INVESTING IN GLOBAL EQUITIES, EUROPE

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1 INVESTING IN GLOBAL EQUITIES, EUROPE Published by MAY 2016 Exploring global equities and determining how to best select, blend and assess different strategies Sponsor Download the full report from

2 Sponsors BNP Paribas Investment Partners is the BNP Paribas Group s asset management specialist and an entity of International Financial Services of BNP Paribas. BNP Paribas Investment Partners offers the full range of asset management services to both institutional and private investors around the world. The company adopts a client-focused approach and is structured around three business lines: Institutional, Distributors and Asia-Pacific & Emerging Markets. BNP Paribas Investment Partners counts more than employees1 in 35 countries1, with a total of more than 600 investment professionals1; each specialised in a particular asset class or product type, and has assets under management totalling EUR 530 billion1. 1 Source: BNP Paribas Investment Partners, as of 31 December 2015, assets under management and advisory Clear Path Analysis is a media company that specialises in the publishing of high quality, online reports and events in the financial services and investments sector. FOR MORE INFORMATION: W: T: +44 (0) E: marketing@clearpathanalysis.com TELL US WHAT YOU THINK We value your interest as without our readers there would be no reports. Please fill out our short survey to give your feedback. The survey will take approximately 3 minutes and all feedback is anonymous. Click HERE to access the survey. Thank you for helping our reports be the best they can be. 2

3 1.3 INTERVIEW - PART 1 Importance of keeping global equities as part of a balanced portfolio Interviewer Noel Hillmann Managing Director, Clear Path Analysis Interviewee Anton Wouters Head of Customised and Fiduciary Solutions, BNP Paribas Investment Partners Guy Davies Director, Equities, BNP Paribas Investment Partners Noel Hillmann: What are the current challenges facing insurers and pension funds, and how do you see this impacting asset allocation decisions? Anton Wouters: The challenges are two-fold, first there is the current general environment in financial markets with low yields and sometimes volatile markets so that is purely based on the more financial management of the portfolios. Secondly, you also have to keep in mind the regulatory part of the portfolio especially on the insurance side as it can also influence asset allocation. If I look at the financial market perspective, the low yields are there and that hurts both funding ratios of pension funds and solvency ratios of insurers. They have to find a way to cope with low yields, growing liabilities and make up for that additional return on liabilities with a good mix of asset classes in the portfolio so that they can achieve higher returns than on their liabilities, given the current circumstances. From the regulatory side, pension funds and insurers are confronted with the fact that an optimal portfolio in an economic sense is not always the optimal portfolio in a pure regulatory sense, they have to combine the two to find an optimal portfolio. These challenges are quite big and on top of that, the low yield environment seems here to stay for the foreseeable future, especially in Europe. Noel: As a fiduciary manager, how do you look at the outperformance of equities and what are the challenges and issues that you see? Anton: If you look to how you would build a portfolio around your liabilities, regardless of whether you are an insurer or pension fund, in the end you have a number of fixed income orientated asset classes where you can at least have returns comparable to the liabilities. In essence you need additional return above the liabilities to grow your funding ratio or for insurance companies, have enough return to distribute to your customers. One way or the other you have to have higher yielding assets in your portfolio. Pension funds already have this attitude and have a reasonable portion of equity within their portfolio and although they are experiencing difficulties in the current climate they are not getting rid of it. They want to keep a certain allocation to equities and try to optimise this. On the insurance side, the regulatory restrictions kick in, because with Solvency II equities are heavily punished in terms of capital that you have to hold. Here insurers have to find a way to still have reasonable allocation to high yielding assets, including global equities, whilst still keeping the regulatory capital contained. Guy Davies: One of the areas we have to be mindful of is regulation and the impact that it can have on time horizons for investment objectives. This can have an impact on the ultimate investment strategy that is put into place and the degree to which the strategy is actively managed. Noel: In respect to time horizons, given the volatility in markets and there being a lot of uncertainty about interest rates plus how deep China s slowdown has been and will be, is this the right time for pension plans and insurers to be setting solid time horizons for allocating? Is there a problem in being too strategic? Guy: I feel it is the opposite as one of the issues that investors face is having too short a time horizon and looking at investment performance too frequently. If we look back at any meaningful period during the markets there will be peaks, troughs and volatility. Those investors who have maintained a longer term approach have typically fared better. One can always question whether markets are reflecting fundamentals or whether investor sentiment is dominating. That said volatility can be used to alter allocations through time which is where a more tactical approach can be useful. From an equity perspective, in terms of factors that are commonly considered to cause stocks to outperform the market, these would include: size - so smaller companies outperforming large value - with cheaper stocks outperforming more expensive momentum - where winners continue to win. There was some interesting work done 2-3 years ago looking at the illiquidity 3

4 Importance of keeping global equities as part of a balanced portfolio premium. This is a term that is being used quite a lot at the moment - whether less liquid stocks may be inversely related to risk so the lower the liquidity, the higher the return and lower the risk. This may be different from traditional portfolio theory, but it nonetheless plays to a long term time horizon. Noel: What are the developments in matching liabilities in expectation of rising yield? Do pension funds take more (equity) risk? And if so, what kind of risk? Anton: When you are expecting a rise in yields you might have the idea to get rid of some of the liability hedging part of the portfolio. But hedging fewer liabilities will increase the risk and depending on the regulatory environment of where you are it might not always be possible to increase the risk of your portfolio. In the Netherlands the regulators look very carefully at how you increase risk especially when you are in a difficult situation from a funding ratio perspective. In the UK it is the sponsor who will look with some concern at this kind of issue. So, from a matching point of view, lowering the interest rate hedge is something that you have to consider very carefully. First of all, trustees should have an opinion about rising yields. Secondly, on a total portfolio level, you might consider (or need to consider) countering the risk by bringing back the equity exposure so that you still have equal risk in the portfolio. But that has some consequences for the return capacity of the portfolio. Investors are still convinced that excess return opportunities can come from a solid, diversified return portfolio and many of them also believe that active management of the portfolio can add additional value. Many pension funds are looking in to this at the moment and some have implemented this already. However rising yields have not materialised, so many are indeed still just considering it. Some have brought back the interest hedging a little, but not a lot. They have also kept their allocation to equity, within the return part of their total portfolio. In the end this brings you to the question of the additional value of the portfolio longer term, even if this year it looks a bit volatile. Investors are still convinced that excess return opportunities can come from a solid, diversified return portfolio and many of them also believe that active management of the portfolio can add additional value. Guy: What has been an interesting development is that pension funds are more actively considering exposure between return and matching portfolios. Within that return portfolio there appears to be a greater willingness on behalf of trustees and perhaps sponsors to provide asset management firms with greater discretion over the management of that portfolio. Noel: Do you feel that there is greater momentum in the income from equity space? Do you feel that this is an area that is going to be quite troublesome for a while with companies under a lot of pressure not to increase their dividends? Guy: It largely depends on the way that individual strategies are established and whether they have specific yield targets, or whether it is a target relative to the market yield. A number of companies are and will be under pressure to cut dividends but there are other ways we would look to try and generate a yield. In the U.S. from a top line yield perspective, the S&P500 may not rank particularly high relative to other markets but including share buy backs presents a different view. We take a more holistic approach. Anton: Income is important although insurers and pension funds might look differently at the word income. If you are an insurer you would look at areas like book or insurance yields, which is different to a pension fund. For the majority in the pension fund sector, they are looking at the fixed income side as the main contributor of cash flows, for example for hedging purposes. The income part from equities can also be important and you can structure it around the opportunity to have high dividends and equities in your portfolio. Guy: We would look at other factors like derivative overlays for generating additional income from an equity perspective. Noel: Please explain the benefits of allocating to a flexible spread of equities vs individual equity allocations to U.S. small cap funds and so forth? Guy: There are various ways of constructing equity portfolios which should reflect a fiduciary s skillset. From our perspective, removing constraints, enlarging the universe and 4

5 Importance of keeping global equities as part of a balanced portfolio adopting a longer term approach are good starts. It s also important to focus on areas in which we feel we can add value. The active share of a portfolio is a useful measure to highlight the degree to which a portfolio s holdings are different from those of the benchmark hence the degree of conviction. Within this we have a preference for more concentrated portfolios focusing on areas in which we have conviction, rather than including fillers to reduce volatility relative to benchmarks. It is a misnomer in the market that many people incorrectly ascribe risk to concentration. We would argue that there is less risk in a carefully and fully researched portfolio of companies as opposed to a larger, diversified portfolio which may contain positions as a result of benchmark inclusion. Depending on the market, 35 stocks could be considered diversified. Another misnomer relates to a focus on tracking error. Tracking error is a measure of how a portfolio performs relative to a benchmark and will be influenced by factor exposures. In line with our focus on stock selection which is where we believe we can make money for our clients - we don t take calls on factors such as growth, value or momentum, etc. Noel: Lastly, how do pension funds and insurers react to the market circumstances and regulatory pressures? Anton: On a high level the fact that an insurance company is a real company and has capital of its own is already a big diversifier because as a consequence if an insurance company is not right, they go bust. If you look to a pension fund, if they don t do things right then they will lose funding ratios but still they are not bust unless the sponsor company is not willing to pay for it anymore and / or goes bust itself (i.e. because of the liabilities of the pension fund). This creates differences in risk attitudes and is one of the reasons why, in general, insurance companies are forced to have a more conservative angle in their asset allocation than pension funds and more specifically, their allocation to riskier assets. Then there is a difference in terms of how the liabilities look. Which factors are liabilities of insurers sensitive to (inflation, interest rates, equity markets) and what kind of optionality is included in the liability structure. The allocation to assets will be based on those elements. Finally, there are many types of insurers. Not all insurers have a long duration liability structure and need carefully structured liability hedging portfolio. Also, the solvency position of insurers is quite different too. For example, if you have a very short term duration of liabilities (and not so sensitive to interest rate movements), and a strong solvency position, a somewhat large equity allocation could be considered. All in all, it is difficult to indicate how pension funds and insurers are reacting as a group. But clearly, the focus on the way the portfolio is constructed has increased and both pension funds and insurers are more than ever aware that they have to combine market risk with regulatory constraints. Guy: The objectives of pension funds and insurance companies are different. This will impact their respective investment objectives, their appetite for risk and ultimately on portfolio construction. That said - and regardless of the various different regulatory changes and pressures as well as the inevitable push towards shorter time horizons within pension funds - there has been more appetite to evolve the asset allocations to allow exposure to longer term strategies. Noel: Thank you both for sharing your views on this subject. This creates differences in risk attitudes and is one of the reasons why, in general, insurance companies are forced to have a more conservative angle in their asset allocation than pension funds and more specifically, their allocation to riskier assets. 5

6 1.3 INTERVIEW - PART 2 Importance of keeping global equities as part of a balanced portfolio Interviewer Noel Hillmann Managing Director, Clear Path Analysis Interviewee Anton Wouters Head of Customised and Fiduciary Solutions, BNP Paribas Investment Partners Guy Davies Director, Equities, BNP Paribas Investment Partners Noel: In part 1 of our interview, you mentioned the optimising of equity allocations and the mix in what you need from a regulatory capital perspective versus what you need from a return perspective. How wide is this mismatch and what elements to global equity allocations do you feel sit more comfortably within the regulatory framework? Anton: From a regulatory point of view the situation for insurers is more stringent than for pension funds. If you look to an insurance portfolio the capital that you need for holding a certain allocation to equities is large so you really need to have a good idea about the excess return opportunities of an equity portfolio. For this reason you need to be careful how you build this equity portfolio within the total allocation. You need diversification and additional alpha on top. Additional alpha/return is what you hope for, because active management as such isn t really punished in Solvency II. Therefore, a nice excess return is good for an insurance company but it should not bring additional risk to a global equity portfolio. So, if you have the ability to have a global equity allocation, the structuring of a global equity portfolio is very important for insurance companies. Noel: Insurers are very restricted in what they can allocate to equities. In terms of optimisation how should insurers be approaching equities more broadly? Anton: Broadly speaking, they should look at the risk point of view. If you invest in global equities it consumes capital so if you are going to spend that capital you want to have the highest return for the lowest risk. The risk within global equities in a portfolio is an important issue. Allocation to global equities should seek to optimise risk and return characteristics. What you see with insurance companies is that they combine equity allocations with some kind of risk mitigating strategy. The simplest form of this would be a put option which not many people are doing because it is expensive. So, you have to structure not only the global equity portfolio but also the risk mitigating strategy around it very carefully. Noel: How can an optimiser work for insurance and pension funds concerned about their weightings in equities given the current market? Anton: An optimiser is a technical instrument but in principle when you look at an insurance company you can optimise from two angles, one is the regulatory and the other is economic. The regulatory angle is pretty fixed so if I take the long term expected return per unit of risk then it is a technical issue. You can optimise it for the longer term and do your simulations. The expected return per unit of risk from an economic angle could be different. If you take your long term expected return and long term economic risk connected to it, perhaps your optimal asset allocation is already a bit different. Optimising this becomes even more interesting when you have different expected returns on the medium term for the different asset classes. For example, If you are of the opinion that equities are quite well positioned to have at least a decent return in low yield environments compared to your investments in credit (which you expect to be quite low over a medium term period because of your rising rate and credit spread expectations), then the difference in expected return per unit of risk from a regulatory and economic angle could lead to a somewhat higher equity allocation even if it requires more capital. The ability to make this transparent to clients is very useful in order to use optimisation from both angles and then to combine it by using stress scenarios and showing them what the benefits of the various asset classes can be. In this sense the asset allocation exercise is still very important and using optimisation techniques can really help make transparent what is actually happening in the portfolio. Guy: This goes back to governance issues, an important element of which being thorough attribution analysis effectively measuring the efficiency of strategic asset allocation decisions, their subsequent implementation and any more tactical considerations. It s a question of focusing on those areas in which you as a fiduciary believe there is a genuine opportunity to generate alpha. 6

7 Importance of keeping global equities as part of a balanced portfolio In terms of structuring equity portfolios, fiduciaries appear to be more comfortable distinguishing between alpha and beta and hence combining the use of less constrained active managers with passive strategies. We ve also seen a marked rise over the last decade in active quant strategies so called smart beta allowing fiduciaries to structure benchmarks that they may deem more appropriate. A positive consequence of this evolution has been an increased focus on the level to which an active manager is truly active: or in other words whether value for money is being offered. Noel: There is growing intrigue amongst pension plans and insurers for private markets or private equity allocations. Do you see this playing a growing role? Do you feel it should be playing a growing role in how pension plans and insurers allocate to equities? Anton: From a fiduciary perspective it is true that pension plans and insurers are looking more at illiquid assets because of the so-called illiquidity premium. Also it s because some of the more illiquid assets, like infrastructure, are actually quite well suited to match liability cash flows. However, it still isn t to the extent that they will replace the liquid global equity part of their portfolio with more illiquid private equity. As private equity is giving exposure to an illiquidity premium and global equity is giving more exposure to a volatility premium this can sometimes be interesting in a portfolio from a diversification point of view. Noel: How important is having a multi asset investment mix in achieving and matching liabilities of a scheme? Guy: A more holistic view to actively managing asset allocations and portfolios is positive and it relates to Anton s point on private equity as well. This approach needn t stop at the level of allocating exposure between asset classes, but within asset classes providing scope for managers to move across the capital structure of companies. For example, from equity through to corporate debt would make sense. In a similar vein, why constrain stock selection to public markets? This is an area in which companies like ours with considerable resource across a range of asset classes are looking at more. Noel: From a governance perspective in terms of investing in a multi asset mix, this does present certain issues of moving into certain asset classes that may be an investor has less past exposure to and so less direct experience. BNP Paribas Investment Partners does have a wide array of experience in this area but how do you as a fiduciary manager ensure that you are getting the best risk return ratio whilst also being very careful of some of the governance risks? Anton: As a fiduciary manager the governance aspect is very important. If you want to introduce new asset classes and there is no past experience within the board of trustees, then education and support is very important. The fact that you want to implement a less liquid asset class needs explanation to trustees as they need to know what illiquidity could mean in their portfolio. Another element to explain is that Alternatives can bring diversification in relation to other asset classes if well-structured within the portfolio. We should ensure that the trustees are feeling comfortable and in full control of their portfolio. Noel: There is a growing realisation that ESG can add value to any equities portfolio, how are you as a manager developing your approach to ESG factors as part of an equity allocation? Guy: ESG is an element that s included within our stock selection process and has been for a long time. The ESG terminology is now becoming more well-known and standardised, so yes, there is a specific ESG column in terms of what we assess, but to be honest good equity managers look at these issues anyway. It is now a formal element in all of our portfolios. We also have a dedicated ESG research team that helps the investment teams to fully embed ESG principles across the board. Noel: Thank you both for sharing your views on this subject. 7

8 IN A CHANGING WORLD, INVESTING ON THE OTHER SIDE OF THE WORLD HAS NEVER BEEN SO EASY. CAPTURE MARKET OPPORTUNITIES WHEREVER THEY MAY BE Our global network of experts in each region of the world directs you to new market opportunities with a large range of investment solutions and the right services to help you achieve new goals. bnpparibas-ip.com The asset manager for a changing world The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial investment. Past performance is not a guide to future performance. For more information, contact your financial adviser. This is an advertisement issued by BNP Paribas Asset Management S.A.S. (BNPP AM)* part of BNP Paribas Investment Partners (BNPP IP)**. Investors considering subscribing for the financial instruments should read the most recent prospectus or KIID available from their local BNPP IP representatives. Opinions included in this advertisement constitute the judgment of BNP PAM at the time specified and may be subject to change without notice. *BNPP AM is an investment manager authorized by French regulator AMF, under number GP 96002, with its registered offices at 1, boulevard Haussmann Paris, France, RCS Paris **BNP Paribas Investment Partners (BNPP IP) is the global brand name of the BNP Paribas group s asset management activities. For further information, please contact your locally licensed Investment Partners. Image Source / 3D : Asile Paris

9 TO READ MORE FREE REPORTS VISIT: The opinions expressed are those of the individual speakers and do not reflect the views of the sponsor or publisher of this report. This document is for marketing and/or informational purposes only, it does not take into account any investor s particular investment objectives, strategies or tax and legal status, nor does it purport to be comprehensive or intended to replace the exercise of an investor s own careful independent review regarding any corresponding investment decision. This document and the information herein does not constitute investment, legal, or tax advice and is not a solicitation to buy or sell securities or intended to constitute any binding contractual arrangement or commitment to provide securities services. The information provided herein has been obtained from sources believed to be reliable at the time of publication, nonetheless, we cannot guarantee nor do we make any representation or warranty as to its accuracy and you should not place any reliance on said information. Clear Path Analysis Ltd, registered in England and Wales No Registered office: 69 Blyth Road, London, England E17 8HP. Trading office: The Foundry, 156 Blackfriars Road, London, SE1 8EN