SEEKING HIGHER RETURNS / BARRON´S MAGAZINE COVER

Barron's Cover

SATURDAY, SEPTEMBER 14, 2013

Seeking Higher Returns

By KAREN HUBE

Taking financial risks has supplanted the defensive crouch in cash.

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     Illustration by James Bennett

 

 

 

After years of playing defense in cash, bonds, and large U.S. dividend-paying stocks, the nation's 40 largest wealth-management firms are recommending investments that, until lately, have been considered far too volatile, too illiquid, or simply too susceptible to economic setbacks. And we're not talking about tentative toeholds up the cliff face of risk. Consider some of the investments that are back in play in clients' portfolios at the biggest wealth-management firms: Stocks in troubled European nations such as Spain, subinvestment-grade European bank loans, subprime mortgages, and hedge funds that use derivatives and other instruments whose performance and liquidity problems terrorized investors in 2008 and 2009.

Now, interestingly, it is wealthy clients themselves who, behind the scenes, are helping to drive this more robust appetite for risk. Back in May, U.S. Trust, the private-banking arm of Bank of America, released a study of 711 folks with more tan $3 million in investable assets; 60% of the respondents said that asset growth was a higher priority than asset preservation. They were tired of not earning a decent return.

That's a complete repudiation of the defensive crouch they assumed since the 2008 financial crisis began. So it's quite simple, really. The path to higher returns in a low-interest environment naturally leads deep-pocketed investors -- and their wealth managers -- into more risky territory. "The guy who bought T-bills -- he can't get any return anymore, so he migrated to T-bonds," Omega Advisors' Leon Cooperman told Penta recently ("Cues From Cooperman," May 20).

"The guy who bought T-bonds has migrated into industrial credits. The buyers of industrial credits have migrated into high yield. The high-yield buyers have migrated into structured credit...and the structured-credit people are increasingly looking at equities. So everybody is moving up the risk curve."     

At the same time, methods for mitigating overall portfolio risk have become more complicated -- and unpredictable. It used to be that more risk could be offset by using core bonds as a portfolio ballast. But wealth managers have been drastically reducing bond exposure out of concern of rising interest rates. Instead, they have been trying to replace portfolios' safety nets with alternative investment strategies.

While this can be effective, "alternative strategies can go either way -- they balance risk or add more," says Tobias Moskowitz, a finance professor at the University of Chicago Booth School of Business. What often happens is, alternatives start out being used to manage risk, but then "part of the objective of alternatives becomes to get more return, and that's a dangerous game to play."

It is indeed. So what, precisely, are folks buying at these higher and riskier altitudes? That's what we wanted to know from this year's list of the top 40 wealth-management firms.

A CENTRAL THEME of the risk-on story is -- no surprise here -- continued and expanded exposure to stocks. Wealth-management firms started recommending that investors buy more blue-chip U.S. stocks about a year ago, but back then it was more out of a distaste for bonds than a sudden hankering for risky investments. Concerned about dismally low yields and the prospect of rising interest rates, they padded portfolios with large U.S. dividend payers, the most defensive of all stocks. What's different now is a growing optimism about stocks beyond just U.S. large-cap stocks.

The change in sentiment is shared almost across the board by the 40 biggest wealth-management firms in our annual ranking.

"The first stage of the move into risk had to do with the fear of rising yields," says Chris Hyzy, managing director and chief investment officer at U.S. Trust. "Now we're in the second stage, in which there are real fundamental reasons why you should add risk."

As Barron's illustrated in its recent cover about Europe bouncing back, developed foreign markets are strengthening. ("Europe's Economy Will Rebound," July 22.) Many companies in recovering regions have strong balance sheets, valuations on many of their stocks are wildly attractive, and correlations between and within asset classes are lower than they have been since prior to 2008, creating opportunity for careful stockpickers.

The global investing mentality that has returned after years in the wilderness is largely based on Europe, the United Kingdom, and Japan. While year-over-year gross-domestic-product growth is still negative in Europe, much has been made of the fact that second-quarter growth was up above expectations over the first quarter. European stocks have already posted strong gains -- the MSCI Europe Index has returned 21% over the past year -- but they are still 10% below their 2007 highs and deeply undervalued by any measure.

"European stocks always trade at a discount to U.S. stocks, but now they're trading at about a 12% to 18% discount to the average discount," says Hans Olsen, Barclays Wealth and Investment Management's chief investment officer of the Americas. "I think it's still a little premature to say Europe is on the mend, but I'd rather be in early."

Furthermore, it appears that the focus in Europe is increasingly shifting away from the macro story to micro tales, says Scott Clemons, chief investment strategist at Brown Brothers Harriman. "When we can find the macro negative, but a good micro story about a company, usually there is a very compelling valuation," he says.

Among Brown Brothers Harriman's top 10 international holdings as of midsummer were shares of Iberdrola (ticker: IBDRY), the leading Spanish electric utility that happens to earn over half of its revenue outside its home market. The company's shares are trading at 10 times earnings and offer a dividend yield of 4.2%.

Spanish stocks in general are being favored by Goldman Sachs, even while it has actually pared back its overall portfolio risk due to concerns that many stock valuations have risen too fast. "We like the European trade but specifically think more emphasis on Spain is warranted, since it has done a remarkable job in terms of structural reform," says Sharmin Mossavar-Rahmani, chief investment officer of Goldman Sachs Private Wealth Management.

While building European stock exposure, Jeff Weniger, senior investment analyst at BMO Private Bank, is carefully hedging his position's currency risk. After a yearlong strengthening against the dollar, "at some point the euro is going to self-correct," he says. "The last thing you want is for your European stock to go up but you're not fully participating in its appreciation because of the euro."

Investors in Japanese stocks should be equally wary of currency risks. Many wealth managers have been recommending Japanese stocks, some for the first time in years, believing that Prime Minister Shinzo Abe's reform measures will be successful in paving the way to long-term growth. Last week's upward revision to 3.8% in second- quarter GDP growth is encouraging.

"Exports are starting to lift, and earnings are starting to come through. There's a lot of profit potential in Japanese companies that have been dealing with a very high currency and rigid labor market," says Olsen. "Think of the operating margins they can achieve when these conditions improve."

But shield yourself from currency risk, he says. The MSCI Japan Index has produced a stunning 17% run-up between April 2 and May 21, but folks with mutual funds or ETFs that hedge exposure to the yen wore the biggest smiles. The iShares MSCI Japan ETF (EWJ), which doesn't hedge, gained 17% between April 2 and May 21, and was up 21% for the past four quarters. But DBX Strategic Advisors' MSCI Japan Hedged Equity fund (DBJP) was up 26% between those dates and 45% for the year through June.

As for emerging markets, wealth managers spent much of 2012 building up their exposures, only to get hit hard on fears of a slowdown in growth. The MSCI Emerging Market Index is down nearly 4% this year. Still, most wealth managers are hanging tight to their recommended exposure; some say it's actually a good time to buy more shares, while they're cheap.

"When I see the MSCI Emerging Markets Index trading at 11 times earnings, versus the S&P 500 at 15 times, I think this is a better entry point than exit," says Leo Grohowski, chief investment officer at BNY Mellon Wealth Management.

But getting the most out of emerging-market stocks is no longer as simple as buying a broad index. "The salad days of buying China just because it's growing are behind us," says Chris Wolfe, chief investment officer of Merrill Lynch's private-banking arm. "It's time to be more active in approach to emerging markets and less focused on indexes. Now, it's about choosing individual opportunities by region or company."

Furthermore, it's always wise to size up opportunities by comparing their relative value with what's on offer around them. As Wilmington Trust's Rex Macey points out, "Emerging markets will regain footing, but at the moment there is simply more opportunity in the developed markets."

We were intrigued to hear, from Merrill Lynch's Wolfe, that some of the more exciting opportunities can be found in "frontier markets." These are nations with embryonic capitalist systems -- like Bangladesh, Lithuania, and Albania -- that are about 15 years behind emerging markets in terms of economic development. As the global economy improves, many of these markets stand to benefit, Wolfe claims.

How so? There is a migration of manufacturing capacity from China to other parts of Asia under way, driven out by Chinese wage inflation and other factors, which is creating investment prospects in Malaysia, Vietnam, Indonesia, and the Philippines. "They've run a lot already, but they're being driven by organic growth," Wolfe says. Such investments "aren't going to pay off between now and Christmas. This is a 10-year theme. You'll have a lot of volatility, but the opportunity is dramatic."

BEYOND ADDING STOCKS, wealthy investors are also increasingly interested in alternative investments. According to a study by Northern Trust, more than half of the 1,700 wealthy Americans surveyed said they are interested in taking more calculated risks, and more are interested in alternatives than they have been since prior to 2008.
 
Wealth managers have plenty of ideas to oblige, some of which can roam through some pretty risky territory. Bill Stone, chief investment officer at PNC Asset Management Group, says he has added absolute-return-oriented fixed-income strategies that hedge interest-rate exposure, using BlackRock Strategic Income Opportunities (BSIIX), Pimco Unconstrained Bond fund (PFIUX), and Driehaus Active Income fund (LCMAX). These funds' goals are to provide downside protection; but to achieve this, fund managers can graze on global high-yield credit and derivatives, which contributed to the collapse or near-collapse of financial institutions in 2008.

Many wealth managers are also continuing to expand private-equity exposure -- a trend that started about a year ago -- and they recently started adding hedge funds. Investors are giving up liquidity, true, but "as rates rise, bonds will fall off, and hedge funds should give positive returns," says Joe Kenney, U.S. head of investments at JPMorgan Private Bank. Historically, hedge-fund returns have spiked during periods of rising rates, thanks to their ability to minimize interest-rate risk and favor strategies with more credit risk.

July saw $8.2 billion in net inflows into hedge funds, bringing assets to a five-year high of $1.97 trillion, according to TrimTabs Investment Research. Prime conditions for global macro funds are developing. Larry Adam, chief investment strategist at Deutsche Bank's American wealth-management outfit, says, "This is an environment for those hedge funds to be more nimble, to take advantage of a huge dichotomy between emerging markets and developed markets, and between regions and sectors. And to be able to go long-short commodities and currencies can add a lot of value."

The mortgages-gone-bad market is also getting attention. Many banks are still carrying soured residential loans on their books, and they're looking to unload them. Some opportunistic hedge-fund managers are buying the loans at a deep discount to the currently appraised value of the homes, then making money off of either a reconstructed mortgage deal or a sale. Also hot: making private loans to small companies that can't secure bank loans.

These loans have yields of between 7% and 12%, says Merrill's Wolfe. But warning: Assets are tied up for about 10 years, and the loans are below-investment-grade. Old-school private equity -- buy businesses, make improvements, then sell them for a profit to larger companies–is also back in favor.

"The opportunities for arbitrage between what you can buy small businesses for in the private market and what you can sell [them] for up the food chain to strategic acquirers are quite attractive," says Jason Pride, director of investment strategy at Glenmede. Strong equity markets means "public companies are in a better position to use their stock to finance acquisitions. The structure wasn't as feasible back in 2008 and 2009." Most opportunities are in middle-market companies valued below $250 million, Pride says. We can only hope that an unexpected storm blowing in doesn't drive investors back down the mountain of risk.   
 

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