures provide zero expected return.
Currency effects in non-equilibrium conditions

Whilst we may make the assumption that, in equilibrium, currency exposures provide zero expected return to investors by themselves, this is obviously not true over all time horizons. Indeed, it is apparent that substantial displacements from equilibrium do occur. Even though these may ultimately tend
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to be corrected, they can have profound differential effects on hedged portfolios compared to unhedged portfolios. Moreover, these effects can persist for a number of years. This observation significantly complicates the decision of whether or not to hedge international portfolios and leads directly to the consideration of dynamic currency management. We can use examples from history to show that, notwithstanding our equilibrium assumptions of zero currency return, currency movements have indeed substantially affected returns to UK investors from non-UK portfolios in the past both positively and negatively. Figure 8.13 shows two cumulative return indices (wealth indices) from a portfolio entirely invested in Japanese bonds. The returns are shown in sterling terms, and for both fully hedged and unhedged portfolio. The difference between the unhedged and the hedged performance is the currency effect. The period measured is over six years, from end December 2000 to end June 2007. In this example, the currency effect is deeply negative. A UK investor holding a portfolio of Japanese bonds unhedged over this period would have earned a negative return while the portfolio would have earned healthy positive returns had the portfolio been hedged. This is because of the sizeable and sustained depreciation of the yen against sterling over the period and the large difference in interest rates. An investor observing or experiencing this performance would be likely to conclude that hedging international investments was surely preferable.
Figure 8.13 The currency effect: Japanese bonds in sterling terms, December 2000 to June 2007
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UK investor accepted the unhedged exposure to the steeply climbing yen, the return would have been pushed up to well over 100%. This experience would surely have caused hedged investors to regret their decision to hedge the Yen exposure.
Figure 8.14 The currency effect: Japanese bonds in sterling terms, June 2007 to February 2012
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Source: Datastream, UBS Global Asset Management Past performance is not an indication of future returns.
These two examples illustrate that the notion of zero currency returns in equilibrium is quite clearly a long-term proposition. Short and medium-term returns from currencies have been significantly far from zero and sometimes persistent. The above examples serve to complicate an investors thinking regarding whether it is a good idea to hedge international investments. Clearly the issue of currency exposure is highly important and cannot be ignored. The long-term assumption of zero return from currency may well be too long-term for many investors to withstand the consequences either of accepting currency exposure when currency effects are negative, or of hedging it and suffering regret and underperformance of peers when currency effects are positive.
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The case for dynamic management

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A second example of pronounced currency effects in practice, this time in the opposite direction, is shown in Figure 8.14. Here the wealth indices once again show the performance of a Japanese bond portfolio in sterling terms, hedged and unhedged. The period measured is end June 2007 to end February 2012. In this example, the currency effect is highly positive. A hedged investment in Japanese bonds over this period would have produced cumulative returns of around 25% but had the
One response to these difficulties is to undertake dynamic management of currency exposure. This is based on two premises. First, that no passive choice about currency exposure will always be the correct or best choice, and second that the decision regarding how an international portfolio is hedged can, and should, change over time. Furthermore, it involves accepting that investors can respond to developments in the currency market such as movements out of equilibrium in such a way as to achieve better risk-adjusted returns than would be achieved by a passive approach. There are several advantages to treating currencies as an additional source of return. Currency markets are the worlds most liquid markets, with some USD 4 trillion traded daily. As a result, transaction costs are minimal. In addition, currency markets are not dominated by profit-
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maximisers; instead, commerical and central bank activity tend to dominate flows and, consequently, they provide opportunities for alpha seeking managers to generate incremental return. Finally, currency returns can have a low correlation with other asset classes and therefore, can offer substantial diversification benefits. Currency managers can seek to enhance the consistency, of their returns and reduce the riskiness, of their returns, by using several strategies instead of relying on just one. For example, they can combine fundamental strategies based on investing in the currencies of strong economies; carry and curve strategies with systematic long and short positions based on yield differentials and yield curve shapes, and trend-following strategies based on momentum. They can also use judgement to generate returns and manage risk. This would, for example, avoid over-reliance on single strategies that can be prone to episodic return profiles, such as carry in and curve 2008, and momentum more recently. Momentum-only strategies have broken down in recent years as the Euro, to take one example, has been whipsawed by the financial crisis amid concerns over sovereign debt in the eurozone periphery. Figure 8.15 shows the Euro plotted against CDS for Italy and Spain, illustrating the volatility of the currency in recent months.
Figure 8.15 Euro spot rate vs CDS of Greece, Spain & Italy
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CDS
The ability to capture excess currency returns independently from the management of the underlying assets in a portfolio exists thanks to the depth, liquidity and flexibility of the forward currency market. Thus, the ability to manage currency separately and the potential to earn excess returns from this mean that dynamic currency management is a valid activity in the same way as dynamic asset allocation, equity and fixed income management. Furthermore, since we assume that the expected correlation of currencies with assets is zero over the long-term, it follows that the management of this separate source of risk and potential excess return should be undertaken by a manager with currency expertise. Traditionally, managers have achieved the separation of currency decisions from the underlying asset strategy by use of the currency forward market. Pooled vehicles are now available to achieve the same aim. By committing a small proportion of the total portfolio to such a pooled vehicle, global bond, equity or multi-asset mandates can access a full range of currency alpha-generating opportunities.
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Separation of currency investment decision

In the arena of dynamic investing, the distinction between currency management and the management of underlying assets (bonds, equities etc.) disappears. Whilst in an absolute return sense, we have acknowledged that expected currency returns in equilibrium are zero, from the perspective of relative returns and while seeking to outperform a passive strategy, currency ranks on equal footing with all other investment decisions. The potential to earn excess returns from dynamic currency management exists due to their volatility and the pronounced non-zero rates of return that currencies can deliver over short and medium term horizons.
EUR
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Gold
Gold has a longer history as an investment medium than any other type of asset. Indeed gold has been used as money for over 5,000 years and, for many periods in history, the two were interchangeable. In many places, especially in the developing world, gold still plays an important part in peoples savings as it is easily transportable and saleable in times of trouble, and may hold its value better than the local currency. Gold today forms a very modest proportion of the worlds wealth in terms of global market capitalisation. Yet, as recently as 1979, the value of the gold held by the central banks around the world was more than the US stock market (as measured by the S&P 500 Index). Silver and other metals, such as platinum can be considered, in general terms, as commodities, which are covered in the next section, although the distinction is somewhat arbitrary. There are several attractions of gold as an investment, not least the high liquidity of the market and golds status as an asset, as perceived by central banks. Gold is often seen as a good diversifier for funds which means that the return on holding gold is very different from the returns on most other investments. Data from the World Gold Council shows that, historically, gold has shown low to negative correlation with the major equity markets. Over the very long-term, measured in centuries, the gold price has broadly matched inflation in the UK and gold is often referred to as an inflation hedge. However, this has not always been the case over shorter periods and need not be true in the future. Gold often performs best in times of geo-political instability, financial turbulence or high inflation as it is seen as a safe-haven. The strong rally in gold in the high inflation era of the late 1970s can be seen in Figure 8.16, along with the subsequent gradual decline in the gold price as the world witnessed lower inflation and a more settled economic outlook.
Figure 8.16 Gold bullion price 2,000 1,600 Index 1,200 800 400 0
A renewed upward trend in gold prices began to emerge in early 2000 its origins seeming to coincide with the start of an equity bear market. In late 2002 and early 2003, with geopolitical concerns adding to the continuing equity market weakness, gold prices gathered further momentum. Across 2002 and 2003, gold prices rose by over 20% p.a. in US Dollar terms. Gold price appreciation levelled off to a more modest 5% in 2004 but accelerated again up until 2007, mainly driven by increased investor demand. 2008 saw turbulent markets with many equities and commodities losing half their value. Gold maintained its safe-haven status though and prices increased for the eighth consecutive year, with investors buying gold due to increasing mistrust of financial institutions. In 2011, gold prices rose for the eleventh consecutive year, up approximately 9% for the year to end December 2011 (in USD terms). Thus, outperforming many global equity and commodity indices. Data from the World Gold Council also shows that 2011 generated a record annual value for gold demand of USD 205.5 billion, an increase of 29% compared to 2010. Investor appetite for gold has been on a generally upward trend. Among investors, few charity portfolios have held gold in recent years but there is some evidence of resurgence of interest, in both gold and other commodities, as the search for diversifying assets continues. Investment in gold can be a strategic or tactical asset allocation decision. The obvious way to invest is to buy physical gold. There are several alternatives to this; the most recent innovations being gold Exchange Traded Funds (ETFs). These are securities that are traded on a stock exchange, are fully backed by physical gold and aim to track the spot gold price. The last five years have seen a dramatic increase in the market capitalisation of these securities from USD 0.4 billion at the start of 2004 to USD 33.1 billion at 30 September 2008, then rising significantly to USD 97.9 billion at 30 September 2010 (as stated by the World Gold Council). Investors did, however, slow down their purchases in 2011. This was in part due to rebalancing and profit-taking but also because many investors had gained exposure earlier (notably in 2009). Another way to gain some exposure to gold is to buy shares in gold mining companies or invest in gold-based pooled funds, although the latter vary in the degree to which they invest in mining company shares the underlying metal and gold futures. It is important to note that mining company shares alone may deliver very different returns from gold itself depending upon the companies gearing and hedging policies, and the performance of their mines as well as general factors affecting equity markets. Finally, there is a wide variety of gold-related structured products and derivatives offered by investment banks.
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In contrast to the attractions of gold, there are some drawbacks. First, gold produces a limited income, although large holders may be able to lend their holdings to gold producers and other market participants, such as manufacturers. Second, there have been fears over the supply and demand balance, especially as central banks have been net sellers since 1989. Third, there is also an argument that the status of gold as an investment class is less important in current times given the huge diversity of other investments now available, such as derivatives, hedge funds, etc. Many of these can provide the insurance policy that has been a golds traditional preserve.
However, despite this growth, commodity prices have considerably lagged equity markets over the long term. Certain commodities, in limited supply, may see longterm price appreciation as supply diminishes. However, to date, substitute technologies and new resource finds have generally averted such problems. In the shorter term, prices are more closely related to changes in industrial production, as well as factors such as inflation and related commodity prices, particularly since some commodities are used as inputs to the production of others. Investment in commodities can be via commodity funds or through the commodity futures market. Investment via funds and futures gives a financial exposure without the need for physical delivery of the underlying commodity. It is possible to gain an indirect exposure to commodities through companies with profits linked to commodity prices, such as mining, energy or agricultural shares. In recent years, the sharp rise in many commodity prices had been very beneficial to commodity based businesses and, until the correction, share prices had been very strong in these sectors. They even managed to record positive returns in the first half of 2008, despite the broader market weakness. However, as concerns over growth began to dominate the economic landscape in the third quarter of 2008, commodity prices experienced a sustained fall, dragging down shares in commodity-focused firms too. More recently, the resurgence of economic growth, led in a large part by resource-hungry China, has helped commodities, commodity-linked shares and currencies rebound sharply.
Figure 8.17 Commodity returns
Commodities
Gold is one specific commodity that is of particular interest to investors. Alternative commodities include other precious and base metals, energy and agricultural products. Commodities typically produce no direct income but they are liquid and are often perceived to provide a high level of diversification, and a hedge against inflation. A paper from another group company, UBS Global Asset Management, challenges the conventional wisdom that commodities offer a hedge against inflation or that they provide a diversification benefit through low correlation with equity and bond prices. The paper concludes that passive investment in commodity futures, a commonly considered route to commodity exposure, is not a sensible investment. Active management of commodity futures exposure is necessary to take advantage of supply/demand imbalances. Returns from individual commodities can be highly volatile and investors may be attracted by the potential for making quick profits. However, this volatility also carries a high level of risk. Prices are driven by perceptions about the balance between supply and demand. A small change in demand can lead to a large change in the price of a commodity due to the time lag before the amount of supply can be adjusted. For example, an increase in demand for copper cannot be easily matched by increased mine production in the short-term, as it can take years for a new mining project to be brought on stream. After a long period of stagnation in the 1980s and 90s, prices appear to have started a powerful new cycle, in part, driven by demand from emerging markets. Until a sharp correction in mid 2008, commodity prices had seen significant increases over the last few years, as shown in Figure 6.17. Demand and prices fell during 2011 as sentiment worsened, and some now question whether the 20 year bull run, that had been predicted, is over.
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Art
Art is not a mainstream asset for charity portfolios. However, there have been some charities that have invested in art, notably in the 1970s, when high inflation eroded the value of equities and bonds, and inflation-linked bonds were not available. Art is an unusual investment category as many valuable works of art are unique. The art market can, therefore, be illiquid as individual buyers need to be matched with sellers for each trade, and transaction costs, such as auction house premiums, are very high. The low liquidity and high costs can be justified if the risk is very low or if the expected returns are exceptional. The risk in holding art is quite high because art tends to perform poorly when economic conditions and stock markets are weak. Art is a discretionary good and usually tempts purchasers when they feel confident. These people may become forced sellers when their personal circumstances deteriorate. In this way, the performance of the art market is broadly linked to the performance of other financial assets and therefore, does not provide as much diversification benefit as might at first be imagined. In the early 1990s, distressed sales of paintings bought by Japanese financial institutions in the late 1980s boom demonstrated the potential link between the art market and the real estate and stock markets. Art prices, and thus art returns, are quite difficult to measure. Few works of art come up for sale regularly and, given that the reasons for sale are often associated with very high confidence or distressed circumstances, the prices paid are not necessarily representative of the overall market. A global art price index, from an organisation called Artprice shows that art prices steadily declined from historic highs in the early 1990s; remained flat for much of the mid to late 1990s, have been on the increase again since mid 2002 and accelerated quite sharply in 2006 and 2007. However, the financial crisis during 2008 and early 2009 caused prices to drop back to their 2004 levels, falling nearly 38% in 15 months, according to the Artprice Global Index (to end Q1 2009). Art market confidence levels are back on the increase after falls during the recession. Prices began to level off in Q2 2009, rising again modestly in the second half of the year as the market regained confidence. Indeed, 2011 was a robust year for art sales, though the split between developed and emerging economies, in particular the BRICS markets, is quite marked. The founder and CEO of Artprice, Thierry Ehrmann, stated in Artprices latest report regarding 2011 that Chinas growth in particular has profoundly modified the geographical structure of the global art market. Growth in Asian and emerging markets has been driven by a combination of very wealthy collector as well as a growing number of art investment funds. As a result, the Asian art market has become the most high-end area of the entire globe. Perhaps the greatest obstacle to art investment for charity portfolios is not strictly financial. Arguably, a large part of the return from art comes from the pleasure derived from viewing it during the period of ownership. This can be thought of as the income generated although there is no financial income. Charity portfolios focused on financial returns cannot really gain from this benefit of ownership and therefore, their returns from holding art will be lower than for private investors. As such, charity portfolios start at a disadvantage although this could possibly be mitigated by renting out works of art. Given arts other drawbacks of low liquidity, high transaction costs and high risk, charity portfolios would need to be confident of earning very high returns to consider meaningful investments in this area.
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Appendices
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Appendix A
Types of risk
Risk measurement
Figure A.1 FTSE All-Share Total Return Index 4,500 4,000 3,500 Index level 3,000 2,500 2,000 1,500 1,000 500 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Year ends
An investor is exposed to a variety of risks. Market risk is the risk that the investments in a portfolio do not provide the returns expected of them due to underperformance of the chosen assets and markets. Other types include credit risk (losses from the default of a debtor) and operational risk (losses due to errors, fraud, legal problems and generally everything not included in credit or market risk). The overall purpose of this appendix is to provide an explanation of market risk. Market risk Market risk is a measure of the deviation of investment returns from expectations. To define market risk, the expected return needs to be defined and the means of measuring the deviations of returns from it. Risk measurement can be applied looking back in time to analyse how a portfolio performed. In addition, the current positions and strategies can be analysed to forecast what range of outcomes could be expected in the future. Ex-post and ex-ante analysis Looking back in time, known as ex-post analysis, a historical series of returns are used to analyse what actually happened. For example, you could look at monthly returns of a portfolio over the last three years. The most common measure of risk in this case is the standard deviation of returns (also called volatility). The standard deviation looks at deviations from the average return realised over the period. In forecasting risk, known as ex-ante analysis, the current positions in the fund can be used to forecast the standard deviation of returns over a period, for example one year. The forecast is based on historical volatility and correlation of the returns of the various assets held in the portfolio. While there should be reasonable comparability between the ex-ante and ex-post risk over the longer term, there can be greater differences if looked at over very short periods. This is because of the impact of random factors, including fluctuations in volatility and changes to relationships, may not be fully reflected in the risk model used. To illustrate this, Figure A.1 shows the FTSE All-Share Total Return Index from the end of December 2001 to the end of December 2011. It is clear that the level of the index fluctuates up and down. The histogram, Figure A.2, shows how often, in this period, the monthly return was in a particular range. The mean (0.39%) and standard deviation (4.48%) of monthly returns are shown. The mean is the average. The standard deviation is a measure of the variability of the returns. In this period, which has 120 monthly returns, there were 17 months with a return more than 1 standard deviation below the mean, 12 months with a return more than one standard deviation above the mean and 91 months with a return within 1 standard deviation of the mean.
Figure A.2 FTSE All-Share Total Return Index, monthly returns, 2001-2011
20 15
Frequency Mean -1 standard deviation -4.09%
Mean 0.39% Mean +1 standard deviation 4.87%
10 5
Annualised risk Normally, annualised rather than monthly returns are used when talking about the performance of a portfolio. Therefore, it makes sense to state risk as an annualised figure too. For a ten year period, there are 120 monthly return figures; enough to draw a histogram, calculate standard deviation with a reasonable degree of estimation error and get an idea of the risk of monthly returns. If annual returns are used instead, there would be only ten observations, too few to make a meaningful risk calculation. It would be possible to use a much longer history but then there would be questions about the relevance of very old data to todays markets. It is possible to overcome this problem if you assume that the return in each month is independent of the return in earlier months. Then a simple mathematical formula applies: to transform from monthly to annualised volatility, just multiply the standard deviation by the square root of the number of months in a year. The annualised risk figure is then 12 4.48% = 15.53%. The continuously compounded annualised return is 12 0.39% = 4.7%. This assumption of independent monthly returns is consistent with the efficient markets hypothesis which says that you cannot beat the market by just looking at the past history of returns.
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Below -12% -12% to -11% -11% to -10% -10% to -9% -9% to -8% -8% to -7% -7% to -6% -6% to -5% -5% to -4% -4% to -3% -3% to -2% -2% to -1% -1% to 0% 0% to 1% 1% to 2% 2% to 3% 3% to 4% 4% to 5% 5% to 6% 6% to 7% 7% to 8% 8% to 9% Above 9%
Normal distributions You may be interested in asking questions like what is the chance I will lose more than 5% this year? or what is the probability my return will be within 5% of the expected return?. These questions could be answered using the histogram of actual monthly returns shown in Figure A.2, or at least such questions about monthly rather than annual returns could be answered. However, you might come to some odd conclusions: with only 120 observations of monthly returns, the histogram seems to suggest that a return between -7% and -8% is less likely than a return between -9% and -10%. This seems intuitively unlikely. To smooth out anomalies like this, a normal distribution is often assumed to approximate the actual return distribution. The normal distribution just requires the mean and standard deviation to specify its shape. Figure A.3 overlays a normal distribution with the same mean and standard deviation as the FTSE AllShare Total Return Index monthly returns, in Figure A.2.
Figure A.3 FTSE All-Share Total Return Index, monthly returns, 2001-2011
Figure A.4 Annualised return distribution
3.0 2.5 Probability density 2.0 1.5 1.0 0.5 0.0 -40 -30 -20 -10 0 10 20 30 40 Annual return (%) (continuously compounded) 50 Mean -1 standard deviation -12.2% Mean 4.67%
Mean +1 standard deviation 19.4%
Source: UBS Global Asset Management calculations
20 15
Frequency Mean -1 standard deviation -4.09%
Mean 0.39%
Mean +1 standard deviation 4.87%
10 5
Below -12% -12% to -11% -11% to -10% -10% to -9% -9% to -8% -8% to -7% -7% to -6% -6% to -5% -5% to -4% -4% to -3% -3% to -2% -2% to -1% -1% to 0% 0% to 1% 1% to 2% 2% to 3% 3% to 4% 4% to 5% 5% to 6% 6% to 7% 7% to 8% 8% to 9% 9% to 10% 10% to 11% 11% to 12% Above 12%
Expected returns We keep talking about returns being within a certain amount of the expected return, so what exactly is this expected return? If you held a risk-less asset, such as a UK Treasury bill (a short term government bond), you would be certain what the return to maturity would be when you bought it (about 0.4% at todays market prices). Equity markets generally, over a long period of time, deliver higher returns than the risk free interest rate. This extra return is often called the equity risk premium. It exists because investors require higher returns from a higher risk asset than from a risk-less asset. However, measuring the equity risk premium is itself prone to uncertainty. For example, if you measured the average annual return of the FTSE All-Share Total Return Index from 1992 to 2011 and 2002 to 2011 you would get a different result for each period. When asking questions such as what is the chance I will lose more than 5% this year?, it may be considered prudent to set the equity risk premium to zero. This may give a rather pessimistic result but it has the advantage of not relying on an uncertain part of the expected return. This can also be applied with a certain degree of confidence, when calculating the Value at Risk (VaR), which is a measure of the potential losses on the portfolio over a particular period. Setting the equity risk premium to zero (so that the expected return is the 1 year gilt bond yield) would give the distribution shown in Figure A.5.
Using the square root of 12 scaling mentioned above, we can transform this normal distribution into a probability distribution relating to annual returns. This is shown in Figure A.4. Relative probabilities are shown by the area under the curve. For approximately two-thirds of the time, the return will be between 16% of the expected return. For roughly one-sixth of the time, the return will be worse than 16% below the expected return, and for the other one-sixth of the time, better than 16% above the expected return.
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Appendix A - Risk measurement
In this example, the one-year value at risk, at the 95% confidence level, is 25.1%. This means that, one year in 20, you could expect to lose more than 25.1%. Value at risk is usually expressed as a positive number as it refers to an actual value that may be lost (i.e. is at risk).
Figure A.5 Annualised return distribution rebased to risk-free interest rate
If you are looking back at actual returns in the past, then the relevant measure is realised tracking error, which is the standard deviation of portfolio returns relative to the benchmark. The portfolio may have a target outperformance level, which could be considered as the expected level of outperformance. However, for prudence, the expected outperformance is often considered to be zero for the purposes of risk measurement. The forecast excess return distribution for a portfolio with 3.4% active risk is shown in Figure A.6.
Figure A.6 Probability of fund excess return (active risk=3.4%)
3.0 2.5 Probability density 2.0
Mean -1 standard deviation -15.1%
Mean 0.4%
1 year VaR at 95% condence 25.1% 1.5 1.0
1 year VaR at 95% condence 5.6% Probability -10
0.5 0.0 -40 -30 -20 -10 0 10 20 30 40 Annual return (%) (continuously compounded) 50
Portfolio risk The previous section showed data for an index rather than for a particular portfolio. All the statistical methods described could be applied to actual historical portfolio returns. To forecast future volatility of portfolio returns, the stocks in the portfolio would be analysed to determine their volatility and correlation of returns. The portfolio ex-ante risk could then be forecast on the basis of current stock positions. Active risk For many portfolios, the objective is to outperform a benchmark. In those cases, it is also relevant to measure risk relative to the benchmark. The most widely used measure is active risk. This is an ex-ante measure of the estimated volatility of performance against the benchmark and is also known as forecast tracking error. It is defined as the forecast standard deviation of annual returns versus the benchmark.
-8
-6
-4
-2 0 2 Excess return (%)
10
Measuring active risk allows an understanding of the risk/return trade-off that a portfolio is undertaking, thereby creating a defined framework within which the Investment Manager can work. The process of risk budgeting involves deciding how much active risk to take and where to allocate it, depending on the market opportunities observed and performance targets. Total fund active risk Figure A.7 shows the contribution to the total fund active risk of the major asset classes for a sample multi-asset portfolio. This demonstrates the relative importance of the asset classes to the risk profile of the portfolio and the dilution of risk that stems from a well-diversified portfolio of assets. The contributions to risk will depend on how both the fund and the benchmark are structured. For example, the impact of the fixed income asset class will generally increase if bonds form a larger proportion of the benchmark.
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In general terms, portfolios that are very close to the benchmark will have low active risk and there will be limited scope either to outperform or underperform the benchmark. On the other hand, portfolios that are significantly different from the benchmark will have higher active risk, giving the potential for returns well above the benchmark but with a corresponding possibility of substantially underperforming the benchmark. An advantage of the active risk approach is that it can be adapted to any benchmark. This has become increasingly important as more funds move to specific benchmarks tailored to their particular requirements. Furthermore, some Trustees have aggressive performance targets that require greater active risk to be taken.
Figure A.7 Active risk breakdown of a sample fund at 31 December 2011
shows that there is a high correlation between portfolio returns and benchmark returns. The active risk line is almost at right angles to the benchmark risk line. This means that active risk is almost independent of benchmark risk. This would be typical for active positions based on a bottom-up stock selection process. Risk relative to liabilities If, in a given year, the benchmark declined 20% and the portfolio outperformed by 2%, that would still represent a loss of 18%, which is substantial in absolute terms. A charity portfolios liabilities are unlikely to be related to the equity market on a time horizon of one year, so this would also represent a significant loss relative to liabilities. It is becoming increasingly popular to recognise the importance of a charity portfolios liabilities, and to set benchmarks and investment performance targets in relation to those liabilities. Liability related benchmarks may be composed of a combination of default-free cash flows (such as government bonds), credit-risky cash flows (such as corporate bonds), inflation-linked cash flows and possibly other elements as well. It is then possible to construct a multi-asset portfolio and measure its risk relative to the liability based benchmark. Risk relative to liabilities is a more relevant measure for a charity portfolio than active risk measured against a traditional composite benchmark consisting of, for example, bond, equity, real estate and cash components. Charity portfolios have been increasingly using derivatives to adjust their risk exposures. Interest rate swaps, inflation swaps and bond futures are particularly relevant. These instruments can be used to reduce the risk of a portfolio of investments relative to liabilities and are explained further in Appendix B.
Total Fund Equity Fixed Income Alternative (including property) Currency 0.0 Risk to single position 0.5 1.0 1.5 Active risk (%) 2.0 2.5
Contribution to total fund risk (including correlation assumptions)
Visualising risk Imagine a portfolio with the FTSE All-Share Total Return Index as the benchmark and with an active risk of 3.4%. Figure A.8 represents the relationship between the portfolio, benchmark and active risks. The length of the lines are proportional to the risks. The narrow angle between the benchmark and portfolio lines
Figure A.8 Visualising risk
isk = Portfolio R
22.6%
Active Risk = 3.4%
Benchmark Risk = 21.8%
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Appendix A - Risk measurement
Impact of volatility
Equity index volatilities declined steeply in 2003 and 2004, and remained low until a volatile period in May 2006. After mid 2007, equity index volatilities increased dramatically. By the end of 2008, they had reached a level not seen since shortly after the stock market crash of 1987. In 2009, volatilities reduced, ending the year a little above their longterm average. In 2010 and the first half of 2011, volatilities were generally moderate except for a period of higher volatility during the middle of 2010. Volatilities were higher in Autumn 2011 but declined later. Cross sectional volatilities (the variation between individual stocks returns over a given period) were also high at the start of 2009 but low during 2010 and 2011, with some increase at the end of 2011. These recent changes are reflected in typical equity portfolio active risk as having been measured using risk models with a short-term perspective, such as Barras UK, Europe and global models or UBS Global Asset Managements proprietary short-term model. Longer term risk models, for example UBS Global Asset Managements proprietary long-term model, have shown stable or increasing risk, as the lower volatility period before the financial crisis is replaced by a higher period of volatility in 2011. Figure A.9 shows the short-term volatility of the FTSE AllShare Index over time (calculated from daily returns over a rolling 60-day period), and the index volatility that would be shown by typical risk models. The typical short-term model line uses weekly returns weighted with a 250 business day half life, so returns one year ago have half the weight of the most recent returns. The long-term example model uses monthly returns weighted with a 48 month half life. By looking at option prices, it is possible to see the volatility that option market participants are expecting in the future. This implied volatility from the market in FTSE 100 options is shown. Figure A.9 shows periods when volatility increased suddenly. Longer term risk models include such periods in their calibration and therefore, implicitly recognise the possibility that volatility may increase at some point in the future. If portfolios took more concentrated positions in response to a low risk figure from a short-term risk model, there would be the possibility that if volatility increased suddenly, the portfolio returns could diverge from benchmark returns by an unexpectedly large amount. Overall, the key point is that the time horizon of the risk model should be aligned with the time horizon of the investment objectives. Treasury bond yield volatility was also very high in the middle of 2009. It fell close to its long-term average level at the end of 2010 but has risen throughout 2011. Figure A.10 shows bond yield volatility over time.
Advanced risk models

Since the financial crisis, there has been an increased focus on the risk of large losses realised over a short period. Several commentators have drawn attention to the shortcomings of using a normal distribution to model the possibility of loss. You can see in Figure A.3, at the left of the diagram, that there are far more monthly losses greater than 12% in the FTSE All-Share Index than would be suggested by the normal distribution. One type of model that addresses this problem is a stochastic volatility model. This allows for volatility changes over time by modelling future possible changes in volatility, and for volatility to be correlated to changes in the market. Normally volatility increases when markets decline and this is captured in such a model. Figure A.11 shows how a stochastic volatility risk model can allow for a higher probability of large losses than a risk model based on the normal distribution.
Information Ratio
The measurement of risk can be combined with the achieved outperformance of the benchmark to give an indication of the skill of an Investment Manager. One commonly used statistic is the information ratio, which is the outperformance divided by the risk. For example, a fund that outperforms by 1% p.a. with 2% p.a. risk relative to the benchmark, has an information ratio of 0.5.
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CHEATED CHART
Figure A.9 Simulated FTSE All-Share Index volatilities 60 50 Volatility (%) 40 30 20 10 0 Dec-01 UBS Model Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 60 Business Day Dec-10 Dec-11 Dec-12
CHEATED CHART
UBS Short-term Model
Long-term (48m life)
Short-term (250bd life)
Option Implied @ 16-Feb-12
Source: UBS Global Asset Management. Option implied figures are for FTSE 100 Past performance is not an indication of future returns.
Figure A.10 Bond yield volatilities 1.75% 1.50% Yield Volatility (absolute) 1.25% 1.00% 0.75% 0.50% 0.25% 0.00% Dec-01 US Dec-02 Germany UK Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11
Source: Bloomberg, 10 year government bond yield, 30 week volatility Past performance is not an indication of future returns.
Figure A.11 MSCI World monthly returns, 1971-2011 stochastic volatility model 1,000 900 Count/1,000 Monte Carlo simulation runs 800 700 36 Number of months 600 500 400 300 200 100 0 < -17.0% -17.0% to -16.0% -16.0% to -15.0% -15.0% to -14.0% -14.0% to -13.0% -13.0% to -12.0% -12.0% to -11.0% -11.0% to -10.0% -10.0% to -9.0% -9.0% to -8.0% -8.0% to -7.0% -7.0% to -6.0% -6.0% to -5.0% -5.0% to -4.0% -4.0% to -3.0% -3.0% to -2.0% -2.0% to -1.0% -1.0% to 0.0% 0.0% to 1.0% 1.0% to 2.0% 2.0% to 3.0% 3.0% to 4.0% 4.0% to 5.0% 5.0% to 6.0% 6.0% to 7.0% 7.0% to 8.0% 8.0% to 9.0% 9.0% to 10.0% 10.0% to 11.0% 11.0% to 12.0% 12.0% to 13.0% 13.0% to 14.0% 14.0% to 15.0% 15.0% to 16.0% 16.0% to 17.0% > 17.0% Stochastic volatility model Normal distribution MSCI World monthly returns
Source: Bloomberg, UBS Global Asset Management Past performance is not an indication of future returns.
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48
24
12
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Appendix B
Derivatives
Derivatives are financial instruments that are based on the movements of underlying assets. They allow exposures to markets and individual assets to be adjusted, often in a flexible and cost-effective way. This allows the risk profile of portfolios to be changed: risk can be increased, decreased or transformed. Just like an asset, whether an individual derivative increases or decreases, the risk of a portfolio depends on the other instruments in the portfolio and on the benchmark for that portfolio.
Types of derivatives
Derivatives can be classified according to the way that they behave as a function of the underlying asset prices. First we shall look at forwards and futures, then swaps and finally options. Forwards and futures Forwards and futures are based on the idea that instead of buying (or selling) an asset now, you can enter into a contract to buy (or sell) the asset at a future date at a fixed price. To enter this contract at a neutral price costs nothing (although initial margin may be required - see later). If the asset rises in price, the holder of the contract to purchase (known as a long position) will make a profit, as the contract now gives the right to buy the asset at a discount to its current price. On the opposite side, the holder of a contract to sell the asset at a fixed price (who holds a short position) will make a loss if the asset rises in price, as they will be obliged to deliver the asset at a discount to the market price. For example, say that on 30 June 2011, an investor entered a forward transaction to sell currency of USD 10 million for GBP 6.2 million on 30 December 2011 and the current exchange rate on 30 June 2011 (called the spot rate) was GBP/USD = 1.6067, meaning that 1.6067 US dollars would buy 1 pound. Here the forward rate was slightly different because of the different interest rates in the two currencies and stood at 1.6031. Figure B.2 shows the profit or loss made by the investor if the exchange rate changed. If the pound strengthened (so 1 pound would buy more dollars, moving to the right of the graph shown in Figure B.2), the investor would make a profit. In fact, the exchange rate on 30 December 2011 was 1.5509, so the investor would have received GBP 6.2 million while paying USD 10 million. The amount paid was worth GBP 6.4 million at the prevailing market rate, so the investor makes a loss of GBP 0.2 million.
Figure B.2 Forward contract to pay USD 10m and receive GBP 6.2m
1.0 Prot or Loss (GBPm) 0.5 0.0 -0.5 -1.0 -1.5 -2.0 1.2 1.3 1.4 1.7 1.8 1.5 1.6 GBP/USD Spot FX Rate 1.9 2.0 2.1
Growth in derivatives markets

The global derivatives market has expanded rapidly over the last ten years and the total notional principal outstanding in 2011, shown in Figure B.1, is very large. This demand for derivatives has arisen from the desire of banks, companies and investors to manage their financial exposures in an efficient way.
Figure B.1 Derivative amounts outstanding USD billion OTC Exchange traded futures 221 21,724 985 n/a n/a n/a 22,930 Exchange traded options 88 31,581 3,733 n/a n/a n/a 35,402
Foreign exchange/currency Interest rate Equity-linked Commodity Credit default swaps Unallocated Total
64,698 553,880 6,841 3,197 32,409 46,543 707,568
Source: Bank for International Settlements Futures and options data as at Dec 2011 (BIS Quarterly Review March 2012), OTC data as at June 2011 (BIS Quarterly Review Dec 2011)
Derivative users
Derivatives are used in many different ways by a variety of users. Banks, for example, use interest rate derivatives to manage potential mismatches between their assets and liabilities. Companies use derivatives to manage the risk on movements in exchange rates and commodity prices which might affect the profitability of their business.
Forward P&L (GBP)

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Cashow (GBP 000s)
Price movements of forwards and futures usually mimic the price movements of the underlying asset closely. They may represent an efficient way of gaining exposure to the market. For example, buying a FTSE 100 future replicates a position in the 100 stocks that are members of the index, but only involves a single transaction rather than the purchase of positions in 100 stocks. Derivatives contracts are based on underlying assets, thus their supply is only limited by counterparties willingness to create contracts. Thus it is easy to take short positions in derivatives that can be used, for example, to reduce exposure to equity market movements while retaining stock selection exposure in a portfolio. For bond portfolios, short positions in bond futures can be used to reduce duration. In general, futures are suitable for taking tactical market positions. Trading spreads are narrow and liquidity in the most popular contracts is high. However, the most liquid futures contracts typically have short maturities and so have to be rolled over, usually every three months. This means that strategic views are still best expressed using the underlying assets. Long positions in futures can be used to gain extra exposure to the market. For example, when there are small incoming cash flows from coupons or dividends, futures can be used to bring the fund back to a market exposure equivalent to being fully invested. This can be more efficient than using each small cash flow to buy very small positions in a variety of stocks. Foreign exchange forwards in the major currencies are very liquid. They provide a cost-effective way of transferring currency exposure among market participants. They can be used to hedge currency exposures associated with investments in foreign stock or bonds and to express currency views as part of a currency overlay strategy. Foreign exchange futures do exist but have not proved popular: this less liquid market is little used by asset managers. Swaps Interest rate swaps Swaps are contracts between two parties to exchange payments based on different assets. There is a highly liquid and mature market in interest rate swaps in the major currencies with maturities up to 30 years. In an interest rate swap, one party pays a fixed coupon to the other, while receiving a set of floating cash flows in return. The two sides of the swap are usually called legs: the fixed leg and the floating leg. Figure B.3 illustrates the cash flows for a sterling 10 year interest rate swap with a notional amount of GBP 10 million, where the investor is receiving a fixed 2.32%, and paying six month LIBOR on the floating leg (first payment at 1.37%). Payments are made every six months. The future floating payments are unknown but their expected values can be forecast from current interest rates and it is these projected rates that are shown in Figure B.3.
Figure B.3 Swap cashflows 10 year, GBP 10m, receive fixed
200 150 100 50 0 -50
NPV Zero
-100 -150 -200 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Receive Fixed Pay Floating Net Cashows
The fixed rate of an interest rate swap is usually selected so that the swap has a zero value at inception. Whilst Figure B.3 shows large cash flows on each side, actually, these amounts are netted and only the net cash flows (shown in mid-green) are paid. The value of the discounted net cash flows in this example is close to zero. If interest rates change, the expected floating payments change but the fixed payments do not. If interest rates rise strongly, the expected net cash flows all become negative. This is because the fixed payments have remained fixed while the floating payments have increased. In this example, a 1% rise in interest rates would imply a Net Present Value (NPV) of the swap contract of minus GBP 860,275. Relative to the notional value of the swap of GBP 10 million, this is a change of -8.6%. This change in value is the same change that would have been seen if investing GBP 10 million in a bond with a coupon of 2.32% trading at par. Swaps are often represented like this as it makes them easier to understand in terms of familiar bond characteristics. Interest rate swaps are usually quoted at one year maturity intervals out to ten years and then at wider intervals out to 30 years, or even longer in some markets. This can give more flexibility than the available spectrum of issued bonds. Also, as interest rate swaps can have long maturities, they are suitable for hedging long-term risks, for example adjusting the duration profile of a portfolio to correspond more closely to expected charity liabilities. Traditionally, an investor would have to invest mainly in long maturity bonds to be able to hedge long-term liabilities. Now it is possible to gain the desired duration profile using swaps and to diversify investments more widely across asset classes. Inflation swaps Recently, inflation swaps have become popular. An example of an inflation swap is one that replaces the fixed coupon
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Appendix B - Derivatives
bond-like leg of an interest rate swap with a leg that looks like an inflation-linked bond. Inflation-linked bonds have coupons and a principal that change in line with an inflation index such as the Retail Price Index (RPI). Another type of inflation swap accumulates all the notional floating flows and inflation-linked flows until the maturity date of the swap and then has just one cash flow at maturity. Whatever the details of the structure, inflation swaps allow investors to change their exposure to inflation. This increases the possible range of investments for charity portfolios with inflation-linked liabilities. Instead of investing directly in inflation-linked bonds, investments can be spread more widely and the desired exposure to inflation can be achieved using inflation swaps. Credit default swaps Credit default swaps provide similar possibilities in adjusting exposures to corporate or sovereign bond issuers. They provide the most efficient way of expressing a negative view on a corporate or sovereign credit. Whilst a negative view on a bond issuer can be expressed by taking short positions in individual bonds, such positions can be difficult or expensive to sustain over a long period, as the lender of a bond can usually call it back at a few days notice or charge a higher borrowing fee. In contrast, as long-term instruments (a typical maturity is 5 years), credit default swaps provide a flexible alternative for taking long or short positions. Credit default swaps on indices have become increasingly popular. Like equity index products, they allow exposure to a whole basket of credits to be taken or hedged with a single instrument. For example, the Dow Jones CDX EM Index is based on a basket of 15 emerging market sovereign issuers. Credit default swaps on this index are a popular way of adjusting exposure to emerging market debt. The credit derivative market has grown and matured over the last ten years. Liquidity is high for swaps on the most popular bond issuers and credit indices. However, valuing and managing credit default swaps is somewhat more complex than for interest rate swaps. Equity swaps Equity swaps provide the return on a single stock or equity index in exchange for a cash flow usually linked to a floating rate or the total return on a different equity basket or index. Equity swaps on single stocks are widely used in market neutral and 130/30 funds to establish short positions, and sometimes for long positions too. They are a more efficient way to manage a short position than borrowing a stock and selling it on because a borrowed stock may be called back at any time by the lender with just a few days notice, whereas an equity swap is unlikely to be terminated by the counterparty.
Equity index swaps are often used in absolute return and portable alpha funds to reduce exposure to a particular market or sector. For example, if you find a technology fund that you believe will deliver positive alpha but you do not want exposure to the technology sector, you could invest in the fund and remove the sector exposure using an equity index swap based on an appropriate sector index. Recently, Exchange Traded Funds (ETFs) that use long positions in equity index swaps to generate their returns have become popular. Such a fund typically invests its assets in a substitute basket of equity securities for the pay leg of the equity swap and then receives the return on the index. The advantage of such an arrangement is reduced tracking error and possibly reduced management costs. Options The buyer of an option pays a premium to the seller (or writer) of the option and receives the right but not the obligation, to buy or sell the underlying asset at some point in the future at a fixed price. An option to buy an asset is a call, while an option to sell is known as a put. It is the right but not obligation of the option contract that makes it different from a forward, future or swap contract. After buying an option, the buyer is said to hold a long position in the option, whereas the seller is said to hold a short position. For example, say on 30 June 2011, an investor bought an option to sell USD 10 million for GBP 6.2 million on 30 December 2011 and the current exchange rate on 30 June 2011 (called the spot rate) was GBP/USD = 1.6067, meaning that 1.6067 US Dollars would have bought 1 pound. Here the forward rate was slightly different because of the different interest rates in the two currencies, and stood at 1.6031; Figure B.4 shows the profit or loss made by the investor if the exchange rate changed and, for comparison, also shows the profit or loss from the forward contract given as an example earlier in Figure B.2. The option price in the above example is GBP 171,086. This price depends on the rate at which the US Dollars can be sold (the strike price: in this case, 1.6031); the current spot rate (1.6067); time to maturity (6 months), the volatility that the market anticipates (the implied volatility: in this case 10.15%) and the interest rates in sterling (1.10%) and dollars (0.40%). Figure B.4 shows that the option price decreases more slowly as the dollar strengthens (moving to the left on the graph), while it increases more quickly as the dollar weakens. This curvature becomes stronger as the option gets closer to maturity and there is less time left for the exchange rates to change again. If the dollar strengthens, the most the investor can lose is the premium paid on the option (in this example GBP 171,086).
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Figure B.4 Forward and option contracts to pay USD 10m and receive GBP 6.3m
1.0 0.5 Prot or Loss (GBPm) 0.0 -0.5 -1.0 -1.5 -2.0 1.2 1.3 1.4 1.8 1.5 1.6 1.7 GBP/USD Spot FX Rate Option P&L (GBP) 1.9 2.0 2.1 6 months to maturity
Derivative market structure and credit risk

There are two methods of trading in derivatives. Trading is possible using recognised exchanges such as the CME Group or NYSE Euronext, with standardised contracts and a central counterparty, such as LCH.Clearnet. Exchange-traded contracts are usually standardised with fixed maturity dates and contract sizes. More recently, exchanges have offered flex options that allow participants to tailor the strike price and expiry date of single stock options but still benefit from trading on the exchange. Standardised contracts increase liquidity, as all market participants trade a limited range of contracts. The clearing house structure reduces credit risk. Market participants must post an initial margin (a cash deposit) to cover the risk that their positions move against them, and also post a daily variation margin if their positions make losses. If the positions make profits, the variation margin is paid out to the holder of the positions. In this way, if a market participant defaults, the losses should be limited to one or two days market movement on their positions minus their initial margin payment. The daily margin process realises profits and losses as they occur. In the over the counter (OTC) market, contracts are between two counterparties. The contracts can, in principle, be tailored to fit any requirements. However, in practice, some types of OTC trades are standardised. For example, interest rate swaps are often executed for standard maturities and coupon levels. Credit risk in OTC markets, especially for long-term contracts, used to be much higher than when trading on an exchange. However, most regular dealers of OTC contracts now use collateral agreements. This means that a counterparty must post collateral (usually in the form of cash or government bonds) to cover unrealised losses. If the counterparty defaults, the collateral taken covers any losses, except for those representing market movements since the last collateral posting. Collateral taking has significantly reduced the credit risk associated with OTC derivatives. Following the credit crisis of 2008, there is a concerted effort across the global financial services industry to move to mandatory centralised clearing of standardised OTC products. Indeed, through 2011, OTC derivatives regulations in the EU and US continued to take shape, with regulatory initiatives in both countries sharing many similarities. This follows 2009 when G-20 leaders agreed that all standardised OTC derivative contracts should be cleared through central counter parties (CCPs) by the end of 2012 at the latest. The transition to centralised clearing is likely to result in increased margin requirements, contrary to todays bilateral OTC environment, where initial margin is not required. We recognise this, in particular, in relation to the potential impacts to investment performance of charity portfolios. The buy side community have been very active in ensuring parliamentary and regulatory bodies recognise these concerns.
Forward P&L (GBP)
There is no obligation to sell the dollars at an unattractive price, the holder can just let the option expire worthless. A short position in options on its own is riskier. If the seller of this option leaves it unhedged, the potential for loss is large if the dollar weakens, and the option seller is obliged to buy USD 10 million at expiry for GBP 6.2 million. However, as part of a portfolio, short positions options may reduce risk. The price of options or the premium paid will depend on the life of the option (the longer the time to maturity, typically the more expensive it will be) and also on the volatility of the underlying asset (an option on a stock that moves 5% on average per day will be more expensive than one on a stock which moves 1%). Options are available on stocks, indices, bonds and currencies.
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Appendix B - Derivatives
For charity portfolios , exchange-traded derivatives are traditionally the preferred choice for equity and bond exposure. Currency management, forward foreign exchange contracts (which are usually OTC) are also widely used. More recently, the flexibility and efficiency offered by other derivatives, especially interest rate swaps, have led to their increasing use by charities.
The traditional advice to invest only in things you understand applies especially to derivatives. Trustees should demand satisfactory explanations of the use of derivatives by their portfolio managers and the associated risks, before giving permission to deal in them. It is especially important that if derivatives are to be used, the portfolio manager has suitable systems and controls. These would include the ability to value and measure risk on derivatives portfolios on a regular basis.
Portable alpha
The growing acceptance of derivatives has bred the concept of portable alpha. Essentially, the ability to outperform a benchmark (or create alpha) can now be transferred from one asset class to another. For example, if a manager can outperform the Japanese equity market, it is possible to create a portfolio that outperforms the US equity market. This is achieved by selling Japanese equity futures against the Japanese equity portfolio and buying US equity futures. Hence the manager has transported alpha from Japan to America. Similarly, alpha can be transported between equities and bonds permitting, for example, achievement of a greater outperformance target for bonds than would be normally possible by conventional management techniques. The operation of these innovative strategies is facilitated by the availability of customised products from investment banks. These are designed to adjust the risk profile of portfolios, and by the growth of ETFs, single share and sector futures, all of which provide extra liquidity and opportunities for leverage or risk control.
Controls
Sound methods of accounting and control, and a clear understanding of derivative markets together with confidence in the managers of the portfolios, are prerequisites for undertaking operations in these instruments. . Derivatives are often seen as relatively high risk. This view arises from the ability to make geared investments, which can result in losses several times the size of the initial margin. However, there is no need to expose an investment portfolio as a whole to excessive risks if derivatives are used responsibly and within clearly defined guidelines. When considering the risks of derivatives, it is important to focus on the risk profile of the whole portfolio. Individual derivatives taken in isolation may appear high risk, not unlike an investment in a single stock. Set in the context of the portfolio of which they are a part, derivatives may increase or reduce risk.
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Appendix C
Calculating returns
Performance measurement
Benchmarks
Clearly the league table approach is not suitable for all charity portfolios because they have different objectives. Many portfolios now measure their performance against a benchmark asset allocation which is tailored to the charitys objectives. The benchmark is normally constructed so that its performance can be measured in relation to market indices. Larger funds are increasingly employing the services of specialist managers in each market and measuring their performance against specific index benchmarks. The difficulty with this approach is that it does not provide a direct mechanism for managing asset allocation. In some cases, charities maintain the asset distribution in line with their benchmark and do not take tactical policy decisions. Others appoint a specialist asset allocation manager to implement policy decisions through overlay strategies. These developments mean that the performance surveys no longer provide a suitable means of comparison for what is now a majority of portfolios. As a result, the performance measurers have extended their broad surveys to cover a number of specialist mandates as well as offering more portfolio-specific analysis. This trend to increasing specialisation is evidenced by Russell/Mellon ceasing to calculate their CAPS Balanced Discretionary Medians from 1 January 2004 as a result of a diminishing sample of balanced mandates. Interpretation is important but can be quite difficult. Any quarter or even year on its own can seldom lead to strong conclusions but persistent patterns can be informative and can provide valuable information. For Trustees, the most generally informative study is of emerging trends over three to five year periods, or even longer. It is generally accepted that most comparisons of fund performance should be made using time-weighted returns. The time-weighted return is, essentially, the rate at which the portfolio would have grown without any new money but holding the same underlying assets as the actual portfolio. It can be calculated accurately by compounding the growth rates of the portfolio for the periods between the flows of new money. This could be complicated and involve frequent valuations but there are a number of recognised ways of estimating time-weighted returns which simplify the work involved. Time-weighted returns are used in preference to moneyweighted returns since the former are independent of the timing of the cash flows into the fund, a factor which is normally beyond the control of the Investment Manager. For example, a fund which receives new money just before a period when a low return is earned will show a lower money-weighted return than a fund with the same investments which does not receive any new money. If the underlying investments are identical, however, the timeweighted returns will be the same. Whilst the way in which returns are used can seem quite complicated and at first sight unfamiliar, the concept of time-weighted return is quite well known. The progress of a pooled funds price, for example, and the comparisons of pooled fund returns frequently shown in the financial press, are based on the time-weighted return of the funds assets. The exception to this general rule is the measurement of the performance of certain closed-ended funds, namely funds with a limited life which are subject to periodic distributions of capital and income. Private equity funds are often of this type as the revaluation of their assets, and thus distributions, tends to be irregular. In such cases, the money-weighted rate of return provides a better indication of the return to investors over the life of the fund. It is important, however, to ensure that the return on any comparative benchmark has been calculated in the same way.
Attribution analysis
An important trend in performance measurement has been towards greater detail in the analysis of what has contributed to the returns on funds. Performance attribution allows the impact of different decisions to be accurately assessed. This can be helpful to investment managers in identifying strengths that can be more fully exploited and weaknesses that need to be tackled. In earlier years it was feasible to attribute performance only between stock selection and asset allocation. Nowadays, advances in computing power have made it easier to attribute performance down to the level of individual securities. A further level of sophistication in attribution has allowed a funds relative performance to be analysed into the contributions from various factors such as company size and style characteristics. Such analysis provides insights into the style and consistency of the portfolio and its manager.
Comparisons
Having calculated time-weighted returns on an individual fund, it is necessary to find a measure for comparison. The league table approach of the large performance surveys is to rank the funds in order of return and quote the funds place in that ranking. The upper quartile is the mark which 25% of funds are above and 75% below; the median is the half way point in the league table; and the lower quartile is the point which 75% of funds are above and 25% below. It is common to hear talk of upper quartile performance when these positions in the ranking are discussed.
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