I had the opportunity to listen to very interesting discussions about the role of emerging markets, commodities, hedge funds, small cap equities and ETFs in global investment portfolios at the Asset Allocation Summit and ETF & Indexing Investments Conference. The conferences were held at the Princeton Club in New York from May 16 to May 18 2011.
Emerging Markets: Benefiting from Urbanization, Growing Middle Class & Infrastructure Spending
The emerging markets panelists were all very positive on the longer term prospects for emerging markets based on their lower debt levels and stronger economic growth relative to developed markets. Frank Brochin, Managing Partner of StoneWater Capital, runs an Asian focused Fund of Fund (FOF) and a broader Emerging Markets focused FOF. Mr. Brochin is looking for best of breed investment managers in Asia whose investments will benefit from the rise of the urban middle class or from huge expected infrastructure spending. The urbanization rate in China is currently in the 40%-50% range and Mr. Brochin expects that 400 million more Chinese people will move from the countryside to urban areas, bringing the urbanization rate to 80% over the longer term. About 15 to 20 million Chinese people are moving to the cities per year and after they move, their incomes tend to increase three to four times, which will drive Chinese consumer spending growth. In Brazil, Mr. Brochin feels that middle class consumer spending will benefit from rising income levels, as well as more access to credit cards, auto loans and mortgages.
Vidak Radonjic, Managing Partner of the Beryl Consulting Group, is also focused on finding the best investment managers in emerging markets that can deliver alpha (outperformance relative to benchmark index). Eight years ago, Mr. Radonjic said that most of the managers that he met in Asia were long biased, but in recent years, he has had more success finding quality alpha-focused hedge funds. In Brazil, he has predominantly found managers who are long-biased so he is not investing in Brazil right now. Mr. Brochin and Mr. Radonjic both stressed the importance of finding local managers that can discover the smaller, undercovered names that are cheaper and have stronger growth prospects.
The panelists were asked about inflation creeping higher in China and Mr. Brochin said that he expects inflation to come down to 4% range in 2nd half of 2011 vs. 5.5% current level based on the government slowing down lending activity. He also thought that 12x average forward price / earnings valuation ratio of Asian stocks overall was not expensive relative to their high expected growth rates and that his Asian managers were finding many quality investments trading in the 10x to 12x range, especially in the small cap universe. In response to a question about the "right" allocation to devote to emerging markets, Mr. Radonjic mentioned that 10%-15% of global investment portfolios were invested in emerging markets currently and that he thought that percentage would increase given the more positive fundamental outlook for emerging markets relative to developed markets.
Commodities: Active New Products, "Right" Weighting and Favorite Segments
There are exciting "third generation" commodity investment products that have been and will continue to be introduced that should allow investors to maximize their returns from their commodity investments. "First generation" commodity ETF products were focused on tracking the performance of the Dow Jones AIG (now Dow Jones UBS) and S&P GSCI commodity indices. These indices have fixed weightings that are only rebalanced once every year. They use first month futures contracts that are rolled over every month. The problem with rolling over first month futures contracts every month when they expire is that in order to replace the exposure, new futures contracts need to be purchased. Negative roll sometimes occurs, in which the investor who is long the spot contract needs to roll to the next contract and has to sell the lower-priced contract and buy the higher-priced contract. Negative roll occurs in "contangoed" markets.
New "third generation" commodity investment products take a more active, fundamental approach to commodity investing. One of the most popular new third generation products is the U.S. Commodity Index ETF (USCI) that tracks the performance of the SummerHaven Dynamic Commodity Index Total Return. The SummerHaven Index was created based on work done by Yale University Professor Geert Rouwenhorst, who discovered that the shape of the futures curve and whether the futures curve is in "backwardation" (which means that forward months trade at a lower price than the spot month) or "contango" (which means that the forward months trade at a higher price than the spot month) has a significant impact on the return of a commodity futures strategy. A normal commodity index owns a broad group of commodities, some of which are in contango and some of which are in backwardation. USCI, on the other hand, only owns 14 of the 27 eligible commodities at any one time and selects the commodities it invests in monthly, based on the 7 commodities exhibiting the steepest backwardation and the seven with the greatest price momentum. A contango reflects a well supplied market carrying a high level of inventory while backwardation reflects a tight market with a low level of inventory. Kurt Nelson, Partner of SummerHaven Investment Management, noted during the commodity panel discussion that inventories are the most important fundamental driver of commodity markets.
Since USCI started trading in August 2010, it has outperformed DJP, the ETF that seeks to replicate the Dow Jones UBS Commodity Total Return index, by about 10%.
The commodity panelists were asked what the appropriate weighting was for commodities in a global portfolio. Mr. Nelson said that larger investors' portfolios tended to have 7%-10% allocated to commodities and he expected that percentage to increase over time. Tim Pickering, Founder and President of Auspice Capital, thought that a 20% allocation to commodities would be a good weighting. John Hyland, Chief Investment Officer of United States Commodity Funds, said that commodity investing right now was like REIT investing was in 1995 and that he expected asset flows into commodities to increase over the next decade.
Some larger investors have also become more interested in adding commodity segment exposure instead of, or in addition to, exposure to a broad group of commodities. Martin Kremenstein, CIO and COO of DB Commodity Services, and Mr. Nelson both thought that agricultural commodities were the most interesting segment in the next year. Mr. Pickering felt that natural gas might be interesting at some point, but not yet.
There was a thought-provoking discussion among the panelists about physical commodity ETFs. A physical gold ETF purchases and stores the equivalent amount of gold bullion in a bank to match the assets under management in its ETF. Investor demand for physical gold ETFs will make gold increase in price over the next few years more than it would otherwise because these ETFs take gold out of the market, making less gold available for jewelry and other uses. Shortages might lead to price spikes as buyers who really need gold will bid up the prices. This dynamic could be even more dangerous for other commodities, such as copper, platinum and palladium, when their physical ETFs are introduced. These commodities are primarily used for industrial purposes and real world companies need these commodities. If these physical ETFs buy and store these commodities and take them out of the market, there is a greater possibility that shortages will develop, leading to price spikes as industrial buyers pay whatever price necessary to get the commodity.
Hedge Funds: In Low Return World, HF Assets Should Grow
Don Steinbrugge, Member of the City of Richmond Retirement Fund Investment Committee, believes that hedge fund assets will grow strongly over the next few years because pension funds and endowments will need hedge funds to try to meet their 8% expected returns. A greater percentage of pension funds and endowments will have a hedge fund allocation and those that already have an allocation, will increase it. Mr. Steinbrugge is cautious about investing in larger hedge funds since it will be much harder for them to generate the same great historical returns going forward with their larger asset size and reduced flexibility.
Wendell Weakley, President and CEO of the University of Mississippi Foundation, was satisfied with the results of the long/short hedge funds that he invested in prior to the 2008 crisis and said they "did their job" of reducing volatility and not declining as much as traditional equity funds. Mr. Weakley said that his foundation is more nimble and opportunistic now than prior to the crisis. His foundation has decreased its allocation to Fund of Funds (that invest in basket of best of breed hedge fund managers) and increased their allocation to investing in hedge funds directly.
Small Cap Stock Funds: Generating Alpha in Less Efficient Market
Stephen Rich, Equity Portfolio Manager at Mutual of America Capital Management, gave an interesting presentation highlighting the outperformance of small cap equity managers relative to their index. In the last 10 years, the median small cap (SC) value manager generated 254 basis points (bps) of alpha (outperformance) before fees on an annual basis relative to the benchmark index. In the same time period, the median large cap (LC) manager only generated 55 bps of alpha before fees on an annual basis compared to the index.
(Click to enlarge) Note: Indices used are the Russell 2000 Value, Russell 2000, Russell Midcap and the Russell 1000. Sources: PSN Enterprise, Mutual of America Capital Management Corporation.
According to Mr. Rich, it is easier to outperform the SC equity index since the market is less efficient due to fewer research analysts covering the securities and lower liquidity. Whereas the average LC S&P 500 stock has 19 analysts covering it, the average SC Russell 2000 stock only has six analysts following it. Similarly, SC stocks are also less than 1/10th as liquid as LC stocks based on average daily share volume, which prevents some larger investment companies from investing in this market.
As a SC portfolio manager, Mr. Rich emphasized that he tries to avoid the most volatile SC stocks because investors have not been compensated for the risk of high volatility in the SC equity market. The 20% most volatile SC stocks underperformed the median SC stock by 7.5% on an annualized basis over the last 16 years. In contrast, in the LC market, the 20% most volatile stocks only underperformed the median by 1.1%.
(Click to enlarge) Note: The table above depicts the equal weighted return of each volatility cohort less the universe average return. Past performance is not indicative of future results. Securities in each benchmark were rated in quintiles according to standard deviation on a sector-neutral basis and rebalanced monthly. The third party marks appearing above are marks of their respective owners. Sources: FactSet, Mutual of America Capital Management Corporation.
ETFs: Active Portfolio Management, Popular New ETFs and ETFs in the Pipeline
Douglas Wolfe, Managing Director of Saddle River Capital Management, actively manages five ETF portfolios. These portfolios are based on risk, and range from an aggressive growth portfolio to an income and preservation portfolio. Mr. Wolfe's firm determines which underlying ETF categories to invest in, based on relative strength analysis. His firm then analyzes the fundamental and technical indicators of individual ETFs within the categories that the firm would like to invest in and creates a score for each ETF. Saddle River then looks at how the best ETFs based on their scoring system rank on scoring systems of outside firms before making their final investment decisions.
Mebane Faber's firm, Cambria Investment Management, has created a Global Tactical ETF, GTAA, which tries to preserve and grow capital by producing absolute returns with reduced volatility and manageable risk and drawdowns. GTAA invests in 50 to 100 ETFs, ETNs and other exchange-traded products in global asset classes including U.S. equities, foreign equities, U.S. bonds, foreign bonds, U.S. real estate, foreign real estate, currencies and commodities. The firm uses a long-term trend following strategy with strict risk control methods. Basically, the portfolio owns ETFs that are going up and holds them until they are no longer appreciating. Its portfolio will be rebalanced to target allocations at least monthly and as often as weekly. GTAA has appreciated 4% since it started trading in late October 2010.
Michael Johnston, Editor of ETF Database, presented an interesting overview of the ETF market. His presentation highlighted some of the most popular "new" ETFs, including the ALPS Alerian MLP ETF (AMLP), WisdomTree Emerging Markets Local Debt ETF (ELD), Market Vectors Rare Earth / Strategic Metals ETF (REMX), United States Commodity Index, Market Vectors EM Local Currency Bond ETF (EMLC) and WisdomTree Asia Local Debt ETF (ALD). Mr. Johnston also said that alternative ETFs have also been introduced to provide hedge fund replication exposure [including (QAI) and (MCRO)], long/short exposure [including (GRV) and (RALS)], managed futures exposure (WDTI) and short only exposure (HDGE). In the future, Mr. Johnston expects more advanced currency ETFs, more regional international bond ETFs and more alternative exposure ETFs to be introduced.
Finding and Using Alternative Investment Solutions Critical to Achieving Long-Term Return Goals
Overall, the conferences were very well organized and presented enlightening discussions about the roles of different asset classes in global portfolios. Clearly, institutional investors are focused on finding and using alternative investment vehicles to achieve their long-term return goals without taking on too much volatility and illiquidity. The following chart shows the average portfolio allocation for Cambridge Associates' endowment clients at the end of 2010.
Based on the discussions at the conferences, it appears likely that allocations to emerging markets, real return strategies (including commodities) and absolute return strategies (including hedge funds) will increase at the expense of developed market stocks and bonds.