Diversifying Into Global Bonds and Currencies

By M. Isi Eromosele

Global investors, particularly those in the U.S. have expressed increasing concern about the stability of their own domestic markets. Over the last two years, investors have worried about the de-basing of their domestic currency, the credit quality of their “risk-free” bond market and what will happen when their Central Banks start to tighten monetary policy.

Investors can diversify their currency and interest rate risk by going global, and start expanding the horizons of their investment universe. The concerns of U.S. investors can also be applied to Europe, the UK and Japan.

When adopting a global approach to fixed income, investors probably should not follow bond indices. Bond indices are based on market capitalization; so the greater the volume of issuance, the heavier the index weighting.

The bond index investor is therefore forced to buy increasing amounts of the bonds of those countries that are issuing large volumes of debt and is thereby locked into those countries’ declining credit story. Is there a better way?

In measuring bond value, investors ignore the power of the yield curve at their peril. Compared to cash rates, longer-dated bonds are historically cheap. Absolute yield levels are low, but this a reflection of the current low cash rates. Inflation and other assets (equities) may provide a useful measure when global concerns begin to subside.

Commodity price inflation has been a further concern for investors during the early part of the year. Moving into the second half of 2012, however, these inflation expectations subsided.

The year-on-year effects are such that yearly headline inflation statistics will likely be in decline. In the absence of a complete collapse in the European periphery, lower inflation expectations, together with Japan’s return to normal should allow economic growth forecasts to rise once more.

Eventually current concerns might subside, which would lead to rising expectations of tighter monetary policy and in turn raise questions about how best to diversify current safe haven assets.

From that perspective, worries about declining credit quality and the potential for higher cash rates could eventually be applied to most developed markets and each country would love to see its currency decline in value.

The traditional global government bond indices are dominated by such markets; the U.S. Dollar, European Euro and the Japanese Yen make up just under 90% of global government bond indices.

When seeking to diversify away from these markets, one must look for better credit quality, where higher official rates are already priced in and a currency that has potential to rally.

Many developing markets fit this description, but their local markets are generally, small, and subject to manipulation. There are also a number of developed markets (Australia, Sweden, Norway, Canada, Switzerland and Denmark) that could also be placed within this category.

The weightings of these markets in bond indices are small or non-existent but their liquidity is more than sufficient for inclusion and their share of world GDP or currency trade puts them in the top 30 countries.

If the net is widened to include investment-grade developing markets such as the BRICs (excluding India), South Korea, Mexico, Poland, Malaysia, Singapore and the Czech Republic, the pool expands to encompass a truly global universe, which provides investors greater opportunity to diversify interest rate, credit and currency risk.

Bonds and currencies are driven by monetary and fiscal policies which, since the global credit crisis, have diverged greatly. Those countries that are not encumbered by legacy debt issues have raised interest rates and kept their government balance sheets clean.

The resultant tightening of monetary policy in those countries, such as Australia leaves them with attractive bond yields and greater fiscal credibility. Those countries that must work through their debt problems will likely continue to finance their rebuilding through ultra-low rates and steep yield curves.

A diversified exposure to these different themes is an exciting way to reduce domestic risk.

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

Copyright Control © 2012 Oseme Group

Global Alternative Investments - An Analysis

By M. Isi Eromosele

For the past decade, institutional investor interest in “alternative” asset classes has grown significantly. Such alternative assets cover a wide range of investment opportunities. The major categories include real estate, private equity, hedge funds, and more recently, infrastructure.

An investment is considered “alternative” if it has relatively limited investment history, is relatively uncommon in investment portfolios, is relatively illiquid, has different performance characteristics than traditional assets, is rarely traded in public markets and requires specialized skills on the part of the investment manager.

By contrast, traditional investments have historically been comprised of stocks, bonds and cash equivalents, are traded in public markets, can be benchmarked and are managed by strategies that are not based on short selling, excess leverage, or the use of derivatives.

Interest in alternative assets has gained increasing momentum over the past decade years in particular. The tanking of the equity markets in 2000 combined with the low yield bond environment has led investors to shift a significant portion of their assets out of traditional investments, public equity and bonds, into alternatives.

Pension fund dollars accounted for the largest share of these in-flows. Moving forward, Oseme Finance concludes that alternatives will constitute an increasing share of new allocations by institutional investors, including foundations and endowments, corporate and public pension funds, and high net worth individuals.

Institutional investors now demand alternative and diversified sources of return that are less volatile, yet higher on a risk adjusted basis. Investors are also targeting assets that are uncorrelated with traditional equity and bond investments in order to prevent the severe capital losses they sustained earlier this decade. Alternative investments have come to satisfy both requirements.

Empirical evidence on return performance of alternatives verifies certain key characteristics including:

Additional Diversification

Alternative assets have different return characteristics than traditional asset classes. Their returns are uncorrelated with traditional equity and fixed income, mitigating undue portfolio risk. The level of correlation, however, will depend on the specific type of alternative investment considered.

Potential For Higher Returns

Alternative investments have the potential to offer investors higher returns. Such higher returns, however, are compensating investors for a higher degree of illiquidity and less transparency surrounding alternative investments.

 Longer-Term Horizons

Alternative investments are relatively illiquid, typically with lock-up investment periods. Institutional investors are required to take a longer-term view when investing in alternatives relative to the more liquid traditional assets.

Long-term investors such as pension funds do not require liquidity, however, and can benefit from the “liquidity risk premium”. With plan sponsor’s increasing emphasis on long-duration liabilities (and liability driven investments, LDIs), investors can actually earn superior returns by investing in relatively illiquid alternative assets.

Capital Preservation In Volatile Markets

A unique feature of alternative assets, hedge funds in particular, is the ability to use a number of trading strategies, such as short-selling and the use of derivatives. These strategies are rarely used in traditional, long-only investments, but have the benefit of producing positive returns regardless of the direction of the market. The ability to execute these strategies, however, depends critically on the manager’s skill.

Over time, alternative investments will continue to gain increasing prominence in institutional portfolios. Returns from traditional asset classes, bonds and equity will not be as compelling over the next decade.

This expectation, combined with increasing investor sophistication, has seen investment in alternative assets become one of the fastest growing trends in the global investment arena.

These perceived advantages and the lackluster outlook for traditional assets have rendered the broad alternative asset class as highly desirable. Investors, however, have to accept some hurdles including illiquidity, irregular and lumpy returns, higher fees,and the lack of appropriate benchmarks.

In addition, for many alternative investments, it is difficult to measure risk because there is no market to provide period by period valuations, as in the case for publicly traded assets.

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

Copyright Control © 2012 Oseme Group