For professional investors - JANUARY
For professional investors - OCTOBER 2011
CONTENTs Beyond peak uncertainty?
MARkETS & ExPERTISE
Among all the challenges financial markets face, two clearly stand out: worries over
Economic Outlook 2 a US double dip and the eurozone crisis. Dismal news over the summer caused a
US fiscal policy in the spotlight huge sell-off in equity markets, but the current rebound is raising the question of
whether we may have passed the peak in uncertainty. If this is the case, then while
Risk & Asset Allocation 3 many uncertainties remain, it implies risks are now less tilted to the downside. US
Markets to remain volatile employment data early this month were a clear relief, with jobs growth well above
expectations and an upward revision of the previous month’s data. Other evidence
Fixed Income 4-5 (durable goods orders) suggests the US may yet avoid a double dip. In the eurozone,
Active management and downside cyclical data disappointed but all eyes are on the strategy to resolve the crisis. This
protection has been narrowed to a package including a proposition to enlarge the EFSF to create
a “buyer of last resort” for peripheral debt.
Catch some shade with convertible bonds However, it is unclear whether these moves will be sufficient to structurally reduce
stress. First, there is the issue of restructuring Greek debt. Second, it would take a
Alternative Assets 7 much larger EFSF to be able to absorb Spanish and Italian borrowing requirements if
Approaching volatility: use, weather or the private sector remains reluctant to buy it, and dramatically increasing the EFSF’s
avoid? size is facing political opposition. These moves may be sufficient to structurally reduce
stress, but “the devil is in the detail” – and in the execution. For now, the talks go on
Emerging Markets 8 and the corridor comments are not always aligned. By promising “answers” at the
EM stocks are vulnerable but investors upcoming EU and G20 summits, political leaders have raised the stakes, prompting an
shouldn’t give up hope equity rally.
SPOTLIGHT As always, do not hesitate to contact your Client Relationship Manager for further
How can 9 bn people be fed?
Written 17 October 2011
Expert’s View 12
Challenging received wisdom
William De Vijlder
CIO Strategy and Partners
2 - BNP Paribas Investment Partners - PERsPECTIVEs - October 2011
Strategist - BNPP AM
US fiscal policy in the spotlight
This is 2011 AD, and all the developed countries are involved in Congress’s vote goes beyond a mere extension of the measures
fiscal deficit reduction programmes. All? No!1 It is not a little village already in place.
that is resisting, but the biggest economy of all, though it is far
from the most virtuous in matters of public finances. A reminder of What will happen afterwards?
this reality was given in early August by the decision − essentially The US budgetary process is complex, and recent developments
symbolic − of Standard & Poor’s to deprive US sovereign debt of do not make things any easier. First, the USD 2 100 billion
its AAA rating. And yet, even though the deficit for the fiscal year increase in the debt ceiling was passed at the end of July in
just ended is expected, according to the latest estimates by the return for a commitment to make cumulative spending cuts
Congressional Budget Office (CBO), to reach USD 1 280 billion (8.5% for at least an equivalent amount over the next 10 years4. A
of GDP), President Obama has presented a new stimulus package2 USD 900 billion reduction in so-called discretionary spending
designed chiefly to increase employment. (operating expenditure, including military spending) has already
been approved and a USD 1 500 billion reduction in the deficit is to
Déjà vu be debated by an ad hoc bipartisan 12-member “super committee”.
The initial estimated cost of the plan is USD 447 billion (i.e. 3% If this committee is unable to reach agreement before 23 November,
of GDP) and the main features extend or adapt measures already or if Congress does not pass its proposals, then automatic cuts
in place, such as the reduction in employees’ social security in discretionary and mandatory spending, in particular some
contributions and an extension of long-term unemployment healthcare expenditure, will be triggered. The CBO’s estimates5
benefits which, barring agreement, will be suspended at the end show that the short-term impact of these decisions on the deficit
of 2011. These represent about USD 180 billion. A reduction in (and hence on activity) will be limited. The idea behind the Budget
employers’ social security contributions for job creation is in the Control Act is, as its name indicates, to return gradually to improved
offing, as well as a tax credit for hiring the long-term unemployed. fiscal discipline. Here again, this is generally a good idea.
The tax breaks and allocations focused directly on employment
add up to about USD 300 billion (taking into account a further In addition to the debates in the super committee, which are likely
reduction in the rate of employees’ social security contributions). to be very lively given the personalities involved, there will be
The remainder of the plan consists of infrastructure spending and the vote on the budget for the current fiscal year and discussions
state support, in particular to prevent public sector layoffs. concerning the jobs plan. The impression resulting from these
debates will not necessarily be flattering for the US politicians.
A good idea in the short term. The effect on confidence will probably not be what was expected
Although it is impossible to know what part of the plan will be either: it is unlikely that US households will embark on purchases of
passed, it seems plausible that the Republicans, who have a large-ticket items or that companies will hire and invest massively.
majority in the House of Representatives, will not want to appear Unlike in the eurozone, fiscal policy will not be restrictive in the
responsible for fiscal tightening at a time when growth remains United States but, as things stand at present, it is hard to imagine
very fragile. President Obama deliberately dramatised the issue that it will provide a lasting stimulus for activity.
when presenting his plan before Congress, staged in a manner
1 We hope that our readers will pardon us this allusion to Asterix, which may seem very remote
similar to the State of the Union speech. Moreover, since his Jackson from investors’ concerns, and very French, moreover. As a reminder, though, the little Gaul
Hole speech at the end of August, Ben Bernanke has repeatedly said travelled the world, his adventures have been translated into 107 languages, and a little magic
that monetary policy has already done a lot to stimulate growth potion would not be a bad thing for the global economy at present.
2 The American Jobs Act, presented on 8 September 2011.
and that fiscal decisions that could negatively affect the recovery 3 The finance ministers and central bank governors at the G20 meeting in Washington on
should be avoided3. At present, even though the question remains 22 September said exactly the same thing in their press release, asserting that they were
"determined to stimulate growth" just after referring to the American jobs plan and the
above all political, it seems likely that the US economy will not reconstruction measures in Japan.
experience budget restrictions next year. It could even benefit from 4 Budget Control Act
a further slight boost (+0.8% compared with the core scenario) if 5 CBO analysis of August 1 Budget Control Act, available at http://www.cbo.gov/
Consensus forecasts: Growth & Inflation
October 2011 GDP YoY % Inflation YoY %
M= Mean; H= High; l=low 2010 2011 2012 2010 2011 2012
Developed Economies M H L -1M M H L -1M M H L -1M M H L -1M
USA 3.0 1.6 1.9 1.4 [1.8] 2.1 3.6 1.2 [2.4] 1.6 3.1 3.2 2.7 [3.0] 2.1 3.5 0.9 [2.1]
Canada 3.1 2.3 2.7 2.1 [2.7] 2.1 2.7 1.5 [2.5] 1.8 2.8 4.0 0.9 [2.9] 2.0 5.7 2.4 [2.1]
Eurozone 1.7 1.7 1.9 1.6 [1.9] 1.0 1.4 0.5 [1.5] 1.6 2.6 2.7 2.4 [2.6] 1.8 2.1 1.3 [1.9]
Uk 1.3 1.2 1.6 0.9 [1.3] 1.8 2.7 0.9 [2.0] 3.3 4.4 4.7 4.0 [4.4] 2.7 3.6 1.9 [2.7]
Switzerland 2.6 2.0 2.8 1.6 [2.2] 1.3 2.0 0.7 [1.7] 0.7 0.5 1.1 0.3 [0.7] 0.7 1.8 0.0 [1.0]
Japan 3.9 -0.5 0.3 -1.1 -[0.7] 2.4 3.6 0.9 [3.1] -0.7 -0.2 0.4 -0.5 [0.3] -0.2 1.0 -0.9 [0.2]
Australia 2.7 1.8 2.8 1.2 [1.7] 3.7 4.5 2.5 [3.8] 2.8 3.4 3.7 3.2 [3.4] 2.9 3.4 2.2 [2.9]
Source: Consensus Forecasts as of 12/09/2011
For professional investors
3 - BNP Paribas Investment Partners - PERsPECTIVEs - October 2011
RIsk & AssET AllOCATION
Head of Strategy - BNPP AM
Markets to remain volatile
This summer you adopted a more cautious investment still poses a problem for us, and we see more value in corporate
policy and recommendations. Are you holding to this credit spreads after they widened in recent months. A lacklustre
positioning? economic scenario should not imply a sharp increase in default
Yes. We expect risky asset markets to remain volatile and rates. However, although this value can be captured by holding the
relatively bearish. They have plunged since the end of July on bonds to maturity, prices could suffer further in the short term from
fears concerning economic growth and the eurozone sovereign spells of risk aversion. Lastly, emerging debt is another possible
crisis. These factors are likely to persist, because they are also alternative and we are waiting for an appropriate time to buy more,
symptoms of a more profound problem facing the developed especially in local currency, since this asset class has suffered from
economies: total debt leverage (private and public) is still currency declines.
historically high. This is not a recent discovery because, at the
macroeconomic level, it is precisely one of the factors explaining Should we currently be factoring inflation into asset
the crisis that began in 2007-2008. However, the slowdown in allocations?
growth has thrown the spotlight on this difficult problem again It’s clearly still too early to do so. We believe there is major
after it was masked by the recovery since 2009. Apart from long-term risk of inflation in the industrialised economies, partly
cyclical fears, it is a factor of financial tension and uncertainty because of the monetary policies currently being pursued, but
that will probably continue to weigh on markets. At the economic also because the temptation could grow over the coming years
level, we expect chronically sluggish conditions to prevail rather to use inflation to lighten the debt burden. However, we expect
than a double dip recession in all the developed economies, but no imminent acceleration of inflation, and it is unlikely that
this will probably be accompanied by persistent fears about the markets will start to price in such a phenomenon without first
economy and financial stress that will adversely affect risky seeing signs of it. Longer-term, though, this is a theme to watch.
assets. But we believe it would be a strategic error to punt immediately
on so-called ‘real’ assets (equities, property, etc.) as a hedge
So what positions do you recommend at present? against inflation. They offer good protection once inflation has
We have a negative bias on developed equities. Pending a ‘technical’ set in, but, knowing that this is not really being factored in at
rebound, we had in the short term maintained a measure of present, an inflationary shock would cause an initial correction in
neutrality, but now we are adopting a negative stance following the fixed income markets. By repercussion, long-term assets that are
market rebound of end September/early October. On fundamental sensitive to interest rates could initially suffer a correction before
grounds, we still prefer emerging equities to developed equities, they actually benefit from inflation. Until such a shock occurs, the
even though the correlation with developed markets is a handicap best hedges against inflation are a shortening of the duration of
for them. In fixed income, the valuation of government bonds fixed income investments, inflation-linked bonds, or investment
issued by the soundest countries (United States, Germany, etc.) products offering contractual protection.
MUlTI-AssET ClAss EqUITIEs DEVElOPED COUNTRIEs EqUITIEs EMERGING COUNTRIEs
CURRENT PREvIOUS CURRENT PREvIOUS CURRENT PREvIOUS
EQUITIES US + + Brazil - -
Developed Equities - = Canada - - China + +
Emerging Equities = + Eurozone - - India = =
FIxED INCOME Japan + + South-korea = =
Government Bonds = = Uk + + Taiwan - -
Corporate Bonds = = Switzerland = - Russia + +
High Yield = = Australia - - South Africa = =
Emerging Debt (ext.) = = Turkey - -
Emerging Debt (local) = + BONDs COUNTRIEs sOVEREIGN
COMMODITIES CURRENT PREvIOUS
Brent Oil = + US = =
Base Metals = = Eurozone = =
Gold + + Japan = =
Agricultural = - Uk = =
CASH - - Switzerland = =
Notes: The indications in the tables reflect views not weights, whereby the “+”, “-” and “=” signs respectively represent positive, negative and neutral views. Two different types of views are expressed
in the tables. Those in the Multi-Asset Class Module are absolute returns views, or more precisely views on excess returns versus cash. Those in the equities and bond modules are relative return
views. Here we assess relative excess returns amongst different countries. These views can of course be translated into portfolio weights. Their size will heavily depend on portfolio constraints and
the specific risk budgets.
Source: BNPP AM - October 2011
For professional investors
4 - BNP Paribas Investment Partners - PERsPECTIVEs - October 2011
CIO, Aternative Fixed Income & Structuring - BNPP AM
Active management and downside protection
Historical analysis is widely used in finance when measuring risk. However, history tells investors
that financial market movements often appear unpredictable using historical data. The risk
framework of active management should thus be seen in light of investor demand: using the skills
of experienced professionals to generate value while benefitting from clear downside protection to
avoid being trapped in rare and extreme scenarios. Here, we describe a possible solution to address
The search for alpha is largely about implementing smart assumptions. Even Monte Carlo simulations would be calibrated
investment decisions in portfolios. What ‘smart’ means is using historical assumptions. Additionally the figure you will get
generally assessed ex-post and directly linked to the realised is certainly not a sure amount of any maximum loss.
performance of the investment strategy. However, it does not tell
us how much money could have been lost had the decision been CPPI, the first popular downside protection mechanism
wrong. In the face of such incertitude, benefitting from a level of
security against extreme events is most valuable for investors.
When managing a portfolio, the key objective is indeed to extract And using cushion management techniques precisely enables
value and to perform, in other words to realise a financial gain portfolio managers to extract value within a secure framework
from an investment decision. However, simultaneously we need for investors. Indeed, this type of investment process offers
to consider that a financial loss could also occur following this investors the benefit of a formal capital guarantee within a
investment decision - hence the need to set risk limits. To be given timeframe and also provides access to the expertise of
specific, in active management, risk is often assimilated to professionals to define, implement and monitor investment
volatility. Indeed, one can be right on an investment decision strategies. These cushion management techniques, widely used
over a three-month period but nevertheless suffer a temporary to leverage an asset class on a systematic basis, led to the strong
financial loss as financial market movements do not usually development of so-called CPPI (Constant Proportion Portfolio
follow straight lines. However, there are two main drawbacks Insurance) products.
when using the shortcut ‘risk is volatility’.
CPPI was introduced in the late 1980s, initially for fixed income
Why risk is not volatility instruments and then for equity instruments. The whole idea
First of all, calculating ex-ante volatility is usually based on was to dynamically allocate assets over time and to set a floor,
historical data, which means that the core assumption from corresponding to the lowest acceptable value of the portfolio. In
a risk perspective is that: the future movement of a financial practice, the cushion is the excess of the portfolio value over the
instrument is primarily determined by its past movements. After floor and the amount allocated to risky assets is a predetermined
several financial crises and as described in many Nassim Taleb multiple of this cushion. The beauty of this technique is that it
books, most of the financial community knows that finance is gives investors downside protection and at the same time gives
dominated by extreme events. In brief, if you solely consider constant and systematic exposure to an asset class.
historical data, normal laws and other empirical ways to precisely
assess the future, you might end up with a serious misperception Insurance: adapted to today’s demands
of risks and be exposed to ‘black swans’1! The idea is now to benefit from active management while keeping
the same security for investors, i.e. a capital guarantee over a
Secondly, a volatility figure does not tell you how much could given timeframe. As shown in chart, the maximum possible risk
actually be lost. The value-at-Risk (vaR) measurement partially (the cushion) is linked to the present value of the guarantee
addresses volatility shortfalls. Indeed, vaR estimates possible that is given at maturity and the risk guidelines are defined with
losses of a portfolio over a given period of time and under the guarantor to account for extreme scenarios with the aim of
different levels of confidence (and vice versa). In that sense, vaR insuring that the investor is immune from extreme risk scenarios.
will usually look at severe risk cases and give you an estimate The portfolio manager is then responsible for implementing
of potential loss. One example of vaR would be the potential active management and deciding on the risk budget consumption
and theoretical ‘maximum’ loss over 10 days and in 99% of the level (the exposure to active management). Finally, he makes
cases for a given portfolio. But here again, you would often look sure that the risk associated with active management stays at
at using normal distribution and historical data to make some all times within the limits set by the guarantor.
1 “The Black Swan” (N. Taleb) published in 2007, describes how people underestimate the impact of infrequent occurrences. Just as it was assumed that all swans were white until the first black
species was spotted in Australia during the 17th century, historical analysis is an inadequate way to judge risk, Taleb said.
For professional investors
5 - BNP Paribas Investment Partners - PERsPECTIVEs - October 2011
This mechanism is all the more efficient if the underlying What does the future hold?
instruments used to implement the investment strategy are highly In the current financial environment, this management process
liquid. Indeed, liquidity is a key aspect of such an investment makes a lot of sense for investors. With the eurozone crisis,
process, as the portfolio manager needs to dynamically adjust recession fears and the significant public deficits in developed
the exposure over time, paying special attention to transaction economies which have been fuelling inflation fears, investors
costs. Investors fully understood the meaning of liquidity risk in are demanding an increased level of protection from asset
the midst of the sub-prime crisis during the summer of 2007. And managers. In this context, we believe that the next generation
to properly address this requirement, asset managers need to of actively managed portfolios with downside protection will
consider the investment instruments used as a core parameter actually feature a minimum level of yield guarantee when
of their process. Capturing a liquidity premium is certainly not possible. For instance, adjusting investors’ principal from realised
adapted to investment processes based on cushion management inflation over a given investment horizon and outperforming this
techniques. On the contrary, unfunded listed instruments, minimum level with active management seems very much in
such as Interest Rate Futures, can prove to be efficient tools to line with current investors’ expectations. And offering a double
implement investment decisions with enough flexibility to adjust guarantee (principal invested and realised inflation) along with
the exposure in order to permanently maintain some downside active management is certainly extremely valuable in uncertain
protection for investors. times.
The “cushion”, defined as the difference between the NAV and the present value of the guarantee, is
actually the risk limit (as defined by the guarantor) associated with the exposure to active management.
Any performance deriving from active management can further be partially or fully put at risk, according
to asset manager’s decision.
Assets at maturity
For illustrative purpose only
Source : BNPP AM For professional investors
6 - BNP Paribas Investment Partners - PERsPECTIVEs - October 2011
Head of Convertible Bonds - BNPP AM
Catch some shade with convertible bonds
Our recent editions have focused mainly on the mechanics of convertible bonds. This time, in the
middle of one of history’s largest sovereign and financial debt crises, we wished to focus on the
practical behaviour of this asset class so as to highlight for investors the relative advantages of
holding convertibles over other risky assets in a highly volatile environment.
Looking back at 2011’s performance as at the end of September, 2. Although the broad rhythm of mergers and acquisitions
the MSCI World in Local Currency fell 13.9% versus an 8% fall has decreased because of lower multiple valuations, the
for the broad convertible market (as measured by the Merrill global economic slowdown is forcing larger companies to
Lynch Global 300 Convertible Index in Local Currency), thereby turn to external growth opportunities. With the convertible
reflecting 60% of the downside in global stocks. market populated by a large number of potential targets in
high growth industries (for example, biotech, technology,
Attractive risk-adjusted returns commodities), and significant sources of outperformance such
However, of that 60% decline, one must take into account as built-in take-over protection, investors can significantly
the deterioration observed in credit spreads, an important outperform equivalent equities in a take-over scenario.
component of convertible bonds. Generally speaking, credit
default swap (CDS) indices for high yield and investment grade 3. As we near a climax in terms of sovereign debt escalation,
across the world nearly doubled during the period, lowering we are tempted to believe that convertible bonds could be
convertible returns by approximately 1% to 2%. At the same time, attractive propositions from both the issuers’ and investors’
option ‘cheapening’ detracted a further 1%, as implied volatilities perspectives. A need to raise fresh cash on the part of
did not track the rise in volatility of the underlying stocks. heavily burdened states could lead to the issuance of some
respectably-sized exchangeable bonds, as happened in 2009
Interestingly, the 1-month historical volatility in returns of the and 2010. This would allow privatisation programmes to
asset class reached half the 25.9% level registered by equities, proceed at a reasonable premium to current market levels
again demonstrating the superior risk-adjusted returns of while leaving some room for governments to maintain some
convertible bonds, even within a very poor environment. form of influence over their stakes in national icons.
Outlook 4. The evolution in solvency requirements for insurance
While most convertible bond fund managers feared a replay companies and banks is increasing the benefits of convertible
of 2008 during this summer, the asset class turned out not bonds relative to equities. Because of the convex nature of
to be prone to similar panic. This may be explained by the the asset class, the required capital is shown to be lower and
better diffusion of convertibles within the investor base and therefore less costly for an institutional holder. This could
by the smaller level of participation from convertible arbitrage lead to some technical ”richening“ of the asset class on the
managers, who have not been inclined to increase leverage in a back of a general search for good quality bonds in a dwindling
deteriorating market. However, we believe convertible bonds still universe.
offer five unique opportunities to investors who wish to reduce
their volatility yet remain exposed to equity markets: 5. Despite the poor performance of emerging market equities
and currencies this September, we still believe in the longer-
1. With the Federal Reserve’s ‘Operation Twist’ in full swing, term benefits of investing in high growth areas. As much as
investors do not appear to be overly worried about inflation. investors have rushed to build exposure to emerging markets
We believe, however, that inflation could rise over the medium through straight debt, the emerging convertible bond market
term as a result of the successive and massive quantitative offers a complementary allocation to a diversified sector
easing policies. With an average term of three to five years range with little direct exposure to financials.
and exposure to equities (positively correlated to moderate
inflation), convertibles are not prone to high interest rate As investors bank on growth, we ask in return: “what better way
sensitivity. They stand as low duration corporate credit assets to capture it than to be indirectly exposed to equities?”.
inclusive of embedded conversion options that are currently
For professional investors
7 - BNP Paribas Investment Partners - PERsPECTIVEs - October 2011
Head of Investment Specialists, Alternative & Structured
Approaching volatility: use, weather or avoid?
The crisis marked a turning point in western countries’ macroeconomic dynamics. Markets may, at
any time, focus on any player (including sovereigns) with low credibility or a weak balance sheet
that must refinance its debt and thus contend with tighter access to liquidity. These liquidity crises
are frequent and cause marked rises in volatility. Monetary and fiscal authorities might be willing
to intervene in such cases, but each new intervention increases players’ mistrust of the financial
system, with little room for manoeuvring to contain the next crisis.
Of late, we have again seen a volatile market environment: from potential per unit of risk, as research1 shows that the lowest risk
the end of July to 9 September, the volatility of the Eurostoxx stocks tend to generate higher risk-adjusted returns than riskier
50 index (vSTOxx) rose from around 28 to almost 54. With ones. In today’s volatile environment, these strategies could offer
little clarity on economic growth or on the outcomes of political an interesting alternative as they tend to concentrate investments
processes, market participants may struggle to position their in defensive market segments, have low volatility and low beta.
investment portfolios, so here we highlight the theme of volatility Another strategy is to implement a Risk Management Overlay
and some strategies that we believe work well in this environment. which offers institutions a way of meeting their long-term
volatility – the measure of the relative rate at which a security’s liabilities while managing short-term solvency constraints by
price rises and falls – can be derived from either the security’s reducing risk exposure when the funding ratio or capital surplus
market prices (historical volatility) or from its market-traded bottom out and increasing it when things improve. It involves
derivatives (implied volatility). During a market shock, volatility adjusting a portfolio’s total risk exposure via derivatives without
rises, as do the prices of corresponding volatility indices and interfering with securities selection. Thus, the weight of risky
options. As volatility regimes change frequently, there are various assets is adjusted depending on market developments to meet a
ways to approach volatility, and here are three that we believe pre-defined objective.
are the most effective.
Using volatility A third way to deal with volatile financial markets is to pursue
First, one can benefit from high volatility and risk aversion. investment strategies that largely avoid volatility as they are not
For example, a long volatility investment can be tactically “marked to market” each day. Private market funds, for example,
attractive. The mean-reversion nature of implied volatility offers regroup investments in non-public assets such as non-listed
opportunities to buy hedges once volatility retreats from a high companies, infrastructure and other real assets. They are long-
level. In terms of asset allocation and due to the potentially large term strategies with an average investment horizon of eight to
price moves of underlying assets, it is important to frequently ten years. Their profitability is based on strict selection criteria:
reassess both the volatility exposure and level in a portfolio. their operational success over full economic cycles and the
Another way to try to benefit from market volatility could be to investment teams’ ability to follow companies as they develop.
apply covered call strategies. These involve selling short-term Private markets’ underlying investments are held for many years,
call options on securities in the portfolio, leading to a defensive with their valuations driven by company financials, overall private
equity investment approach, the benefit of which is also linked to market flows, returns, cost of debt, market sentiment and stock
the volatility level. As equity markets decline, the premiums from market behaviour. Investing in these products enables investors
option sales provide a cushion and bring in additional revenues. to diversify away from the short-term volatility of listed financial
In our view, when pursuing a covered call strategy, one has to markets.
pay attention to maturities of the call options that are sold. The
shorter term options are to be preferred because they capture a The current markets, via the changes of volatility regimes, offer
high level of implied volatility with a low risk of adverse valuation a panel of opportunities. These can be assessed as a source of
should volatility rise. alpha, such as in some specific absolute return strategies, or to
temper risk exposure. In any case, experience and know-how are
Weathering the risk key elements to manage these high risk periods.
Second, investors can try to weather volatility by adopting Low-
volatility Equity strategies – so called ‘minimum variance’ or
using Risk Management Overlays. Low-volatility equity strategies
can optimise the risk/return characteristics of an equity portfolio.
The objective is to build a portfolio that optimises the return 1 Source: BNP Paribas Investment Partners
For professional investors
8 - BNP Paribas Investment Partners - PERsPECTIVEs - October 2011
Head of Emerging Markets Equities
EM stocks are vulnerable
but investors shouldn’t give up hope
The steep fall in emerging markets this year has proved that, whether we like it or not, they will
not trade at a premium to developed markets and will remain vulnerable to global cues. However,
we still believe these markets still offer superior returns versus the risk and good diversification,
particularly if investors include some smaller EM countries that have so far been neglected.
The collapse of EM markets in supporting local equity markets. This may be about to change
The eurozone debt crisis, weaker growth in the US and the as most countries have been able to cover external debt with
risk of outright recession in Europe have hit markets hard, yet Fx reserves. So we should expect a much broader diversification
emerging markets have turned out to be the main victims (along into EM assets (at least local bonds), providing more support
with Western banks). The crisis, which started in August with for currencies in the future. Similarly, the decline of local rates
the decline of emerging stocks and unfolded more broadly in over the past few years should eventually fuel diversification into
September with the collapse of EM currencies, has sent us back equities in countries like Brazil or Turkey.
three years, when emerging markets lost 60% between June and
October 2008. That crisis, too, was triggered by debt problems in Dedicated EM Equity Flows (USD billions)
developed markets. 95.8
Emerging markets remain largely correlated to basic indicators
such as: 54.2
. the New Orders component of the ISM index, a leading indicator
of EM economic activity (showing that the export model is still 6.9 5.5 6.1 8.0
dominant throughout EM),
(2.9) (3.7) (3.6)
. the global volatility level (vIx) as a measure of risk appetite/
aversion, showing the high correlation of EM equities to other
risky asset classes. (49.3)
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
The ISM index fell below 50 in August - within a downward
trend. This was followed by readings still signaling a contraction Source: EPFR Global
of orders. Almost simultaneously there was a rise in volatility
(fuelled by the eurozone crisis). These two factors signaled the
decline in emerging equities. This tells us that EM economic and Don’t expect emerging markets to trade at a premium
financial models are still imperfect. Also, that they need almost Based on P/E ratios, emerging markets trade at a 15% to 20%
ideal economic conditions, or very specific market conditions, to discount on average to developed markets. This discount has
outperform developed markets and/or achieve positive returns: widened recently, but is still narrow compared to levels during
moderate global growth and low inflation, or a large valuation periods of EM outperformance (beginning in 2002 and 2009).
gap. On Price-to-Book ratios, emerging markets have now become
cheaper than developed markets. However, we could expect
Any other scenario is likely to worsen imbalances that, without further relative de-rating of emerging markets (another 10% to
a strong domestic investor base, weigh on stock markets. This 20%) before the capacity to outperform appears.
explains why we so brutally shifted from fears of inflationary
pressures to concerns of collapsing demand from Western It is noteworthy that, despite the much higher GDP growth
countries, with limited undervaluation to cushion these shocks. potential, strong earnings growth and returns on equity in both
absolute and relative terms, valuations of developed markets have
Fund flows still play a major role in setting market trends. Their acted as a cap for emerging markets. This is because EM stocks
impact is quite obvious, highlighting the still dominant role of and economies have higher volatility, their corporate governance is
developed country savings in global, including EM, asset classes. still questionable and investors still don’t adequately understand
Despite high saving rates and massive Fx reserves in most market drivers, resulting in a higher risk premium.
emerging countries, these pools of money have had little effect
For professional investors
9 - BNP Paribas Investment Partners - PERsPECTIVEs - October 2011
Why invest in EM equities? universe. But the most ‘exciting’ part of emerging markets may
In our opinion, there are still good reasons for investing in lie between these larger countries and the much smaller and
emerging market equities: the risk is rewarded; GDP growth less liquid Frontier Markets. Yet many investors do not have a
matters and can be captured in returns and country diversification strategic allocation to these intermediate markets (unless part
creates investment opportunities. Although the performance of a BRIC or commodities fund) and may not realise that they are
of emerging markets can sometimes be frustrating, they still underexposed to markets with potentially strong returns.
consistently outperform developed markets over the medium to
long term and we don’t see this situation changing. The impact The cases for some intermediate markets like India, Russia, South
of local GDP growth on EM companies is still huge. Though we Africa or Mexico, which weigh between 4% to 8% of a GEM fund,
acknowledge that a large part of their economic growth is based are quite well known. But take Turkey, with 1.5%, Indonesia with
on demand originating from developed countries, local capital 30%, the Philippines at 0.7%, Poland at 1.5% or Colombia at 0.9%
formation and structural changes (e.g., urbanisation, rising of the MSCI GEM index. Unless invested amounts globally exceed
purchasing power, etc.) are also powerful drivers as long as USD 500 mn, the liquidity level of these countries is reasonably
profitability is not hurt by excessive inflation or a credit squeeze. good and would be appropriate for a much more equally-weighted
Looking at three to five-year average prices for equities, we find
that the performance of a ‘smoothed’ index is very close to the With the exception of Central European countries, which collapsed
performance of EM GDP in USD. The main periods when figures in September, most other small markets displayed remarkable
diverged were: at the end of the 1990s, when emerging equity resilience and should continue to do so as long as the global
valuations dropped; in 2007, when valuations became excessive; economy doesn’t plunge into recession. The GDP growth prospects
and recently when they fell abnormally low. However, the and public finances of these countries are reasonably good
recent pull-back of EM currencies will also lower the EM GDP and in several cases, these economies are geared to domestic
in USD significantly. We think it will be some years before this consumption and supported by dynamic demographic trends.
relationship between stock markets and GDP fades. You also tend to find a large proportion of conglomerates, which
guarantees reasonable valuations. These markets remain highly
Similarly, we found that, looking at a three year investment, volatile, but you can expect somewhat less correlated returns to
valuations at the time of investment are enormously important. global markets than with the largest emerging markets.
Currently we stand at 1-1.2 standard deviation below the average
valuation level over the past 15 years (including the Asian, Russian Investors are still massively geared towards the largest countries,
and Argentinean and 2008-2009 crises), which has consistently at the expense of investment opportunities and risk diversification.
proved a rewarding time to invest. Historically, this situation has We are convinced there is room for improved investment solutions
led to positive returns 95% of the time. Interestingly, investments through wider diversification and a larger share of investment in
bought when markets are priced above long-term averages second (India, Russia, Mexico, South Africa) and third tier countries
generate most of the times negative returns after three years. (ASEAN, small Latin American and Emerging European countries),
finally making the most of this EM investment universe.
The compelling case for smaller EM countries
Emerging market investors may not always realise that they
invest in portfolios that are dominated by just a few countries:
China, Brazil, South korea and Taiwan represent 60% of the
For professional investors
10 - BNP Paribas Investment Partners - PERsPECTIVEs - October 2011
Erik Orsenna Helena Viñes Fiestas
Author, Member of the Académie Française Co-Head of SRI Research
How can 9 bn people be fed?
At a time when the planet is set to receive its seven billionth inhabitant on 31 October (UN estimates),
and the global population could reach 9 bn by around 2030, agriculture is a more topical issue
than ever. We have therefore chosen it as our subject of discussion on 8 November during our fifth
Sustainable Development Circle conference with specialists such as Pierre Jacquet, Chief Economist
of Agence Française de Développement, Didier Nedelec, Market Director of Invivo, and Jean-Pascal
Tragnie, co-founder of the Euro-Asian group, Aloe Private Equity. In a preview of these discussions,
Perspectives talks with Erik Orsenna, moderator of the Circle, and Helena viñes Fiestas, co-manager
of SRI research at BNPP IP.
Perspectives (P): In the coming years, there will be 9 bn humans P: You mention inadequate investment as one of the historical
on the planet, how can the earth feed so many mouths? causes of the problem. Could you elaborate on that?
Erik Orsenna (EO): Indeed, the issue of agriculture is far from EO: This subject is of fundamental importance in my opinion,
being settled, because it is estimated that nearly one billion and deserves more attention. This phenomenon, due to a sort
people, or 15% of the world’s population, do not have enough to of contempt for agriculture, is not new: as shown by World Bank
eat. Note that among the most undernourished are farmers. This reports, financing for this key sector has never been sufficient to
paradox can be explained by the fact that agriculture has suffered its needs. It is striking to note that budgets to support agriculture
from inadequate investment, and this has led to a vicious cycle: are given no priority. Yet any decline in financing could have
farmers were not earning a living from the land, so they left to dramatic consequences: food crises, or even famines leading to
join workers in the cities, thereby causing a fall in production. To violence and popular uprisings. That said, more generally there
avoid riots, governments had two solutions – to import foodstuffs are grounds for hope because in the past five years there has
and lower prices – both of which exacerbated the rural exodus. At been a growing awareness of the inadequacy of the resources
present, demand is growing even more strongly because, on top employed relative to the needs.
of pressure from population growth, there are changes in eating
habits related to rising living standards. Meanwhile, supply Helena Viñes Fiestas (HVF): I would also like to emphasise the
is still restricted by the increasing scarcity of arable land, the need to invest in infrastructure, and for awareness raising among
water crisis and climate change, all factors that greatly increase farmers. This includes training in practices that are less harmful
the likelihood of droughts and floods. to soils and water and raising awareness of the damage their
actions do to the environment, but also technology transfer. One
These major tensions between supply and demand explain of the aims is also to address the problem of waste: at present,
agricultural price volatility: clearly, the slightest political or between 30% and 50% of food production is wasted, especially
climate problem leads to huge price fluctuations. The significant due to storage and transport inefficiencies. Investment in
impact of the fires in Russia on wheat prices during the summer infrastructure is therefore of fundamental importance whether
of 2010 is a perfect example of this. The problem is that this for irrigation (over 60% of the water used on earth is for
volatility of agricultural commodity prices is as powerful as it agricultural purposes), storage of foodstuffs, roads or means of
is unpredictable, making the farmer’s job increasingly difficult. transport.
He needs to have hedging against prices over three, six or even
nine months, depending on the period. So, to sum up, agriculture In addition to support from the public sector, private investors
is currently faced with global tensions of both a structural and play an extremely important role in financing agriculture. Above
cyclical nature, and it is the duty of all of us to solve them. all, this involves investment in ‘physical’ activities, as opposed
to speculative operations. We believe efficient investment can
contribute by financing producers and all productive activities so
as to ensure a supply of sustainable agricultural products.
For professional investors
11 - BNP Paribas Investment Partners - PERsPECTIVEs - October 2011
P: Can ‘socially responsible’ investment have a significant impact ESG (Environment, Social, Governance) criteria are central to our
on the development of sustainable agriculture? Do you think strategy; they help us to distinguish between good and less good
that this could really change things in the long term? practices and to pre-empt social tensions, especially those that
may exist between small and large agricultural firms.
EO: As much as I believe that investment has a strong influence
on agriculture, I am equally convinced that socially responsible P: And if we look to the future, around 2030 or 2050, what are the
financing will make it possible to transform the vicious cycle solutions that will make it possible to feed the planet?
described above into a virtuous one. If being ‘fashionable’ can help
develop SRI, so much the better, every possible means should be EO: At a time of global climate warming, when nature cannot
used to increase world production by 50% by 2030. Given the keep up with booming population growth after being disdained,
huge difference between forecast investment and the sums we polluted and depleted for too long, I believe we will have to turn to
believe will be needed, and also due to budget pressures, it is research, and genetic research in particular, to find alternatives.
clear that public finances will not be able to make up the deficit. At present, GMOs (genetically modified organisms) get a bad
The baton must be picked up by the private sector. press, they are demonised, and although some of the reasons
put forward are plausible, others are unacceptable. However, this
HVF: It is clear that socially responsible investors can make a very research work, if well managed and performed from a long-term
positive contribution to agriculture if a determined, intelligent perspective, should provide sustainable solutions.
policy is applied. That is why our SRI analysts look very closely
at how these investments are made. They have defined a three- HVF: The problems are far from being solved, but we believe that
point strategy: the current growing awareness will bear fruit, and that financing
by numerous private stakeholders, backed up by the public sector,
1. Select the best companies in terms of their social and will make it possible to initiate the virtuous cycle mentioned by
environmental impact at each stage of the value chain Erik. Our aim is to contribute to the goal of a 50% increase in
2. Through our thematic funds, invest in technologies and global production through intelligent, discerning investment. It
businesses that will not only be able to increase productivity, is the quality of such investment that will determine the level of
but do so in ways that are best aligned with sustainable our contribution to the creation of sustainable global agriculture.
development, such as new irrigation systems That is why we have chosen to make in-depth research and
3. Establish a dialogue with the companies to ensure that their analysis central to our investment decisions.
investments go to technologies of the future and that they
support research programmes for less harmful products – for
example, by replacing noxious fertilisers with nutrients that
are less harmful to the soil in the long term
For professional investors
12 - BNP Paribas Investment Partners - PERsPECTIVEs - October 2011
CIO of Equities, BNPP AM
Challenging received wisdom
Just as we chose to structure BNP Paribas Investment Partners as a group of independent asset
managers, we have organised the equities division around small, independently focused teams.
We have identified four main elements which we beleive ensure teams perform to their maximum:
smaller team sizes, existing in a single location, emphasising regular face-to-face communication
and working autonomously: even though these factors seem to go against the received wisdom.
Bigger is not better The information trap
For example, a commonly held belief is that you need more As information technology progresses, the mass of data available
people to manage equities and that the more analysts you have to fund managers grows. The belief that we would challenge
on your team the more thorough and in-depth your research is that processing more data leads to taking better decisions.
– and therefore your stockpicking will be better. We disagree In fact, we would argue it is the opposite, as illustrated by the
with this concept. On the contrary, we believe that having too diagram, in which the mass of data available on stocks makes
many people within one team reduces the chance of providing a up the pyramid’s base. This data, too overwhelming to be used
focused, top-performing product. A study by Russell Investments as such, is sifted, an activity that demands huge resources, to
in September 2010 backs this up. It found that teams with five identify the most important information relevant to the fund.
people or less outperformed those with five to 10 members. In That information is again sifted - again implying important
fact, performance was reduced the larger teams became - with resources - until eventually the fund manager can take his
those having more than 20 members being the worst performers. investment decisions. Too many staff in one team leads to too
Within BNPP AM’s equity management teams, we find this to much data to analyse and there, we think, the focus gets diluted.
be verified as well: As an example, Hubert Goyé’s US equity An example of an equity management team avoiding this trap is
team, with only five fund managers/analysts, has been regularly Andrew king’s team, which uses a unique system based on the
outperforming his benchmark on an annual basis* for more than Heindrich Hirschman Index, to analyse stocks and does not let
15 years1. their focus waver from the short-list of companies that fit their
1 Source: BNPP IP, as at 5 October, 2011. Outperformance in 11 out of 15 years (annualised).
Excess returns to Russell Global Large Cap Developed universe
by size of team (2006 - 2010)*
5 or less 5 to 10 10 to 20 more than 20
Number of team members
Source: Russell Investments, September 30, 2010. Universe is Russell Global Equity Universe
(INTWORLD) with current membership of 233.
The Russell Universe is a group of managed portfolios that fulfill certain geographical and/or
criteria. Russell Investment Group performs extensive research and monitoring on investment
managers across all asset classes worldwide. Universe participants are selected by our research
division based on portfolio fundamentals and specific universe.
*Past performance or achievement is not indicative of current or future performance.
For professional investors
13 - BNP Paribas Investment Partners - PERsPECTIVEs - October 2011
Location, location, location
Another commonly held belief we wish to challenge is the idea
that geographical spread helps achieve better performance.
When teams are spread across the globe, too much reliance on
technology can occur, creating problems as people assume that
cyber contact is as efficient as communication in person. In our
view, 15 people around the world joining in a conference call
from different time zones, with less than perfect connections will
always be less conducive to optimal decision making than when
you have one small team in a single location sitting together
around a meeting table. We believe that having huge teams
spread across multiple locations leads to multiple agendas and
a lack of focus. We have put this in practice by recently relocating
our listed real estate team. Previously spread across three
countries, the entire team is now located in Amsterdam. The
benefits of this reorganisation are already showing with good
performance and new clients coming on board again.
Such a view coming from BNPP IP which is known for its size and
global coverage might be surprising, as our asset management
centres are spread across many countries. However, the teams
within those countries work autonomously to provide funds
focused on their speciality.
The BNPP IP philosophy of using a number of independent
business partners has long supported the idea of independent,
autonomous asset managers which focus on their core expertise.
This approach is working just as well within equities where
different teams are not interdependent, but rather left to
focus on their speciality. It may seem counter-intuitive as the
commonly held belief is that teams talking to each other and
sharing research adds value, but we have found that, for equities,
autonomy works better.
So despite the received wisdom that encourages ever larger teams
spread across the global relying on technology to communicate,
we believe that our four main elements ensure our equity teams
perform to the maximum: smaller teams, located in one place,
using face-to-face communication and working autonomously.
14 - BNP Paribas Investment Partners - PERsPECTIVEs - October 2011
pertise investment capab
& regional solution
15 - BNP Paribas Investment Partners - PERsPECTIVEs - October 2011
This material is issued and has been prepared by BNP Paribas Asset Management S.A.S. (“BNPP AM”)* a member of BNP Paribas Investment
Partners (BNPP IP)**.
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2 any investment advice.
Opinions included in this material constitute the judgment of BNPP AM at the time specified and may be subject to change without notice.
BNPP AM is not obliged to update or alter the information or opinions contained within this material. Investors should consult their own legal
and tax advisors in respect of legal, accounting, domicile and tax advice prior to investing in the Financial Instrument(s) in order to make
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investments, if contained within this material, involve varying degrees of risk and there can be no assurance that any specific investment
may either be suitable, appropriate or profitable for a client or prospective client’s investment portfolio.
Given the economic and market risks, there can be no assurance that any investment strategy or strategies mentioned herein will achieve
its/their investment objectives. Returns may be affected by, amongst other things, investment strategies or objectives of the Financial
Instrument(s) and material market and economic conditions, including interest rates, market terms and general market conditions. The
different strategies applied to the Financial Instruments may have a significant effect on the results portrayed in this material. The value of
an investment account may decline as well as rise. Investors may not get back the amount they originally invested.
The performance data, as applicable, reflected in this material, do not take into account the commissions, costs incurred on the issue and
redemption and taxes.
*BNPP AM is an investment manager registered with the “Autorité des marchés financiers” in France under number 96-02, a simplified
joint stock company with a capital of 64,931,168 euros with its registered office at 1, boulevard Haussmann 75009 Paris, France, RCS Paris
319 378 832. www.bnpparibas-am.com.
** “BNP Paribas Investment Partners” is the global brand name of the BNP Paribas group’s asset management services. The individual asset
management entities within BNP Paribas Investment Partners if specified herein, are specified for information only and do not necessarily
carry on business in your jurisdiction. For further information, please contact your locally licensed Investment Partner.
Publisher: Philippe Marchessaux
Editor in Chief: Anthony Finan
Deputy Editor: Maryelle Ouvrard
Publication coordinator: Sandrine Bensussen
Graphic design: Studio Graphique BNPP IP
Translations: Tectrad, CPW Group
A global presence
October 2011 - Design: Studio BNPP IP - P1110027
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