Global Investment – The Ideal Portfolio

By M. Isi Eromosele

In a world of unprecedented uncertainty, it is no longer possible to optimize investment portfolios on an asset class by asset class basis, nor are naïve asset allocation strategies acceptable.

One should never assume that the future will resemble the past, unless there is strong reason to believe so. The experience of the stable 1980s and 1990s has caused many lazy investment habits to get institutionalized as conventional and acceptable practice as market participants are learning to their cost.

More focused investment strategies are required.

All investors should strive for a multi-asset portfolio, designed to deliver profits in as many of the scenarios that can be anticipated over the next year – from outright market

crisis to sustained recovery.

The portfolio should be liquid and, for all intents and purposes, unlevered (with the exception of some relative value positions and some substantial long volatility or option positions).

The portfolio should be divided into five main parts:

Strategic assets

Emerging markets equities and bonds, EMFX overlays, gold and commodities. These are assets considered to have the biggest positively-biased asymmetric pay-off profile, on an option-adjusted valuation basis, across multiple scenarios.

This involves an assessment of the nature and intensity of each scenario against the volatility adjusted valuation of the asset in question.

Defensive assets

These are principally long regulated utility positions in Europe. These are assets that have historically outperformed during periods of high volatility.

Defensive hedges

These include equity variance swaps and a number of short dated currency and rate option positions. These are positions that statistical analysis reveals to perform well in dislocated markets and market crises.

A relative value book

A book in which one of the largest trades is a short position in non-financial European equities versus selling protection on the iTraxx Crossover index.

A currency overlay

This overlay should consist of long emerging market foreign exchange versus EUR

and GBP.

There is currently no excess cash recommended but there are large cash positions available against the face amount of derivative positions.

The rationale behind this mix of asset selections is as follows: There is recognition that the unstable world we live in will not last forever. Indeed, it is expected that by the end of the decade, we will enter a world of lower real growth, of emerging market currency appreciation and of possible higher inflation.

In such a world, owning the longest duration, highest real-yielding assets available is a good strategy. Ideally, these should be denominated in emerging market currencies (e.g. Brazilian inflation-linked bonds); or should be assets capable of being hedged back to emerging market currencies (e.g. Western European regulated utilities); or assets that mirror the behavior of emerging market currencies (e.g. agricultural commodities, gold).

Each of these asset classes should be bought whenever they are attractively priced, using capital accumulated by astutely navigating the current treacherous markets.

We are overweight equities versus rates because our analysis indicates that the equity risk premium for equities is now at unprecedented levels versus rates, even on an option adjusted basis.

In credit, focus on crossover paper because they have cheapened as much as equities (when you compare equity risk premia against volatility adjusted credit spreads).

The rationale behind the defensive hedge selections is as follows: there is recognition that in the short-term, there is a very considerable risk of systemic market failures with about a 40 percent chance of negative shocks ranging from a prolonged bear market in sovereign bonds to a market crisis.

The defensive positions are selected using option-based analytical tools that identify asymmetric pay-offs: trades that should perform well overall in highly volatile markets and also when strategic assets under-perform.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2013 Oseme Group

Financial Institutions 2013 – A Global Analysis

By M. Isi Eromosele

Since 2007, the reduction in bank leverage has been largely achieved through retained earnings and capital raisings. The fall in equity valuations and consequential negative impact on equity raising has shifted focus to the asset side of bank balance sheets.

Pressure on banks to deleverage is increasing as they seek to address capital and funding

requirements imposed by regulators, meet the requirements of the market and, in certain cases, achieve imposed restructuring deadlines.

It is widely believed that asset deleveraging across the global banking sector will increase substantially in 2013 and that European banks, for example, have identified over 1 trillion Euros in asset deleveraging.

Amongst investors, there is a widespread expectation that significant asset portfolio sales may take place in 2013 at fire sale prices. This expectation may or may not turn out to be correct.

At Oseme Finance, we believe rapid and price insensitive deleveraging on a widespread basis is unlikely. There are several reasons why deleveraging through asset sales by European and other global banks will occur in a much more staggered and orderly manner over an extended time frame than many expect. These include:

Continuation of well established deleveraging process

Deleveraging through asset sales is not new with many banks undertaking significant deleveraging. The deleveraging trend will continue with new asset classes becoming relevant but increased volumes of assets identified for deleveraging will likely be incremental to a well-established process, not a step-change.

Asset sales are a less attractive form of deleveraging

Asset deleveraging can occur via several means: write-off, disposal, redemption or refinancing. Given the capital benefit of run-down over divestment, expect the majority of assets to be reduced by refinancing or redemption.

Funding pressures

Whilst a reduction in U.S. dollar funded assets remains a priority for those European banks finding access to U.S. dollar funding markets difficult, immediate term funding pressure has reduced as the European Central Bank (ECB) has expanded provision of term liquidity to banks.

ECB funding reliance is not sustainable and will need to be addressed through deleveraging but only over time. In addition, innovations in secured funding give banks increased flexibility to hold funded assets to maturity rather than incur losses immediately.

Regulatory pressures

Regulatory pressure to meet capital ratios will only be aided by certain forms of deleveraging. With the exception of certain high RWA and other marked-to-market trading book assets, large scale deleveraging through asset sales is unlikely to be capital accretive, making it a less attractive strategy for banks required to meet substantial new capital requirements under the Basel 3 or EBA frameworks.

Interaction of deleveraging with alternative capital relief measures

Deleveraging is only one tool to achieve capital objectives. The relative attractions of alternatives such as canceling dividends, equity raising or liability management will have a significant bearing on the volumes and pricing levels of asset sales.

Substitutability of portfolios identified for deleveraging

Non-core assets identified for deleveraging that prove difficult to sell could be supplemented by other assets identified for their salability rather than their profitability.

Separating platforms from portfolios

A substantial business element of certain loan portfolios may reduce buyer appetite but may be difficult to divorce from a portfolio sale due to, for example, goodwill destruction or stranded costs.

Bank deleveraging through asset sales are likely to continue in 2013, at an increased but managed pace, as banks continue to use deleveraging as a tool to address capital and funding pressures and restructure business models to ensure adequate shareholder returns.

In an environment where many banks are simultaneously seeking to reduce balance sheets, asset deleveraging processes will need to be carefully constructed. Two key elements to improving execution are 1. definition of the sale portfolio perimeter and sale structure; and 2. the sale process.

The sale portfolio perimeter definition and sale structure will have a material impact on buyer appetite. Sale portfolio sizes will need to be kept small, despite significant deleveraging requirements, due to buyer funding availability and the reduced attractiveness of portfolios that are too diversified to buyers.

Portfolio tailoring is essential to minimize cherry picking. Structured sales (e.g. tranching) may be required to attract a wider investor base. Sale strategies should evolve in response to buyer interest, competing processes and changing market conditions.

A series of narrow auctions or bilateral discussions may be better than a failed process polluting further deleveraging initiatives.

For acquirers of assets, the key challenges faced in 2013 will be

1. identifying and accessing available opportunities

2. differentiating interest with sellers likely to be inundated by often opportunistic interest

3. acquiring assets that meet pricing and return expectations

Buyers must identify opportunities early and demonstrate credibility. For banks with substantial deleveraging objectives, it may not be necessary for buyers to wait for a formal sale process.

Given the substantial deleveraging task for certain banks, reverse enquiries may be well received. Importantly, a detailed understanding of seller objectives, time pressures, pricing constraints and alternative strategies may assist buyer positioning, through highlighting such attributes as transaction track record, due diligence efficiency and access to financing.

As the focus of asset sales moves from bank trading books to whole loans and loan portfolios, banks face a greater disparity between carrying value and realizable value. As pressure on banks to deliver increases, pricing expectations may fall but buyers may find that they also need to adjust return expectations.

Increasing innovation and detailed understanding and insight are required in an environment where funded buyers are few and resource constrained. Further innovation is expected and needed in areas such as financing, facilitating buyers into new asset classes and the way portfolios or businesses are presented to the market.

In an increasingly volatile and complex banking environment, a mutual understanding of objectives and drivers between buyers and sellers becomes less straightforward but even more necessary to ensure an efficient transfer of assets.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2013 Oseme Group