Finding Value in Africa

Paul Amery, editor of IndexUniverse.eu, recently conducted a telephone interview with Charles Morris, head of absolute return strategy at HSBC global asset management. Morris and his colleagues are active users of ETFs in their portfolios.

IU.eu: Charles, please describe your fund operation.

Morris: We manage money for sovereign wealth funds, retail investors, private clients and charities, all on an absolute return basis, with US$2.2 billion under management. Our portfolios are multi-asset, with around a third invested into alternatives (predominantly hedge funds) and two thirds in bonds, equities, commodities and credit.

IU.eu: What proportion of that is invested in ETFs?

Morris: Our current ETF exposure is 10% in inflation-linked bonds (in US government TIPS, French OATs or UK index-linked gilts, depending on the underlying currency class of the investor). We have an additional 10% in gold bullion via ETF Securities Physical Gold (PHAU) and 5% in agricultural commodities via the ETF Securities Agriculture DJ-UBSCI ETC (AIGA), which we bought a couple of weeks ago.

IU.eu: Do you use European-listed ETFs only?

Morris: No, we have an international client base so we use them from listings around the world.

IU.eu: What’s been the historical range of your ETF exposure?

Morris: On average it’s been slightly lower than it is currently, at around 15%, but we’ve had up to 30% invested at times. Historically we’ve had a lot of equity exposure via ETFs – for example, we’ve owned India, Brazil, the FTSE 100, S&P 500, and the Nasdaq using exchange-traded funds – though we don’t have any right now.

IU.eu: If you decide, say, to invest in US equities via an ETF, what decision-making process do you go through to determine which one to buy?

Morris: We have internal procedures which mean that, first of all, we have to approve the provider. Not all issuers are on our approved list and of the 2000-plus ETFs on offer worldwide I’d say that we only deal with around a third of the providers. Then we look at things like UCITS compliance (for European clients), tax-friendliness and intra-day liquidity. Fees are a secondary issue.

IU.eu: Do you have any views on whether a certain type of ETF structure is preferable – for example, physically replicated or swap-based?

Morris: As long as the fund is run according to the UCITS rules, the fact that a fund may have some derivatives exposure (for example, in a swap-based ETF) doesn’t concern us, provided the counterparty has been approved by our due diligence process. We’ve owned both types of fund in the past, although currently we only have iShares and ETF Securities trackers in the portfolio.

IU.eu: How do you buy and sell ETFs? For example, do you deal in the market, intraday, or at the closing NAV?

Morris: If it’s a large transaction – say 50 million dollars – then nine times out of ten we’d deal at the closing NAV, as we think it’s the cheapest way to get the transaction done. When we’re doing smaller deals (say rebalancings) or client subscriptions or withdrawals we may deal intraday, so that’s why checking the trading liquidity of an ETF and the cost of dealing is important.

IU.eu: If you’re dealing predominantly at the end of day NAV, wouldn’t you be better off just using a traditional index fund?

Morris: That’s a good question and in fact we’re looking at precisely that right now – whether to use index funds more actively. ETFs may well be attractive if you buy and hold them but if you’re trading there will be brokers involved who don’t work for free, so you have to keep an eye on secondary market costs. ETFs may not be as cheap as is commonly believed. That’s why we prefer to trade at NAV in most cases and we certainly want to consider alternative investment vehicles such as index funds or even investment trusts.

IU.eu: Doesn’t trading at NAV expose you to potential market volatility in the latter part of the trading day, so you’re not sure what price you will be getting? Isn’t there sometimes a suspicion that brokers can move prices around based on likely end-of-day order flows?

Morris: Yes, it does, but there’s no easy solution here and it comes down to a trade-off between accepting that possibility of late-day movements and wanting to trade without incurring a bid-offer spread. If you call up to get a “risk” price during market hours there will inevitably be a dealing spread incurred, although clearly it varies from fund to fund, with some ETFs being very liquid now.

IU.eu: Do you use short or leveraged ETFs?

Morris: No, we don’t. The idea of an ETF as something to provide “delta-one” exposure to an index, and to do so cheaply, makes a lot of sense. As always in finance, though, people take things too far, and I’m strongly against index products that don’t deliver what’s expected. So an inverse FTSE tracker doesn’t give minus one times the FTSE over time – which is what you might think it does – and likewise the leveraged funds don’t give you two or three times the index return over time. I think that a lot of people don’t understand these products and they may cause a lot of problems down the line. We wouldn’t own these products and the world would be a better place if they didn’t exist.

IU.eu: Then how do you go short, if you want to protect against markets falling?

Morris: We use hedge funds so they go short on our behalf.

IU.eu: What are your current market views?

Morris: We have around 22% in equities, including some African exposure, holdings in Berkshire Hathaway and an actively managed US fund, a fund with exposure to gold stocks and an emerging market infrastructure fund. We’re bullish on Africa and slightly interested in middle-eastern markets as a late catch-up play. Overall, though, we’re suspicious of the big, broad bull market that some now see. We don’t think that the stock market is particularly cheap and we believe the outlook is uncertain. Long-term volatility is at its highest on record. Put those three things together and it’s not a great outlook for equities. Ideally you’d want a cheap, low-volatility and under-owned market to give you confidence in investing. You can find that in certain parts of Africa but you certainly don’t get that here in the UK.

Original post