The answers are as varied. In the pages ahead, we look at the investment strategies that have paid the richest dividends in terms of return in 2006. They are the investment manoeuvres that we have recommended to our clients, the initiatives we have suggested to maximise their holdings.
Not every strategy suits every individual. Some will suit none, while others will suit some but only in the context of a broader portfolio that matches their circumstances and lifestyle. What this article illustrates, however, is the way an intelligent and well-researched tactical investment can have a strong positive impact on a strategically diversified portfolio.
Without the strategies, even the most careful investment can flounder. As the Chinese general Sun Tzu, author of the Art of War, wrote. ôStrategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.ö
EQUITIES
1 Global Equity Markets. In 2006, year-to-date, global equity markets have risen by around 6.2%, and look set to underperform full-year 2005Æs total return of 16.3%.
At the beginning of the year, UBS put an overweight recommendation on the equity markets of the EMU, Switzerland and the UK while advising a more cautious approach toward Japanese equities, which were expensively valued and had only limited scope for further earnings growth. EuropeÆs equity markets have outperformed its peers, such as the US which is up 9%, rising 15% year-todate.
Also, Switzerland and the UK showed high returns with 15% and 10% respectively. In stark contrast, Japan is up only 3%, a steep decline from the 45% rise posted at the end of 2005.
In Europe, consumer staples and telecoms performed strongly, rising 11%. UBS rated both sectors with ôoverweightö at the beginning of the year and believes that at current valuations, Eurozone equities remain attractively priced. On a global sector level we see that financials, which were our largest ôoverweightö recommendation, is the second best performing sector after utilities and increased by 14%.
2 Emerging Markets and Asian Equities. Emerging market equities have so far outperformed global equity marketsÆ average, rising 13%. But when compared to the last three years of annual gains of between 26-56%, it looks less impressive.
High growth in Asia and thus high earnings growth kept valuations at fair levels despite the price increase on stock markets. Investors would have benefited from the impressive performance of the Chinese stock market which was up 35%.
UBSÆ Asian Equity Portfolio, a discretionary portfolio of Asia ex-Japan stocks, returned an estimated +15.9% year-to-date on a gross basis. This was an actively managed offering with investments in individual securities, best of breed investment funds, hedge funds and structured products. Investments in equities and investment funds were made within the Asia ex-Japan region, whilst money market instruments and alternative investments were also made worldwide. The mandateÆs objective was to maximise asset growth in the long term and since it was our most volatile discretionary investment strategy, it was suitable for capital-gain oriented investors seeking an optimised and diversified portfolio within the region.
FIXED INCOME
3 Emerging Market Debt. Early in 2006 clients were encouraged to participate in ArgentinaÆs debt restructuring and to ride the countryÆs recovery story by purchasing the countryÆs US dollar external debt as well as restructured bank debt. Thanks to ArgentinaÆs growing economy, much-improved government fiscal accounts and low short-term debt servicing requirements this strategy proved to be extremely successful. ArgentinaÆs US dollar bond prices shot up an impressive 27% September year-to-date with the Argentina par 2038 bond providing the highest returns û a stunning 33% total return.
Clients willing to assume emerging market currency risk were advised to profit from BrazilÆs improving fiscal and macroeconomic environment. Specifically, clients were encouraged to invest in local-currency bonds in Brazil in order to take advantage of high and falling interest rates coupled with an appreciating currency. Many clients did heed the advice and invested in BRL-denominated eurobonds whose cashflows all settle in US dollars. BRL bonds had a September year-to-date US dollar return of 21.5%.
NON-TRADITIONAL ASSET CLASSES
4 Commodities. Commodities year-to-date have experienced losses of around 11% if one takes the GS Commodity Index on total return basis. This can be attributed mainly to the energy sector, and more specifically, natural gas. Despite the increase of spot prices in many commodities, most of the underlings are in a contango term-structure (futures prices are higher than spot), thus exhibiting negative roll yields.
Big winners on this asset class were base metals, which reflected the firm demand and supply bottlenecks and precious metals, which benefited from gold's performance due to geopolitical tensions, inflation fears and currency uncertainties.
The UBS Multi-Manager Alternative Commodities Fund offers a different angle to investing in commodities via a hedge fund approach. Rather than long exposure to commodity prices or indices, the fund invested in hedge fund managers who utilised various investment styles and strategies in physical (spot and futures) and financial commodities (commodity related equities). Because the underlying managers could go long and short, the fundÆs performance (up 14% at the end of September) was lowly correlated to most commodity indices while at the same time delivered good risk-adjusted returns.
5 Listed Real Estate. The global real estate market experienced a strong performance of up to 20% year-to-date. UBS forecasted at the beginning of the year that 2006 was going to be a good year for real estate returns. Investments in continental Europe have so far yielded the most, with gains of 30%. Japan however has experienced gains of 5%.
There were several reasons for this nice development: high real estate demand from investors caused risk premiums to decline. Worldwide, physical real estate markets were showing signs of recovery with rising rents, particularly in markets for office space. The interest rate movements at the long end supported markets or at least did not affect them negatively.
The UBS Global Property Fund was a strategic real estate offering for investors looking for diversification from traditional asset classes through exposure to physical properties globally. It was important to view the allocation to real estates in a portfolio context. The low correlation to other asset classes and the fact that real estates were generally a good inflation hedge made it a good diversification agent.
CONVERTIBLES
6 Convertible Bonds. Bond investors were rewarded if they were exposed to the right credit. US and EMU high yield corporate bonds did relatively well, as default rates remained low. US high yield credit returns are at around 6.8% while their European counterparts yielded 7.1%. Since the beginning of 2006, global convertible bonds posted a total return in excess of 8% of US dollar-based investors on a currency-hedged basis. Particularly strong performance resulted among European convertibles. US convertibles evolved in line with the global average, while Japanese convertibles barely provided any return at all.
The behaviour of convertible returns was largely dictated by the trends in the underlying equity markets. Unsurprisingly, the regional differences among convertibles this year have mirrored the strong equity performance in the Eurozone and the weak Japanese equity market. In addition, as the value of the conversion option embedded in convertible bonds reacts positively to equity market volatility, the slight increase in volatility since the beginning of the year has provided a marginal positive contribution to the performance of convertibles in the US and Europe.
YIELD ENHANCEMENT PRODUCTS
7 Reverse Convertible on Crude Oil. In 2006 we witnessed one of the most exciting rallies in commodities, from base metals to precious metals, and from orange juice to crude oil. Although commodity prices have since corrected in the short term, long term fundamentals driving demand for commodities remain unchanged. In particular, crude oil prices were very sensitive to supply disruptions and geopolitical instability. Then OPEC published another report showing that demand growth for crude oil in the first half of 2006 was strong. How did we strategise to optimise returns?
One of the most successful ways was via Reverse Convertibles. This was a yield enhancement strategy where investors took a one-year view on a particular commodity, for example crude oil. Investors would reap an attractive coupon of 9% at maturity, if on final redemption date crude oil did not trade below 67% of its initial level (which translates to about $40 per barrel). UBS issued several versions of the Crude Oil Reverse Convertible Note in late 2005 and early 2006, each yielding at least 9%. Current shortterm weakness in crude oil prices presented yet another opportunity for our clients.
8 Bonds Disappearing Dual Currency Investment (Bonus DDCI) on Gold. In early 2006, our research call to invest in the secular uptrend in commodities reaped impressive returns for our clients. Gold, in particular, jumped more than 40% due to rising crude oil prices, heightened geopolitical tensions and higher physical demand. Our clients capitalised on this excellent opportunity by investing in the Bonus Disappearing Dual Currency Investment (Bonus DDCI) and achieved outstanding returns.
The Bonus DDCI was a short-term investment that expressed a bullish view on gold. The investment yielded a minimum coupon above money market interest rates and had conversion risk into gold at expiry. An additional bonus coupon would be paid when the gold price hit an upper barrier. In addition, the conversion risk would be eliminated once the upper barrier was touched.
Our clientsÆ investments were US dollar denominated and for a tenor of one month. As gold prices rose, our clientsÆ investments were redeemed in US dollars and received the bonus plus minimum coupon. The return on their investments was four times the money market interest rates.
9 Thematic Variable Maturity Range Accrual Equity-Linked Notes (VMRA). Variable Maturity Range Accrual Equity-linked Notes (VMRA) belong to the family of ôOptimisationö or Yield-enhancement Equity-linked Structured products. In 2006, reflationary economic conditions in Asia resulted in strong sector outperformance for Asian banks and real estate.
Topical news such as the awarding of the Marina Bay Integrated Resorts Casino project drove market sentiment. An example of how this theme was played came via the six month US dollar 26% per annum Marina Bay VMRA basket. City Development and Capitaland were the underlying stocks. Both these stocks were seen as beneficiaries of the buoyant property market conditions in the Marina Bay area where the Integrated Resort was being built. Investors in this basket enjoyed a fixed coupon of 4.33% flat (or 26% pa) for the first 2 months. From the third month onwards, interest accrued daily so long as the laggard stock (or slowest relative performer) was at or above a preset strike price, which was set at an 11% discount to initial spot. Additionally, the VMRA structure also had an early call feature which allowed the structure to be early redeemed at the end of each two-month period if the laggard stock was at or above a preset call level which was set at a 2% discount to initial spot. The early call feature accounted for the variable maturity element in the structure of the note.
Further interesting VMRAs launched were: 1) Six month Singapore dollar 16% Temasek VMRA basket (linked to DBS+Capitaland+Keppel Corp); 2) Six month US dollar 18% regional bank VMRA basket (linked to DBS+Bangkok Bank+Kookmin Bank); 3) 1 year US dollar 15% pa China Energy VMRA basket (linked to Petrochina+Sinopec+CNOOC). All of these VMRA baskets allowed investors to play sector themes while enjoying an investment return through a coupon which was often three to five times higher than the risk-free rate. Bullish market conditions resulted in many of these VMRA baskets being early redeemed. Whilst a value-added strategy in a portfolio context, it should be appreciated that the underlying risks of a VMRA basket are the same as the underlying stocks. Investors have the risk of delivery of the laggard stock, and should be comfortable owning it at the preset strike price.
10 Fixed Income Focus. Although interest rate structures, which drove 2005Æs growth in structured product issuance, have declined significantly this year, rate play structures remain one of the key product offerings to private clients. Whilst the market continues to see innovation of new products in this sector, clients were focused on simple formats where the benefits of higher returns are reaped from taking a straightforward view of 1) non-inversion of the swap curve and 2) LIBOR range note barrier plays.
This was expressed through CMS (Constant Maturity Swap) Spread Range Accrual Notes and LIBOR Callable Range Accrual Notes. Clients enjoyed a fixed coupon return of up to 9% per annum on these investments. In the case of the non-inversion notes, the coupons are paid as long as the underlying swap curve did not invert. A yield curve inversion was usually observed as a precursor to economic recession. Historical back testing has shown that the curve had fixed negative for only eight days (in total) for the past 10 years.
In the case of LIBOR range notes, coupons were paid as long as the three-months LIBOR (which is the most commonly used index) stayed within a stipulated range. The widely accepted threshold of 7%, had not been breached for the past 15 years, hence the wide appeal of these products.
This article first appeared in the winter issue of Asian Private Capital magazine. Benz is the regional head of products and services at UBS Wealth Management.
¬ Haymarket Media Limited. All rights reserved.
