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Multi Asset Strategy September 2012

The 10 key trends changing investment management


and how they will affect asset prices
We are in an unusual investment world of ultra-low interest rates, swings between risk-on and risk-off, and investors demanding yield, low fees and limited risk This raises big challenges for the investment management industry. We identify 10 trends that are shaping the industry from the decline of hedge funds and the growth of multi-asset funds, to the relentless rise of ETFs and the stirring interest in ESG These trends should be positive for credit, high-yielding equities and alternative assets (such as long-term debt financing and structured derivatives products) By Garry Evans

Disclosures and Disclaimer This report must be read with the disclosures and analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

Multi Asset Strategy Global September 2012

Summary
How is a world of low interest rates, risk aversion and unusually high correlations affecting the investment management industry? We identify 10 trends changing how investors invest, and assess their impact on the price of assets

The 10 trends shaping the investment world


We are in a very unusual investment world. Interest rates are at historical lows, equities more volatile than normal, different assets classes abnormally correlated and demographics are altering savings patterns in rich countries. These developments have already caused big shifts in investment flows over the past five years. Investors have switched massively from equities into bonds, moved their money into index funds and ETFs, and searched for new ways to achieve return without too much risk. In this report we look at how investor behaviour is changing and what this means for investment management businesses. We identify 10 themes that we believe will shape the future of the industry over the coming years. Not only is an understanding of these important for strategy planners at investment management firms (and we held discussions with many CEOs and CIOs of investment firms in the preparation of this report), we think these trends will affect asset prices too. Will the search for income push down yields on credit to ridiculous levels? Will investors completely abandon equities because of their volatility? Will demand for alternative assets (infrastructure financing, distressed debt, derivative structures) push up their prices? We believe that understanding these sorts of deep underlying trends in investment is important for asset allocation. It is too easy to get caught up in the day-to-day movements of the economic cycle. Thinking about long-term drivers, such as demographics, changes in wealth or market micro-dynamics, can help improve investment decision-making. We believe the ideas and copious data in this report will prove thought-provoking for anyone interested in understanding these shifts. After an introductory section, which analyses the macro background and describes the state of the investment management industry today including projections for its future growth each chapter of this report details one of the trends, with our assessment of its implications of each for asset prices. There are some common threads running through the trends. In brief, these are: the struggle to produce income in a low interest-rate world (via credit, high dividend yield equities or illiquid investments); the desire to tailor risk (though risk-minimising products and absolute return multi-asset funds); and the shift to passive investments such as index funds and ETFs, which has begun to hurt hedge funds too.

Multi Asset Strategy Global September 2012

Our 10 trends are: The search for yield. With risk-free rates so low, investors are desperate for income. They have already piled into bonds. Credit remains in a sweet spot, though issuers are attracted by the low interest rates but, for investors, spreads over government bonds remain decent (Chart 1). We think dividend yield stocks remain attractive, too. Many investors argue its too late to buy them but in the US, in particular, income funds still comprise only 3% of equity mutual funds. Page 13 The death or rebirth of equities. Bill Gross of Pimco says the cult of equity is dead. But equities have actually outperformed bonds over the past 10 years, although admittedly with high volatility (Chart 2). Perhaps a bigger risk which bond houses are worrying about is the bursting of the bond bubble: could 2014 be another 1994? At the very least, with cash yielding zero and high-quality government bonds 1.5%, it seems likely that equity returns will beat these over the next 10 years. Page 17
1. Average US BBB-rated five-year corporate bond

10 8 6 4 2 0 03 04

Yield Spread

05

06

07

08

09

10

11

12

Source: Bloomberg

2. Total return indexes* (log scale) since 1988

6.5 6.0 5.5 5.0 4.5

Equity Bond Cash

88 90 92 94 96 98 00 02 04 06 08 10 12
Source: Bloomberg, MSCI (*Equity=MSCI ACWI TR Gross, Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD, Cash=3-month T-bills)

Risk minimising strategies. Investors ideally would like equity-style returns with bond-like volatility. Thats rarely possible. But fund managers are developing products that offer different combinations of risk and return. Such strategies include: multi-asset funds, long/short equity strategies, risk parity products, minimum volatility equity funds and using options to target a level of risk. Page 20 The growth of multi-asset. The fastest growing type of risk minimising strategy, especially in the UK, is the absolute return fund, most famously Standard Lifes GARS. Such funds target Libor-plus absolute returns, with bond-like volatility and costs lower than hedge funds. They have their detractors (do they really create alpha, or are they just leveraged bond funds?) but look likely to grow further, even in the US where they have yet to take off. Page 22

Multi Asset Strategy Global September 2012

The shift to passive. A third of active equity money has shifted into passive funds in the past 10 years (Chart 3). We think passive encroachment is likely to continue, since active funds empirically underperform on average (with higher costs). But indexing strategies are likely to get smarter: some indexes outperform others, for example the equal-weighted S&P500 has beaten the regular (market cap weighted) S&P500 by 37% in the past decade. Page 24 The relentless rise of ETFs. ETFs have reached USD1.5trn (up from USD105bn in 2001 Chart 4). But there are issues with these, too. Are ETFs suitable for bonds? Some overly sophisticated ETFs have blown up spectacularly: will this invite the regulators attention? The two keys for future growth are (1) whether active ETFs take off, and (2) the trend of retail financial advisors being remunerated by fees rather than commissions on the products they sell (ETFs dont pay a commission). Page 28 The decline of the hedge fund? Hedge funds have struggled to perform recently (Chart 5). The average hedge fund is up only 2.5% so far this year. The underlying problem is that the hedge fund community has become so big that it has arbitraged out most of the alpha. Like active equity funds, hedge funds in aggregate cannot by definition outperform. Moreover traditional fund managers are increasingly converging with large hedge funds and they dont charge fees of 2% and 20%. Page 31

3. Cumulative net inflows into mutual funds worldwide (USDbn)

800 600 400 USDbn 200 0 -200 01 02 03 04 05 06 07 08 09 10 11 12 -400 -600


Source: EPFR

Passiv e

Activ e

4. Assets of exchange-traded funds (USDbn)

1,600 1,400 1,200 1,000 800 600 400 200 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012*
Source: Blackrock (*end-Jun)

US

Europe

Other

5. Cumulative performance of hedge funds

350 300 250 200 150 100 00 01 02 03 04 05 06 07 08 09 10 11 12 HF index L/S equity Macro HFs

Source: Bloomberg, EurekaHedge

Multi Asset Strategy Global September 2012

Harvesting the illiquidity premium. Most investors have a strong preference for liquidity. But some notably pension funds and insurers dont always need it and may be overpaying for it. Amid the desperate search for income, they may see the attraction of the extra yield available in illiquid assets (Chart 6) such as infrastructure, real estate finance and private debt (structured like private equity, but providing debt financing). Page 34

6. Illiquidity premium estimate, by asset class

500 400 300 bp 200 100 0 Equity Corporate Gov ernment Cov ered bonds bonds bonds

Source: Adapted from Barrie & Hibbert (www.barrhibb.com/documents/downloads/Liquidity_Premium_Literature_REview.pdf)

Where will the money come from? Defined benefit pensions are dwindling (Chart 7). The growth areas for investment management companies in the next few years will be personal pensions, Asian high net worth individuals and sovereign wealth funds. But each of these will demand more sophisticated products and solution-based services. Page 36

7. Global pension assets (USDtrn)

30 25 20 15 10 5 0
2001 2002 2003 2004 2006 2009 2010 2008 2005 2007

Autonomous pension funds Other managed funds


Source: OECD

Pension insurance

The challenge of ESG. Plan sponsors, particularly public pension funds in Europe, are increasingly focusing on environmental, social and governance issues. So far, most fund managers pay only lip-service to this. But momentum is building (Chart 8) and companies with superior ESG policies and disclosure might start to outperform. After all, who wants to buy a company with poor corporate governance, which pollutes or treats its staff badly? Page 42

8. SRI assets under management (USDtrn)

10 8 6 4 2 0 2005 US SRI AUM ($tn)


Source: US SIF, Eurosif (definitions differ slightly)

2007

2010 Europe SRI AUM ($tn)

Multi Asset Strategy Global September 2012

Implications for asset prices


The search for yield should be positive for credit and for high dividend yield stocks, both of which remain attractive in our view. Equities in general may struggle for a few more years as global economic growth remains low, but the basic concept that equities have a risk premium and therefore generate greater returns in the long run will not disappear. If investors become more willing to buy illiquid assets to boost yield, the pricing of long-term loans, commercial real estate and infrastructure finance should be positively affected. The development of multi-asset funds should aid the development and liquidity of more esoteric asset classes and derivatives products. We believe the further growth of passive funds and ETFs will keep inter-market and intra-market correlations high.

Multi Asset Strategy Global September 2012

Contents
Introduction: an unusual world
Cyclical or evolutionary?

7
7

The decline of the hedge fund?


Is there any alpha left?

31
31

The search for yield


in credit and dividends

13
13

Harvesting the illiquidity premium


Do you really need liquidity?

34
34

The death or rebirth of equities


Problem is volatility, not return

17
17

Where will the money come from?


The sources of growth

36
36

Risk-minimising strategies
Tailoring risk, not return

20
20

The challenge of ESG


Unavoidable momentum

42
42

The growth of multi-asset


GARS and all its friends

22
22

Disclosure appendix Disclaimer

46 48

The shift to passive


Its hard to beat an index

24
24

The relentless rise of ETFs


Attractive but problems too

28
28

Multi Asset Strategy Global September 2012

Introduction: an unusual world


Low rates, high volatility, high correlation the world has changed Fund managers are struggling to cope: how to find returns without too much risk, and provide solutions to investors with new needs We indentify three threads: the search for income, tailoring risk, and the continuing shift from active to passive

Cyclical or evolutionary?
We are in a very unusual investment world. Interest rates are at historical lows, equities more volatile than normal, different assets classes abnormally correlated (the risk on-risk off phenomenon) and demographics are altering savings patterns in rich countries. These developments have already caused a big shift in investment flows over the past five years. Investors have: Sold equities and bought bonds in huge volumes: in the US since end-2007 bond mutual funds have seen inflows of USD920bn and equity funds outflows of USD430bn. Loaded up on risk-free assets. But the supply of these has shrunk (according to the BIS, AAA-rated government paper now totals only USD12trn, compared to USD26trn in early 2011 Chart 1). This has pushed down their nominal yields to below zero in some cases. Increasingly understood that active equity fund managers in aggregate underperform

benchmarks (even before fees) and so moved heavily into index funds and ETFs. Searched for new ways, other than equities, to achieve a decent return without too much risk. This has led to the development of absolute return (or diversified beta) funds and riskminimising strategies.
1. Credit risk of pool of government debt

Garry Evans* Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6916 garryevans@hsbc.com.hk

*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations

40 35 30 25 20 15 10 5 0 01

AA to below AA+ AA+ to below AAA AAA

02

03 04

05

06 07

08

09

10 11

Source: BIS (Ratings used are the simple averages of the long-term foreign currency sovereign ratings from Fitch, Moodys and S&P.)

Is this a permanent structural change, or will we eventually go back to the old normal? Probably a bit of both. The side-effects of the 2007-9 Global Financial Crisis will eventually wear off (though

Multi Asset Strategy Global September 2012

this may take a few more years), with interest rates, volatility and correlations returning to their historical norms. But there has been some evolution too. Investors behaviour is likely to have changed permanently: Investors will increasingly question whether hedge funds can generate alpha and whether they deserve fees of 2% and 20% even if they can. Retail investors will demand access to the sort of absolute return strategies that hedge funds previously specialised in and at a reasonable cost. There will be more demand for solutions: whether liability-matched investments for a defined benefit (DB) pension fund that is winding down, or a to-and-through personal pension plan for an individual due to retire in five years who wants to fix post-retirement income. Interest in buying stocks in companies with a strong ESG (environmental, social and governance) record will increase. This is not idealistic green talk after all, who wants to own a company with poor corporate governance or which treats its staff badly?

Many of these themes are fairly obvious, and have been under way for a number of years. But how the fund management industry will be affected by them is not yet at all obvious. Like any business, an investment management firm has to pick a strategy: should it rush into all these new areas (ETFs, absolute return funds, pension solutions, ESG) or should it decide to focus? Is it better to be a large global investment house or a focused boutique or hedge ones bets by becoming a multi-boutique umbrella organisation? These trends will affect asset prices too. If investors abandon equities for a generation, PE multiples would contract further, as they did in the 1970s or after the Great Depression. Further growth in ETFs and index products could push correlations up further. A rise in demand for alternative assets (infrastructure financing, distressed debt, derivative structures) could shift the prices of these assets. As banks in Europe deleverage, infrastructure lending, leasing and other forms of long-term finance could pass to institutional investors, in a form of disintermediation, which could bring down borrowing costs.

2. Demographic trends: % of population aged 35-54 in DM

3. Demographic trends: % of population aged 35-54 in EM

30% 28% 26% 24% 22% 20% 1990 2000 2010 2020 2030 2040 2050

29% 28% 27% 26% 25% 24% 23% 22% 21% 20% 1990 2010 Emerging
Source: HSBC, UN Population Division.

2030

2050

Dev eloped markets


Source: HSBC, UN Population Division. NB: MSCI World markets

Multi Asset Strategy Global September 2012

Why this matters


This is a topic that HSBCs strategy team has tackled before. We believe that understanding the deep underlying trends in investment are important for asset allocation. It is too easy to get caught up in the day-to-day vicissitudes of the economic cycle. Thinking about long-term drivers, such as demographics, changes in wealth or market micro-dynamics, can help improve investment decision-making. Earlier this year, for example, we published a report (Who will buy by Daniel Grosvenor, 3 February 2012) which argued that demand for equities is likely to remain structurally weak due to prolonged risk aversion, regulatory changes and deteriorating demographics. In particular, ageing populations in the developed world (Chart 2) will tend to own fewer equities. This, the report argued, could keep DM valuations depressed, but EM should be immune (partly because of its better demographics Chart 3). We also described the growing importance of emerging markets investors in Asia buys Asia by Herald van der Linde and Devendra Joshi , June 2012. Asian equity markets have traditionally been dominated by foreign investors or speculative local individuals. But this is changing, as Asians diversify their wealth into financial assets, and pension systems develop across the region. Our colleagues in quantitative strategy have also looked at the risk on-risk off phenomenon (their latest report is Risk On Risk Off: Fixing a broken investment process, by Stacy Williams, Daniel Fenn and Mark McDonald, April 2012). They suggest ways in which fund managers can adapt their investment process to cope with the phenomenon and take advantage of it. For this present report, we met with CEOs, chief investment officers and senior business managers at almost 20 investment firms in the US and

Europe. These ranged from niche long-only equity specialists to opportunistic macro hedge funds, from major ETF providers to large global multiasset investment managers. Naturally most of the senior managers had a bias based on what they specialised in: equity houses tend to believe that actively managed equity will come back, and passive specialists argue that in future everything will be indexed. But our conversations gave us a good idea of the sort of concerns investment managers have when they are being candid. Bond houses worry about how to cope with the crash in bond prices that we believe is inevitable in the future. Active managers worry whether its too late to enter the index ETF business or whether they should try to structure their active funds as ETFs. Many managers are struggling to create innovative products risk-hedged funds, absolute return strategies, pension-friendly structures in a world where their revenues have stagnated and so R&D budgets have been cut.

The global investment industry today


Before we try to draw out some threads from the 10 trends in investment management we have identified, some background.
4. Assets under management (USDtrn, end-2010)

PE, 2.6 SWFs, 4.2

HFs, 1.8

ETFs, 1.3 Pension funds, 29.9

Insurance funds, 24.6

Mutual funds, 24.7


Source: TheCityUK estimates

How big is the global investment industry? Conventional assets (pension funds, mutual funds

Multi Asset Strategy Global September 2012

and insurance) total about USD80trn, split roughly evenly between the three (Chart 4). The AUM of these institutions has doubled since 2000. Hedge funds manage around USD2trn, and private equity funds a little more than that. Add to this sovereign wealth funds which, in their pure form, have assets of about USD5trn; include FX reserve managers and other sovereign institutions (such as national pensions or development funds) and the total reaches about USD20trn. ETFs comprise another USD1.5trn or so. Private wealth is harder to figure out: various estimates put it at between USD26trn and USD120trn. At the top end of estimates, the total amount of money available for investment firms to manage exceeds USD200trn almost 3x global GDP. The US is still the largest source of funds, with USD35trn out of the USD79trn in conventional assets globally (Chart 5). That is 224% of US GDP. The UK, though much smaller in absolute terms, at USD6.5trn, is the biggest in proportion to GDP, with conventional funds representing 257% of GDP (although some of that comes from money domiciled in the UK but not from UK nationals).
5. Source of conventional assets, by country (USDtrn)

assets have grown at a compound annual rate of 7.1%. While it is likely, in our view, that global economic growth will be lacklustre in coming years as the after-effects of the Global Financial Crisis are worked off, this does not mean that global savings will be stagnant. Indeed, quite the opposite. Households and companies are likely to increase their savings as they stay risk averse (and governments are likely to reduce fiscal deficits, albeit slowly). The IMF projects that US and UK gross national savings, which have already improved modestly since 2009 (to 12.9% of GDP from 11.5% in the case of the US), will continue to increase over the next five years, with the US reaching 17.8% by 2017 (Chart 6). China, meanwhile, is unlikely to reduce its savings rate much, despite efforts to get households to spend. Australia has already made some headway in raising its savings rate since its bubble in the early 2000s. Japan is the only major economy where the ratio may fall, as retirees start to eat into their savings. All this suggests that the savings glut, which drove the fall in interest rates and strong equity performance in 2003-7, will not disappear.
6. Gross national savings rate, selected countries (% of GDP)

40 35 30 25 20 15 10 5 0

Pension funds

Insurance assets

Mutual funds

60 50 40 30 20 10

France

Japan

Germany

Switz.

Other

0 80 85 UK
Source: IMF

US

UK

NL

90 US

95

00 AU

05

10 CH

15 JP

Source: TheCityUK estimates based on OECD, Investment Company, SwissRe and UBS data. (Figures are for domestically sourced funds regardless of where they are managed. No reliable comparisons are available for total funds under management buy country.)

and the chances of it growing

There is no reason to suppose that the rate of growth of institutional assets will slow over the coming years. Over the past decade, conventional

And, at the same time as savings grow, companies in the developed world are unlikely to need to raise much money for the next few years. Corporate cash holdings are at record highs, especially in the US, and companies are being cautious about capex.

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Multi Asset Strategy Global September 2012

Dividend payout ratios are very low (31% in the US last year, for instance). This suggests that large listed companies, at least, will not need to raise much capital, either debt or equity, for the next few years although capital-hungry emerging markets companies, of course, will. As countries get richer, they tend to increase the amount of institutional assets under management and increase the amount invested in equities and bonds (rather than placed in bank deposits), as shown in Charts 7 and 8.
7. Increasing wealth brings growth in institutional assets

This suggests that, as long as emerging markets continue to develop (which in most cases we think likely), then not only should the pool of potential savings grow, but the proportion of the pool available for international investment institutions to manage should grow even faster. Not that this will be without challenges: how do London or New York-based investment managers get access to wealth held in China or India, which is still highly restricted in where it can invest and mostly off limits to them? Indeed, a well-read report by the McKinsey Global Institute The emerging equity gap: Growth and stability in the new investors landscape, December 2011, argued that the growth of international securities ownership by emerging market investors will be essential if the role of equities in the global financial system is not to be reduced in the coming decades. In particular, emerging market investors will need to triple their allocation to equities if companies in these countries are not to be starved of equity capital.

% of household w ealth in institutional assets 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1970 Bubble size = per capita GDP (PPP)

1980 UK

1990 US

2000

2010 Germany

2020

Source: HSBC, CEIC

Common threads
In this report, we highlight the 10 trends that we think will drive the investment management industry over the next few years. Understanding these trends and considering their implications will be important both for investment institutions in planning their strategies, and for investors interested in the impact of these trends on asset prices.

8. amid withdrawals from bank deposits

% of household w ealth in bank deposits 70% 60% 50% 40% 30% 20% 10% 0% 1970 1980 UK Bubble size = per capita GDP (PPP)

1990 US

2000

2010 Germany

2020

Source: HSBC, CEIC

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Multi Asset Strategy Global September 2012

Inevitably, there are some overlaps between the 10 trends. Broadly, we see three threads running between them. The search for income. With interest rates so low, investors are desperate to generate income. This has triggered demand for credit and high dividend yield equities, which we expect to continue. It is also forcing investors to consider whether they are overpaying for liquidity, and to look at harvesting a premium for investing in illiquid instruments such as infrastructure and private debt funds. Tailoring risk. Modern derivative techniques make it possible to tailor risk to an extent. Investors scared of drawdowns can hedge fattail risk. Fixing a return is not possible (except for a very low return); tailoring a level of risk may be easier. This concept has spawned the development of risk parity funds and a boom in multi-asset absolute return funds. A continuing shift from active to passive. Academic evidence strongly suggests that active equity fund managers in aggregate underperform their benchmarks. That has pushed investors over the past decade from active to passive funds, especially ETFs a trend we expect to continue. It is also forcing a rethink of the role of hedge funds, which have grown so large that in aggregate they no longer seem to be able to produce superior performance either. In the following sections, we describe in detail the 10 trends we have identified and analyse their implications for asset prices.

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Multi Asset Strategy Global September 2012

The search for yield


With risk-free rates so low, investors are desperate for income Credit is in a sweet spot, with issuers enjoying record low borrowing costs, but investors finding decent spreads We think dividend yield stocks remain attractive too

in credit and dividends


With cash yielding zero and top-quality government bonds little more than 1.5%, it is unsurprising that investors are scrambling to pick up yield. Indeed, one could even say that the market has become obsessed with income.
1. Cumulative net flows to bond funds worldwide, by type

300 250 200 USDbn 150 100 50 0 -50 07 -100


Source: EPFR (Other includes muni funds, MBS funds, total return bonds, and funds able to invest in a mix of bond types)

The sort of funds selling well is clear from the list of the largest fund launches year-to-date. The top 20 new US-based funds, ranked by assets under management now (Table 2 overleaf), include 10 bond funds, two asset allocation funds and only eight with an equity focus (remember, this is for the heavily equity-centric US market). Three of the best-selling funds include the word income in their names. Credit is in a sweet spot. Interest rates at which corporates can issue are at historic lows. But, at the same time, spreads over US Treasuries are quite high, making the bonds attractive for investors too.

Gov t Credit Other

08

09

10

11

12

Look at flows into bond mutual funds recently. It is well known that these have been very healthy, totalling USD580bn over the past three years according to EPFR. But, for the past 12 months at least, bonds flows have been predominantly into credit funds (for example, corporate, high yield or EM bond funds) with even a small net outflow from government bond funds (Chart 1).

In the US, for example, BBB-rated five-year corporate bonds currently yield only about 2.8% the lowest for decades but that represents a spread over Treasuries of around 200bp, well above the average of 130bp from the 2003-7 period (Chart 3). The same is true in emerging markets. The HSBC Asian Dollar Bond Index (Chart 4) currently has a record low yield of 3.7% but the spread over Treasuries is a still attractive 300bp. This is why lots of bonds have been issued this year: August, for example, with over USD120bn of issuance according to Dealogic, was the highest August on record and more than double the USD58bn average for August. Sub investment

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Multi Asset Strategy Global September 2012

2. Largest mutual funds launched in the US this year Ticker Name Manager Inception Asset class date Objective AUM (USDbn)

TGIRX US OIBIX US WAPRX US OSIIX US OGLIX US PSTQX US AEMSX US OIGIX US MSKHX US MSFKX US PEFAX US CMCPX US OBBCX US JQLAX US OEIIX US MIDLX US JIPPX US WABRX US MFBKX US JDVPX US

Int'l Value Fund Int'l Bond Fund Core Plus Fund Global Strategic Income Fund Global Fund Short Term Corp Bond Fnd Emerging Markets Fund Int'l Growth Fund Mid Cap Growth Portfolio Total Return Fund EM Fundamental IndexPLUS Active Portfolios Multi-Manager Core Plus Bond Fund Mortgage Backed Securities Fund Life Aggressive Fund Equity Income Fund Int'l New Discovery Fund Strategic Income Opportunities Fund Core Bond Fund Bond Fund Disciplined Value Fund

Thornburg Oppenheimer Western Asset Oppenheimer Oppenheimer Pridential Aberdeen Oppenheimer Morgan Stanley MFS Pimco Columbia JP Morgan John Hancock Oppenheimer MFS John Hancock Western Asset MFS John Hancock

5/1/2012 1/27/2012 5/1/2012 1/27/2012 1/27/2012 3/2/2012 2/27/2012 4/27/2012 6/15/2012 6/1/2012 5/31/2012 4/20/2012 7/2/2012 3/1/2012 4/27/2012 6/1/2012 3/1/2012 5/1/2012 6/1/2012 2/29/2012

Equity Debt Debt Debt Equity Debt Equity Equity Equity Asset Allocation Debt Debt Debt Asset Allocation Equity Equity Debt Debt Debt Equity

International Equity International Debt Govt/Corp Intermediate Government/Corporate Global Equity Corporate/Preferred-Inv Grade Emerging Market-Equity International Equity Growth-Mid Cap Balanced Index Fund-Debt Government/Corporate Asset Backed Securities Flexible Portfolio Value-Large Cap International Equity Global Debt Govt/Corp Intermediate Government/Corporate Value-Large Cap

26.5 12.6 9.6 8.6 8.3 8.0 7.5 6.2 6.0 5.8 5.4 4.7 4.1 3.7 3.3 3.2 3.1 3.0 2.8 2.8

Source: Bloomberg

grade issuance in August totalled USD27bn, up from USD1.3bn the same month in 2011.
3. Average US BBB-rated five-year corporate bond

only 3.8%. You have to stretch to Belarus (B-) to get a decent yield, just over 10%.
4. HSBC Asian US Dollar Bond Index

10 8 6 4 2 0 03 04

Yield Spread

12 10 8 6 4 2 0

Yield

Spread

00 01 02 03 04 05 06 07 08 09 10 11 12 05 06 07 08 09 10 11 12
Source: HSBC

Source: Bloomberg

Investors are clearly now having to take more risk to get yield. Fund houses report that investors who 20 years ago would not have touched BBB credits will now buy almost anything for yield. One example is bonds from riskier emerging markets. Ten-year paper from the Philippines, a BB-rated issuer, now yields only 2.5%. Investors have been buying bonds from countries such as Gabon, Belarus, Nigeria and Vietnam. But five-year bonds even from Gabon (BB-rated) now yield

This could all go very wrong. Credit spreads are supposed to compensate investors for the probability of default. At the investment grade part of the credit spectrum, defaults are rare, but at the sub-investment grade end they are less so. At present, the combination of low rates on high quality government bonds and relatively wider credit spreads, combined with very low default rates, places credit in a sweet spot; compared to some other assets classes. However, in an

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Multi Asset Strategy Global September 2012

environment of low growth rates, credit quality is at risk of deterioration and, if default rates begin to rise, the credit spreads sought by investors could widen significantly.
Income from equities

5. Cumulative net flows into mutual funds by theme

80 60 USDbn 40 20 0 -20

Div idend Balanced/multi asset Gold Commodity

The other obvious place to turn for yield is equities. With the dividend yield on global equities currently averaging 3.2%, the spread over government bonds is the highest since the 1950s. Investors have been buying into this theme enthusiastically over the past two years. There have been almost USD80bn of flows into dividend funds over this time (Chart 5), making it the most popular of the themes tracked by EPFR. Oddly, the theme has not been so popular in the US. Maybe there are definitional differences but US income funds tracked by ICI have seen net outflows of about USD11bn over the past two years (Chart 6). Income funds comprise only 3% of outstanding US equity mutual funds (compared to 33% for growth and aggressive growth funds).

00 01 02 03 04 05 06 07 08 09 10 11
Source: EPFR

There are a number of explanations for the lack of interest in dividend funds in the US. The dividend yield in the domestic market is quite low (2.6% compared to, for example, 4.3% in Europe), since companies prefer buy-backs which are more tax efficient. The tax on dividends (currently 15%) is due to rise next year as part of the fiscal cliff to an investors marginal tax rate, i.e. as high as 40%; this is causing uncertainty. It may be simply that investors are just too nervous of equities to touch even ones with good income.

6. Cumulative net flows into US equity mutual funds, by type

700 600 500 USDbn 400 300 200 100 0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12


Source: ICI

International Grow th Balanced Agg grow th Global EM Sector Income

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Multi Asset Strategy Global September 2012

Many CIOs argue that it is just too late to buy dividend stocks, since they have already performed well. We disagree. The global dividend yield has not fallen much: it peaked at 4.4% in early 2009 at the market trough, but has been fairly steadily around 3% for the past three years. High dividend stocks have not outperformed that much yet either. For example, the global MSCI High Dividend Yield Index has beaten MSCI World by only 7% over the past three years (ignoring the dividends paid). And the MSCI USA High Dividend Yield Index (launched in January this year) has performed just in line with the headline MSCI US year-to-date.

Implications for asset prices


The search for yield will continue if, as we expect, risk-free government bond yields remain low for some time to come. That suggests to us that both credit and high dividend equities will see further inflows, and therefore a contraction in bond spreads and rise in equity prices.

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Multi Asset Strategy Global September 2012

The death or rebirth of equities


Bill Gross says the cult of equity is dead But equities have actually outperformed bonds over the past 10 years, although admittedly with high volatility A bigger risk is the bursting of the bond bubble: could 2014 be another 1994?

Problem is volatility, not return


Bill Gross, Co-CIO of Pimco, famously announced this August that the cult of equity is dead. But the truth is not that simple. Indeed, many bond fund managers are worrying more about the crash in the bond market that we believe is coming, and thinking about how to position themselves for it. Certainly over the past few years, investors have switched massively away from equities and into bonds. Since the end of 2007, USD920bn has flowed into bond mutual funds in the US and USD430bn out of equity funds (Chart 1). This is not only because of the equity bear market of 2007-9. The trend has been accelerated by demographics in developed economies (older people hold fewer equities) and by regulation, as regulators, especially in Europe, pushed pension funds and insurers to derisk their portfolios.

1. Cumulative net flows into US mutual funds (USDtrn)

1.5 1.0 0.5 0.0 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12


Source: ICI

Equity funds Bond funds

But have equity returns really been that bad? Many investors talk about the past 10 years as having been a structural bear market for equities. But the fact is that over that period the total return from global equities (a compound annual rate of 8.0%) has been better than the return from global bonds (5.2%). Of course, the picture is a little more complicated than that. The return depends greatly on the starting-point: the 10-year return for equities is flattered by the fact that August 2002 was close to the bottom of a bear market.

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Multi Asset Strategy Global September 2012

And equities have been particularly volatile over the past decade or so (Chart 2). In the bull market of 1992-9, equities produced a much smoother annual return of 16% with volatility of 13%, compared to a 6% return for bonds with a volatility of 5%. Over the past 10 years, the volatility of bonds has been pretty steady, at 6%, but the volatility of global equities has risen to 19% (Tables 3 and 4).
2. Total return indexes* (log scale) since 1988

That volatility explains a lot. Retail investors and regulators have been made very nervous by the big swings in stock prices. It will take a lot for them to get confident in equities again. Many equity fund managers worry that one more crisis or another nasty bear market in the near future would put investors off equities for a generation, as happened after the 1929 stock market crash. The high volatility also explains the big flows into passive funds in recent years (discussed in a later section): volatility makes it hard for active or thematic fund managers to perform well. But there are issues for bond markets too, valuations for a start. The interest rates on toprated government bonds are at unprecedently low levels: the 10-year US Treasury yield, for example, fell below 1.4% this summer, the lowest since at least the late 19th century (Chart 5).
5. 10-year US Treasury bond yield (%)

6.5 6.0 5.5 5.0 4.5

Equity Bond Cash

88 90 92 94 96 98 00 02 04 06 08 10 12
Source: Bloomberg, MSCI (*Equity=MSCI ACWI TR Gross, Bonds=JP Morgan Aggregate Bond Index TR Unhedged USD, Cash=3-month T-bills)

16 14 12
Cash

3. Compound return from different asset classes Equity Bond

10 8 6 4 2 0 1880 1900 1920 1940 1960 1980 2000

1 year 2 years 5 years 10 years 20 years 1992-1999 Since 1988


Source: Bloomberg, MSCI

9.8% 8.1% -0.9% 8.0% 7.1% 16% 7.2%

1.4% 5.2% 6.4% 6.7% 6.4% 6% 7.1%

0.2% 0.2% 1.1% 2.1% 3.5% 5% 4.3%

Source: Robert Shiller

4. Annaulised volatility of different asset classes Equity Bond Cash

1 year 2 years 5 years 10 years 20 years 1992-1999 Since 1988


Source: Bloomberg, MSCI

20% 18% 24% 19% 17% 13% 17%

4% 5% 6% 6% 6% 5% 6%

0% 0% 0% 0% 0% 0% 0%

Meanwhile, equity valuations, while not exceptionally low, are certainly well below longrun averages: the forward PE on the S&P500, for instance, is currently about 12.5x, compared to a 140-year average of 13.6x (Chart 6).

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Multi Asset Strategy Global September 2012

6. One-year forward PE, S&P500 (x)

35 30 25 20 15 10 5 0 1870 1890 1910 1930 1950 1970 1990 2010

They key question, then, is whether the recent volatility in equities and the shift in investors preferences to bonds are structural or cyclical. The answer is that it is surely a bit of both. With the debt overhang in the developed world likely to hold down growth for a few more years, policy uncertainty and low inflation will probably keep interest rates low and equity markets on edge. But this will not last forever. And, in the meantime, investors will struggle to make decent returns from bonds at current levels. The financial textbooks may dictate that as an individual nears retirement he or she should sell out of equities and own only bonds. That might have worked when interest rates on government bonds were 7% and a 65-year-old could expect to live only 10 years. But it certainly doesnt work with bond yields at 1.5% and life expectancy of 80-85.

Source: Robert Shiller, IBES, MSCI

Indeed, the best way for investors to regain confidence in equities would be if bond prices were to crash. This might be caused by a rise in inflation or signs that the Fed and other central banks were looking to begin unwinding their unothodox monetary easing measures. Some CIOs have started to worry whether 2014 could be another 1994 (when the Fed raised rates unexpectedly and sent bonds crashing). How could bond houses stay relevant in a rising rate environment? Indeed, several we spoke to have begun to prepare for this eventuality, and started to consider how they might enter the equity business. Grosss Pimco set up four equity funds for the first time in 2010, and others are starting to address this, also. Other traditional bond houses told us they were looking at specialising in equity tactical asset allocation, using ETFs to execute country and sector bets.

Implications for asset prices


Our conclusion is that equities are likely to struggle for a few more years, with economic growth in the developed world anaemic. But the basic concept that equities have a risk premium should not disappear. And we would have a high degree of conviction that the total return from equities over the next 10 years will be higher than that from cash or government bonds (admittedly not a big hurdle). The problem to solve is investors perception that equities are risky. But there might be ways to reduce the riskiness of equities, without sacrificing too much of their return. We examine the idea of risk-minimising strategies in the next section.

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Multi Asset Strategy Global September 2012

Risk-minimising strategies
Investors want equity-style returns with bond-like volatility Fund houses are developing products that tailor a level of risk in return for giving up or boosting return Strategies include diversified beta, risk parity, min vol, call writing

Tailoring risk, not return


What all investors would ideally like is a good return with low risk. Of course that is impossible, but fund managers are increasingly designing products that give at least a decent return (or income) with some downside protection or reduced volatility. The key insight here is that, while it is impossible to fix return, it is possible to tailor risk to a degree. One could, for example, buy an equity index together with a put option, thus giving up some income in return for a pre-determined limit to drawdown. Investors have a reduced tolerance for drawdown after the upheaval of 2008; fund managers can structure their offerings with the aim of avoiding an outlier outcome. Such products are not new (private banks have for at least 20 years sold capital guaranteed equity indexes, where the dividend stream is used to buy downside protection). But, in a world where investors are hungry for yield but nervous of equity risk (as we saw in the previous two trends) they are increasingly popular. They are also becoming more sophisticated and nuanced.

There are many such structures around. The fastest growing, especially in the UK, are multi-asset funds (aka diversified beta or diversified growth), which we discuss in detail in the next section. These aim at absolute returns in a range of assets, with a targeted level of volatility. Essentially, they intend to provide a nice return but with low correlation to equities. Risk aware equity services, such as long/short or market-neutral strategies, have for long been the territory of hedge funds, but are increasingly being used by conventional fund managers. Balanced funds (with a mix of equity and bonds, typically 60:40) have long been a mainstream of retail fund management houses. But they have often produced poor returns, mainly because the vast proportion of the risk lay in the equity portion. A recent development is risk-parity products, where risk between the asset classes is equalised, for example by leveraging the bond portion.

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Multi Asset Strategy Global September 2012

Minimum volatility equity funds focus on low-beta stocks in an index, often using a quants model. They are based on the finding in some academic research that beta does not produce the outperformance in the long-run that it should. These funds, it is claimed, can produce at least as good performance as a major index, but with significantly reduced volatility. Using options to target a level of risk. For example, a fund could write calls and buy puts to an equal value to specify acceptable downside risk at the expense of upside. This could also be done simply, and relatively cheaply, to eliminate extreme tail risk. Similarly, a strategy of passive-plus with call writing allows a fund to boost the return on an index, in return for capping the upside. Again, the level of the cap can be tailored. Some funds have experimented with the idea of hanging a coupon off an equity fund. This might look more attractive than a simple dividend fund, since the coupon, as long as it was relatively low (for example 2%) could be fixed for a period, since shortfall is unlikely. Any dividend payment in excess of that would be reinvested. This hybrid of bond and equity characteristics may be attractive to some investors.

Not that such tailored products are without problems. It may be hard to explain their characteristics and attractiveness to retail investors: as one CIO told us: You cant sell a Sharpe ratio. The products can be quite expensive too. Some highly risk-averse investors may end up giving away too much upside to buy insurance. With implied volatility for equities still high (though lower this year than for a while), the cost of options protection is high. The lack of transparency on costs may leave some retail investors wondering whether the investment bank selling them the structured product is offering a good deal. But for both sophisticated retail investors, with astute advisers to guide them through the complications, and for institutions with strong risk consciousness, for example insurance companies, products that minimise or at least tailor risk might be a wise investment.

Implications for asset prices


If risk-minimising products grow further, this should be positive for the growth of options markets and for liquidity in the sort of assets that multi-asset funds typically target.

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Multi Asset Strategy Global September 2012

The growth of multi-asset


Funds that target Libor-plus absolute returns, with bond-like volatility and costs lower than hedge funds, look attractive to us The success of Standard Lifes GARS has spawned competitors Multi-asset funds are likely to grow further, even in the US where they have yet to take off

GARS and all its friends


Standard Lifes Global Absolute Return Strategies (GARS) Fund has been causing a stir in the UK. Since its inception in 2008, it has gathered assets of GBP11.7bn. It aims to produce an annual return of cash plus 5% with an investment timehorizon of three years (and to have a positive return over any 12-month period), by investing in a range of assets and derivative strategies (see Table 1 for example of its positions). Over five years it has produced a compound annual return of 7%, putting it in the 99th percentile of its peers (with volatility over the past year of only 5%). The GARS Fund has spawned a raft of competitors in the UK but not yet in the US, although by all accounts GARS has started to gain traction there. It is the leader of a growing category of multiasset absolute return funds, known also as diversified growth, diversified beta or diversified return funds. These funds typically target Libor plus 4% or 5% (or sometimes inflation plus, say, 3%), with volatility lower than equities and often targeted to be similar to US treasuries (i.e. 4-6%). They usually use leverage to achieve the targeted return. In a sense they are similar to hedge funds,

but fees are lower (GARS charges 75bp a year, with no performance fee) and many are offered to retail as well as institutional investors.
1. GARS fund: selected positions July 2012

Market return strategies High yield credit Russian equity Korean equity Global index-linked bonds FX hedging Directional strategies US forward-start duration Long USD v CAD Mexican rates v EUR Long BRL v AUD Long equity volatility European swaption steepener Relative value strategies Relative variance income US tech stock v small cap European financials capital structure Hang Seng v S&P volatility HSCEI v FTSE variance Broad v financial sector equity Financial sector v broad credit
Source: Standard Life, public website

The track records of GARS, and of many of its later-established competitors, have been impressive. But multi-asset funds have their detractors, too (and not only among houses late to the game).

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Multi Asset Strategy Global September 2012

Some argue that Standard Life has been lucky to achieve such good returns (or maybe has done so only because its fund managers are particularly talented) and wonder whether similar funds would be able to replicate the returns. Wont multi-asset funds in aggregate underperform their benchmarks, just as active equity managers do and (as we describe in the section below, The decline of the hedge fund?) hedge funds may have begun to do too? That may happen eventually, but for now the asset class is still so small that it does not yet face a zero-sum game. Other critics wonder whether multi-asset funds are really an alpha product, or simply take beta risk with leverage. In our view, the answer to this is that, even if part of the return that multi-asset funds achieve is beta, timing the beta and managing asset allocation can be forms of alpha. A final doubt is that leverage may work with interest rates so low, but what happens when the cost of the leverage goes up? It is also somewhat of a puzzle why multi-asset funds in the US have failed to take off yet. Certainly, most CIOs at US funds we talked to were aware of the GARS phenomenon, but few have tried to market anything similar. One problem is that required returns in the US are too high: pension funds typically assume a return of close to 8%. Setting up a multi-asset fund with a target of Libor+7 or Libor+8 would, in the view of most fund managers, involve taking too much risk. Retail investors, in the current environment, also tend to be wary of anything that isnt yield oriented. Would there be a way to set up income multi-asset funds?

Implications for asset prices


The obvious attraction of multi-asset funds (decent yield with low volatility at a reasonable cost) means that, in our view, they should continue to grow rapidly and develop more diverse structures. Eventually, their flourishing may push down returns but, for now, they are rare enough that there is still plenty of alpha to be picked up. As multi-asset funds grow, they should aid the development and liquidity of more esoteric asset classes (look at the sort of things that Standard Life holds in Table 1). Most multi-asset funds implement their strategies through index futures and other derivative instruments; these should see improved liquidity too.

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Multi Asset Strategy Global September 2012

The shift to passive


A third of active money has shifted to passive in the past 10 years Passive encroachment is likely to continue, since active funds empirically underperform on average (and have higher costs) But indexing strategies will need to get smarter: which index?

Its hard to beat an index


There has been a massive shift of investment flows from actively managed funds to passive (indexed) funds over the past 10 years. According to EPFR data (Chart 1), passive equity

(Chart 2); these now total USD242bn. TowersWatson estimates that global assets managed passively totalled USD7trn in 2010.
2. Annual flows into US indexed funds by type, 1997-2011

60 50 40

USDbn

funds worldwide have seen inflows of about USD660bn over the past 10 years, and active funds outflows of USD543bn (one-third of their assets under management at the start of the period).
1. Cumulative net inflows into mutual funds worldwide (USDbn)

30 20 10 0

-10 1997 1999 2001 2003 2005 2007 2009 2011 Domestic equity
Source: ICI

800 600 400 Passiv e Activ e

World equity

Bond & hy brid

USDbn

200 0 -200 01 02 03 04 05 06 07 08 09 10 11 12 -400 -600

Source: EPFR

This is unsurprising, in our view. Almost all academic studies find that in aggregate active funds underperform their benchmark, particularly once fees are taken into account. This logically must be so since, before fees and trading costs, the average investor must by definition perform in line with the index. But the turnover of an active fund is almost always higher than that of an index. So, even before fees, the average active investor must underperform. (The only question is underperform what? a subject we return to later.) Index funds also typically charge lower annual expenses, for example usually 20-30bp for

In the US, according to the Investment Company Institute, inflows to passive mutual funds have totalled USD427bn over the past 10 years, bringing the total size of such funds at the end of last year in the US to USD1.1trn. There have been particularly big flows into bond funds over the past three years

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Multi Asset Strategy Global September 2012

an S&P500 index fund, compared to 80-150bp for a traditional actively managed US equity fund. Data from Standard & Poors suggest that over the past 10 years, on average only 40% of large-cap US funds and 38% of small cap funds outperformed their benchmarks (Chart 3).
3. % of mutual funds outperforming their benchmark

Fans of active investment have a number of arguments against this. Many claim that, while the average investment manager may underperform the benchmark, their firm has superior investment processes that allow it to outperform consistently. Unfortunately, academic research shows little evidence of sticky outperformance. Others argue that, if an increasing portion of the investor universe turns passive, there should be more merit in picking stocks, since they would be increasingly mispriced. That is an appealing argument, but not well grounded in logic. Think of it like this: if there were 98 passive investors in an asset class and only two active managers then, after fees and trading costs, the two active investors would still in aggregate underperform the index. Bond houses argue indexing might not make sense for bonds. Bond indexes are unlike equity indexes in that they include many more securities, which change frequently (for example when their credit ratings downgraded) and most of which have a finite life. They are usually weighted by the total outstanding debt of the issuers, which means highly indebted and risky borrowers represent a large part of the index. Many active bond managers claim it is not hard to outperform bond indexes for these reasons. Standard & Poors data does not bear this out, though: almost no category of US-based bond funds has outperformed its benchmark in aggregate over the past decade (Chart 4).

80 70 60 50 40 30 20 10 0

Large cap funds S i 3

Small cap funds

2002

2003

2004

2005

2006

2007

2008

2009

2010

Source: Standard & Poors (Large cap funds were compared with S&P500, small cap funds with S&P SmallCap 600)

Will the shift to passive continue? In our view, almost certainly. Passive funds still comprise only 16.4% of US equity mutual funds (up from 10% ten years ago). International equity funds run passively in the US total only USD120bn. Index funds are still relatively small outside the US. With interest rates and expected returns from all assets very low, investors will focus more and more on minimising expenses. Going passive is the best way to do this. Sophisticated investors, such as institutions or high net worth individuals, will also increasingly separate beta and alpha. They will do this, for example, through so-called 80:20 solutions, where they have 80% of their assets in passive market-linked beta assets, and a 20% alpha tranche aggressively managed in alternative assets (with the market risk hedged out). They will want to buy the beta portion as cheaply as possible.

2011

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Multi Asset Strategy Global September 2012

4. % of bond funds outperforming their benchmarks

60 50 40 30 20 10 0

2002-2006

2007-11

index); similarly, deleted stocks fall before their removal. A less well-followed index with similar characteristics might outperform.
5. Performance of S&P500 market cap and equally weighted

2500 SPX Index 2000 SPW Index

intermediate

EM debt

Government

income

MBS

HY

long funds

General

Global

1500 1000 500 0 90 92 94 96 98 00 02 04 06 08 10 12


Source: Bloomberg

Source: Standard & Poors

It may be possible to outperform an index when a large group of investors hold the securities for non-investment reasons. An example is Japan in the 1990s, when many foreign investors outperformed the Topix index simply by underweighting (or owning no) banks. Bank stocks were mainly owned by Japanese corporates for relationship reasons.
But which index?

Many passive investment managers understand these reservations, and have moved to index-plus or passive-plus strategies. Fundamental indexes, where stocks are weighted by sales or book value (or even the number of employees), rather than by price or market cap, have also grown.

This all begs the question of which index. Some perform better than others. A traditional large-cap market cap-weighted stock index, such as the S&P500, may not be the best choice. That is because, empirically, smaller cap stocks outperform large caps in the long run. Moreover, when using market capitalisation, expensive stocks are overweighted. It is well accepted that value stocks also outperform in the long run. (There is a possibility, though, that both these phenomena may just be capturing the greater illiquidity and higher transaction costs of smallcap and value stocks.) So in the US, for example, the S&P500 index has risen by 50% over the past 10 years, while an equal weighted index of the same stocks has risen by 105% (Chart 5). A further problem is that, when stocks are added to a popular index, they tend to rise on the announcement (but before they actually join the

Implications for asset prices


If we are correct to believe that passive encroachment has years to go, there are many important implications for asset prices.
6. Average correlation of MSCI country indexes with ACWI

1.0 Av erage 0.8 0.6 0.4 0.2 0.0 90 92 94 96 98 00 02 04 06 08 10 12

Source: Bloomberg, MSCI

Correlations between markets, and between stocks in a market, have risen consistently over the past decade. The average correlation between MSCI

26

Multi Asset Strategy Global September 2012

country indexes and the overall MSCI All Country World Index (Chart 6), for example, has risen from 30-40% in the early 2000s to 60-70% by 2010 although they are some signs of it declining recently, perhaps as flows into equity funds, whether active or passive, have stagnated. At the stock level, the implied correlation between individual stocks in the S&P500 index (Chart 7) rose to a peak of 80% late last year, from 40-50% in 2007 (when the correlation contract was first launched on the Chicago Board Options Exchange).
7. Implied correlation of S&P500 stocks (%)

Further growth of passive funds is likely to push correlations up further, or at least keep them at the current elevated level. If bond funds grow in popularity, a similar rise in correlations may happen between different bond classes or issuers. The growth of index-plus strategies or fundamental indexes might also offer some arbitrage opportunities in securities lying just outside the major indexes, or which are large but underrepresented.

90 80 70 60 50 40 30 20 10 0 07 08 09 10

Implied correlation 11 12

Source: Bloomberg, CBOE

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Multi Asset Strategy Global September 2012

The relentless rise of ETFs


ETF assets have grown to USD1.5trn But there are issues: are ETFs suitable for bonds? Will overly sophisticated ETFs blow up and invite regulators attention? Key to future growth is whether active ETFs take off

Attractive but problems too


Closely linked to the rise in passive funds (see previous section) has been the growth of exchange-traded funds (ETFs). There are currently over 3,200 ETFs around the world, with assets of USD1.5trn, up from only USD105bn in 2001 (Chart 1).
1. Assets of exchange-traded funds (USDbn)

they are often used by institutions to execute asset allocation changes. Some participants estimate that as much as 60% of ETFs are owned by institutional, rather than retail, investors. The way ETF units can be created and redeemed by authorised participants such as market-makers usually means that they generally trade close to net asset value (NAV). For retail investors, the ability to see live prices and trade any ETF via a discount broker (rather than having to use the proprietary platforms of various fund management houses) make ETFs particularly easy to use. But they also have their detractors. Common criticisms include: They are sub-optimal for long-term investors. Why would these investors want to trade intra-day, when they could buy an equivalent mutual fund that guaranteed they could buy or sell at end-of-day NAV? This can only encourage short-term speculation, unsuitable for most retail investors. Moreover, since ETFs pay exchange fees and have a bid/offer spread, they should fundamentally cost a little more than a similar mutual fund.

1,600 1,400 1,200 1,000 800 600 400 200 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012*
Source: Blackrock (*end-Jun)

US

Europe

Other

ETFs have a number of advantages, which explain their popularity (trading volumes represent around one-quarter of US stock market turnover). They can be traded intra-day, giving investors a way to take (or remove) exposure quickly to a country, sector or asset class. Their liquidity means that

28

Multi Asset Strategy Global September 2012

They are still very much a US phenomenon. US ETFs have AUM of USD1.1trn but Europe only USD273bn and the rest of the world just USD169bn. Regulatory difficulties still make it hard to set up an ETF in Europe. The range of available ETFs and their liquidity is very limited in many countries. ETFs are best suited to equity index products. They work much less well for bonds or other assets. Equity ETFs globally total USD1.2trn, but fixed income ETFs have reached only USD308bn, and commodity ETFs only USD35bn. Fixed income is trickier because of the problems inherent in bond indexes, described in the section on passive funds above. It is also much harder to replicate a bond index because of the lack of liquidity in many of its components. Moreover, the transparency requirement of ETFs (in the US they have to publish their full holdings daily essential for marketmakers to create new units) means that traders can see their positions and trade against them. A number of ETFs have backfired spectacularly. Some have failed to mirror the returns on the underlying security or index they claimed to match. This has been especially true of gold ETFs. More sophisticated ETFs that promised a multiple, or the inverse, of the return on the underlying have diverged dramatically. The Proshares Ultrashort MSCI Emerging Markets ETF (Code: EEV) is one of the most notorious. It seeks double the inverse of the return on the MSCI EM index. But when the index fell 49% in the second half of 2008 and so the ETF should have risen 98% the ETF actually fell by 30%. It has failed in the past 12 months too, falling by 15% when MSCI EM fell by only 8%.

The defenders of ETFs say that the resilience of the industry, despite these blow-ups (and others such as the flash crash of 2010, which was partially blamed on ETFs) demonstrates the products fundamental attractiveness. The chances are, though, that regulators may clamp down, particularly on exchange-traded products (ETPs), which replicate an index or assets through derivatives rather than by owning (at least some of) the underlying securities. There are USD182bn of ETPs, in addition to the numbers on ETFs quoted above.
The keys for further growth

We expect ETFs to continue to grow. But there are two key questions that will determine their rate of growth. The first is whether active ETFs can take off. These are somewhat problematical. The transparency rules mentioned earlier make it hard to structure, say, a 30-stock high-alpha equity fund as an ETF, since competitors and traders would be able to see daily changes in the funds holdings. Some investment houses, notably Eaton Vance, claim they have found a way to report daily holdings that would get round the transparency problem. But so far the Securities and Exchange Commission hasnt approved these ETFs, and indeed has been reluctant to approve many innovative ETF structures. Perhaps the highest profile active ETF launch recently was Pimcos Total Return ETF (Code: BOND), listed in March this year. In six months, it has grown AUM to USD2.5bn. The ETF aims to mimic the Pimco Total Return mutual fund; both are managed by Bill Gross. But the two have performed rather differently: in the past six months the ETF has risen 6.6% and the mutual fund 3.2%. One reason for this is apparently is that the larger size of the long-established mutual fund (total assets USDUSD270bn) means it cannot move in and out of positions so quickly.

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Multi Asset Strategy Global September 2012

One answer may be quants funds which, rather than being managed in accordance with the managers judgement, chose stocks on the basis of a model. For example, the largest ETF provider, Blackrocks iShares, is focusing its marketing efforts currently on minimum volatility equity ETFs. These use an MSCI Barra model that optimally chooses low volatility stocks from an index. Its promoters claim that this allows investors to keep most of the upside, with significantly lower volatility. And, indeed, over the past five years, the MSCI US Minimum Volatility Index has outperformed the regular MSCI US by 17%, with volatility of 18% compared to 23%. The second key question is how financial advisers are remunerated. Until recently, FAs were reluctant to recommend ETFs to their retail investor clients, even though this might have been the wisest course since, unlike mutual funds, ETFs do not pay commissions. But the trend is increasingly for FAs to charge an annual fee of 12% of assets for their advice, and to take nothing from the investment products they put their clients into. This makes them more impartial. In the US, the number of Registered Investment Advisers (RIAs) has soared as investment professionals have left wire houses to set up on their own: estimates from Cerulli Associates suggest assets overseen by RIAs have tripled over the past 10 years to USD1.7trn. In the UK, the Retail Distribution Review, which takes effect next January, will ban financial advisers (including private banks and wealth managers) from accepting commissions for recommending investment products to UK retail investors. Similar moves are afoot in Australia and Asia. This might all make it more common for FAs to recommend an ETF-heavy investment strategy to retail investors and spur the growth of the product.

Bad news for mutual fund managers

This is good news for the ETF industry, but wont help conventional fund managers. The ETF business is largely sewn up by three providers iShares, State Street and Vanguard which between them manage 68% of outstanding ETFs. Other firms have struggled with whether it makes sense to enter the business, but the only space left for new entrants is in increasingly esoteric products, or in low-cost ETFs on plain-vanilla stock indexes. Both are hard to make profits from, and ETFs from smaller providers are often illiquid, making them unattractive to investors. Indeed, some smaller providers have begun to pull out: Scottrades FocusShares, for example, liquidated its 15 ETFs in August and Russell Investments announced it would scale back its offering, currently 26 funds. A total of 71 ETFs have closed in the US this year.

Implications for asset prices


As with the move to indexation (described in the previous section), the rise of ETFs raises intraand inter-market correlations. ETFs make it easy even for large institutional investors to change weighting rapidly. A fund that decided to raise its weighting in Brazil, for example, could buy a Brazil index ETF immediately, and then ask its fund managers to slowly build up a portfolio of their favoured Brazilian stocks. So far this has mainly been limited to equities. But if bond ETFs and style ETFs (min vol, value, high dividend yield) take off, the same effect could be seen within and between other asset classes.

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Multi Asset Strategy Global September 2012

The decline of the hedge fund?


Hedge funds have struggled in the recent trendless market The underlying problem is that the hedge fund community has become so big that it has harvested most of the alpha Large hedge funds and traditional fund managers are likely to converge

Is there any alpha left?


Earlier this year, the assets under management of hedge funds finally regained their previous peak from 2007, around USD2.2trn. But that was one of the few pieces of good news for an industry that has struggled in recent years. In the five years to the end of 2007, AUM grew at an annual compound rate of 29%. Since the end of 2008, the CAGR has been only 12% (Chart 1).
1. Hedge fund assets under management

Hedge funds tend to do best in absolute terms during economic expansions and equity bull markets, such as 2003-7, and in relative terms during market collapses like the Global Financial Crisis of 2007-9 (Chart 2).
2. Cumulative performance of hedge funds

350 300 250 200 HF index L/S equity Macro HFs

2,500 2,000 1,500 1,000 500 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012* Assets (USDbn)

150 100 00 01 02 03 04 05 06 07 08 09 10 11 12
Source: Bloomberg, EurekaHedge

Source: TheCityUK and HSBC estimates (*end-Jul)

The reasons are not hard to find. Performance has been unimpressive in the past couple of years.

But they may struggle during the trendless, risk on-risk off type of market we have seen recently. This year, for example, as of end-July the average hedge fund monitored by EurekaHedge was up only 2.5% y-t-d. The performance of long/short equity funds (+1.9%) and funds of funds (+1.7%) was even poorer. By contrast, global equities have

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3. Growth in hedge fund AUM by category of fund, end-2007 to end-2011

Change in AUM 2007-11 15% 10% 5% 0% -5% -10% -15%


Distressed Securities Equity market neutral Sector specific Multi-strategy Total Convertible Arbitrage Merger Arbitrage Equity long/short Emerging markets Macro Event Driven Equity Long Bias Fixed income Equity Long only

8%

12%

2%

13%

10%

5%

100%

6%

9%

2%

7%

11%

% of total HF AUM 2% 13%

Source: Barclay Hedge

risen 7.5% (MSCI ACWI) and global bonds (JP Morgan Global Aggregate Bond Index TR) 2.4% so far this year. Its not exactly worth paying twoand-20 (a 2% management fee and 20% performance fee) for that sort of performance. Macro funds have particularly struggled in the past couple of years. They have been one of the strongest growth areas since the Global Financial Crisis (when they performed well), with 10% growth in AUM in the four years to end-2011 (compared with a 5% decline for the hedge fund universe as a whole) see Chart 3. But this year so far macro funds on average have returned only 1.1% and macro funds of funds -0.5%. Last year too, return was poor: -1.2%. There have been a relatively small number of consensus macro trades (for example, betting on a rise in Bund yields) that many macro funds put on, but which were unsuccessful. The biggest problem is that these funds are essentially making calls on the actions of politicians and central banks, something that is hard to do. Many macro funds take an opportunistic attitude to investing, switching from one strategy to another as they spot profit-making trades. But this lack of a consistent investment approach has, in

the view of some CIOs we spoke to, turned some institutions away from macro funds.
Why should hedge funds outperform?

The fundamental problem is that, as with active equity fund managers, in theory hedge funds should not be able, in aggregate, to out-perform. When the universe of hedge funds was small enough, there was still alpha for them to harvest. In essence, they were getting their alpha from traditional long-only fund managers. But, once hedge funds became a USD1trn-plus community, they increasingly had to get their alpha from each other. Many investors believe that hedge funds are charging alpha fees simply for beta. So the expensiveness of hedge fund fees is increasingly an issue. Two-and-20 (or even oneand-a-half and 15) is much higher than traditional fund managers charge. Standard Lifes GARS Fund, for example, has a management fee of 75bps despite aiming for a hedge-fund-like return (see the section on The growth of multi-asset, above, for details). More vehicles are becoming available to allow retail investors to access alpha: hedge-fund-like UCITS in Europe, dubbed Newcits, can short and use leverage, for example. These trends will inevitably put downward pressure on hedge fund fees.

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Hedge fund managers are responding. Some larger ones have admitted that their size makes alpha generation hard, and have returned funds to their investors or closed to new money. Moore Capital, for example, returned USD2bn in July. Others have started to tailor their funds so that they can sell them to retail investors. AQR Capital Management, for instance, markets a number of retail funds with active strategies such as momentum, risk parity diversified arbitrage, and managed futures. KKR, best known for its private equity business, in July registered with the Securities and Exchange Commission two hedgefund-like mutual funds, which will invest in special situations such as distressed debt in Europe and Asia. Under the 2012 JOBS Act, US hedge funds may soon be able to advertise for the first time.

Implications for asset prices


Hedge funds are, in our view, unlikely to shrink, never mind disappear. After all, the industry still represents only about 2% of the total of USD82trn in retail and institutional assets worldwide. But the more conventional strategies, such as long/short equity or multi-asset macro, will be under increasing pressure from traditional fund houses, which will run this money for much lower fees. We believe that large hedge funds will increasingly converge with traditional investment managers, in terms of style, fees and remuneration. There will, though, be room for small hedge funds concentrated on unusual asset classes, or with a particular talent for digging out alpha. The growing universe of investors looking at hedge-fund-like strategies including pairs trades, multi-asset arbitrage, illiquid debt should aid price discovery, making capital markets increasingly efficient. As long as smaller hedge funds continue to be able to gather funds, alternative asset classes (distressed debt, foreclosed mortgages, art, volatility) should become more mainstream.

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Multi Asset Strategy Global September 2012

Harvesting the illiquidity premium


Most investors have a strong preference for liquidity But some notably pensions and insurers dont always need liquidity and may be overpaying for it They may start to see the attraction of the extra yield available in illiquid assets such as infrastructure and private debt funds

Do you really need liquidity?


In the desperate search for yield, one way of finding it has been largely ignored up to now: being rewarded for illiquidity. During the global financial crisis so many investors rushed for the exits that investment managers have since had an almost pathological preference for liquidity, buying assets that they can liquidate quickly in volume if necessary. But does this make sense? Pension funds or insurance companies, with liabilities that have an average duration of 10 or 20 years, do not need much liquidity. Individual investors, particularly for their pension savings, should preferably have limited ability to sell their holdings, since this would tempt them to invest speculatively, or to use the savings for purposes other than postretirement income. Moreover, liquidity comes at a price. Investors may be overpaying for something they dont need (or need for only a portion of their portfolio). A survey of academic research on this topic (Liquidity Premium: Literature review of theoretical and empirical evidence, September 2009) by risk

consultancy Barrie & Hibbert (Table 1) suggests investors may receive 350-550bp lower returns from liquid equities compared to similar more illiquid ones, and 40-200bp less from bonds, depending on their credit rating.
1. Illiquidity premium estimate Illiquidity premium estimate (bp) Equity Government bonds Covered bonds Corporate bonds AAA AA A BBB Investment grade BB B CCC Speculative grade No. of studies

450 39 18 50 11 15 30 31 53 110 173 420 180

2 5 2 9 2 3 3 3 1 2 1 1 1

Source: Adapted from Barrie & Hibbert (www.barrhibb.com/documents/downloads/Liquidity_Premium_Literature_REview.pdf)

Gradually, though, investors are starting to look at harvesting this illiquidity premium. Many complain, however, that this is an under-researched area. Few investors have a good answer to the question: where am I paid most for illiquidity?

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Multi Asset Strategy Global September 2012

We found fund managers actively looking at the following asset classes, with potentially attractive returns because of their illiquidity. Private debt. Everyone is familiar with the concept of private equity, where a fund raises a significant lump-sum in a big launch and then invests it for five to 10 years, with investors locked into the fund during this period. Why not apply the same concept to debt? While private placements are not new insurance companies use them for their buyand-hold portfolios especially in the US they look increasingly attractive in a lowyield world, since they allow creditors to invest in a tailor-made instrument to suit their needs in terms of maturity, yield and covenants. The downside is that it is very difficult to exit a position should circumstances or investment criteria change prior to maturity. Infrastructure investment. With governments fiscally strapped, and banks deleveraging and constrained by tighter capital rules (especially in Europe), there should be opportunities for institutional investment managers to step in. Such deals could be structured as public/private partnerships (PPPs), with the investors choosing which part of the capital structure to participate in. Some of these deals could be low-risk, as long as they focused on income generating assets, with utility-like returns but at a premium because the money was locked in. Replacement for bank lending. Creditworthy companies may also struggle to get long-term funding because of banks troubles. Could investment institutions step in? Such deals could be structured as closed-end funds, collateralised loan obligations (CLOs).

Real estate finance. Commercial real estate has an obvious requirement for long-term funding at different levels of the capital structure. Obviously, this is a traditional area for insurance companies and other longduration investors. But many fund managers are looking at the area afresh. There are hurdles, too. Many investors are restricted from buying illiquid assets. This is particularly true of defined contribution (DC) pensions, which might actually benefit from owning some. Defined benefit (DB) pensions are able to buy illiquid securities, but their outstanding assets are likely to shrink over coming years as many such plans are wound down. European banks have been slow to unwind their loan books: hedge funds, looking to expand exposure to corporate loans, have been disappointed by the slow speed at which such assets have come onto the market. Illiquid assets also entail risk, rather like selling an option. Essentially, an investor garners a premium each year until there is a market crash and the investor pays out by being unable to exit a losing position. The danger is that, after illiquid assets gain in popularity, one day they will blow up, causing regulators to clamp down.

Implications for asset prices


If long-dated debt funds were to take off, this could have a significant impact on the pricing of loans, commercial real estate and on the returns available from infrastructure projects.

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Where will the money come from?


Defined benefit pensions are dwindling But personal pensions, Asian high net worth individuals and sovereign wealth funds are areas of growth for fund managers But each of these will demand more sophisticated products

The sources of growth


The changing needs and dynamics of different investor groups the decline of defined benefit (DB) pensions, for example, or the growing wealth of Asian high net worth individuals have major implications for the investment management industry and offer the best sources of growth. In this section, we discuss these changes and look at how the industry is responding.

The struggle of DB pensions

Liability constrained investors


Liability driven investment (LDI) has become one of the biggest buzz-words in the investment management industry over the past few years. DB pensions and insurance companies need to worry not just about the risk and return of their investments but, even more importantly, about matching these to what sits on the liability side of their balance-sheets. In the past decade, they have become even more constrained than before, as regulators have pushed them to derisk. Low interest rates and longer life expectancy have made it very hard for pension funds, in particular, to produce sufficient return to match projected liabilities.

Over the past two decades, companies have increasingly closed their DB pensions and shifted their employees into defined contribution (DC) plans (where the employee takes the investment risk, but benefits from some advantages such as the ability to take the pension pot with them to a new job). In the UK, for example, only 18% of DB pensions are still open to new members (down from 35% in 2006), 54% are closed to new members but allow existing members to continue to make contributions, 26% are closed even to contributions, and 2% are being wound up. Nonetheless, DB pensions still represent the major proportion of the total pension industry (about USD19trn out of a total of USD29trn in the OECD in 2010, for example), as shown in Chart 1. That is partly because public-sector pensions are almost all DB, and because in many major pensions markets (Japan, the Netherlands, Switzerland, for example) DC funds are still rare. In the US, DB pensions have shrunk to 61% of the total, and in the UK 67%.

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Multi Asset Strategy Global September 2012

1. Global pension assets (USDtrn)

30 25 20 15 10 5 0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

move was propelled by the Pensions Act of 1995 and other regulatory changes. Equities have fallen to 42% of assets from 82% in 1993 (Chart 2).
2. UK pension funds asset allocation

100% 80% 60% 40% 20% 0% 1962 1968 1974 1980 1986 1992 1998 2004 2010

Autonomous pension funds Other managed funds


Source: OECD

Pension insurance

The biggest issue DB pensions face is their increasing underfunding, caused mainly by recent poor returns and the fall in interest rates. A study by pension consultant, Towers Watson, found that last year pension funds in 11 major economies had on average a 25% gap between assets and liabilities (compared to a 4% gap 10 years ago). And the true situation would be even worse if pension funds used realistic return assumptions. In the US, for example, both public-sector and company DB pension schemes use an assumed return of about 7%. That sounds bizarre when the yield on a 10-year BBB-rated bond is only 3.7% (and even the 2002-2011 average only 6.0%). But auditors insist on sticking to the long-run historical return in calculating assumed returns. Investment managers are increasingly offering holistic pensions solutions to plan sponsors faced with this sort of dilemma. The sort of riskminimising, return-maximising strategies described in an earlier section of this report are often attractive to DB pensions, although their need to make a return of Libor plus 7 or 8ppt means they have to take large amounts of risk. In the UK, at least, the shift to liability matching has meant that pension funds have moved a lot of their assets into fixed-income instruments (which they assume wrongly in our view have a better duration match with pension liabilities). This

Cash & short term


Source: ONS

Debt

Equities

The US has not yet seen the same phenomenon. Equities are a smaller share of assets than before the 2007 crash but, at 63%, they are still higher than at any time in the 1974-95 period.
3. US private pension funds asset allocation

100% 80% 60% 40% 20% 0% 50 55 60 65 70 75 80 85 90 95 00 05 10 Cash & short term


Source: Federal Reserve

Debt

Equities

The reason US investors still hold such a high proportion of assets in equities is their return assumption. After all, it is almost impossible to make a 7% or 8% return from bonds. This is also pushing US DB funds into a wide range of alternative assets. The California State Teachers Retirement System (CalSTRS), with USD152bn in assets, for example, has been looking to invest in a range of oddities including covered calls, infrastructure, leases, senior secured debt, royalty

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streams and distressed debt to try to get high returns outside of equities (although it still has 50% of its assets in equities). In the end, the dilemma for DB funds is whether they should rerisk in order to achieve the sort of returns they need to reduce their growing excess liabilities. The problem is that, by doing so, they could face a blow-up that would make matters worse.
Insurers and Solvency II

2014, will require capital to be held against assetside, as well as insurance, risks; equities will carry a higher capital requirement than other assets. Given that Solvency II has been discussed for years, it is tempting to think that insurers must have already adapted their portfolios for this. But the lack of any decline in equity holdings in the past five years suggests this is not the case. Many believe that the insurance companies spent the time lobbying against the new rules, not preparing for them. It seems likely, then, that insurers will have to reduce equity holdings from now to boost capital efficiency under the new rules. However, with bond yields so low, this may be exactly the wrong time to make this move. German insurers, for example (which already have very low equity allocations) are reportedly asking their regulators for the new rules to be relaxed. Will US regulators follow the European lead and tighten regulation on pension funds and insurers equity holdings? It is a risk that many US investment institutions are aware of. Probably the ingrained equity culture in the US will see off this risk. But another big fall in stock prices could be the trigger for regulators to force a cut in the assumed return and tell liability constrained investors to derisk.

Insurance companies face similar liability constraints to pension funds but, in Europe especially, have been pushed even harder by regulators to reduce risk (meaning, lower their equity weightings). The proportion of equities held by insurers differs significantly from one region to another. US insurers have significantly raised their equity holdings over recent years; equities now comprise 27% of assets, up from less than 10% in the early 1990s (Chart 4).
4. Life insurers: equities as % of total assets

60% 50% 40% 30% 20% 10% 0% 1980 US 1985 1990 Japan 1995 UK 2000 2005 2010

The institutionalisation of retail


As retail investors increasingly take more responsibility for their own pension provision, their needs and the opportunities for investment managers are developing. DC pensions are growing, as we saw above. In OECD countries their assets have doubled over the past 10 years to USD6trn. But governments, knowing that many people have failed to save enough for their retirement, are increasingly nudging workers to set up DC pensions. In the UK, for example, the National Employment Savings Trust (NEST), which begins operations in

Eurozone

Source: Federal Reserve, Bank of Japan, ONS, ECB

By contrast, UK insurers have cut their weighting to roughly the US level, 31% last year, down from over 50% in 2000. Data for Eurozone insurers does not go back far, but latest data show they have only 19% in equities. The new European insurance capital solvency directive, Solvency II, which comes into force in

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October this year, will automatically enrol all employees without an existing company pension (unless they opt out). Employers must contribute 1% (3% in future) and can contribute more. The attraction of DC plans to investment managers is that, since no liabilities are attached, there is much greater freedom in the types of investment products that can be offered. One of the most popular has been target-date, or lifestyling, plans which automatically shift asset allocation as people near retirement (financial textbooks state that investors should have maximum equity holdings until the age of about 50, then wind that down to 0% by the time they retire at 65). In some countries, target-date plans represent as much as 70% of the products sold to individual pension holders. Increasingly, retail investors with DC plans are demanding the sort of sophisticated products that previously were offered only to DB pensions plans and other institutions. This would include access to hedge funds (or hedge-fund-like absolute return products) and risk-aware funds. A challenge for investment managers in coming years will be to provide such services to retail investors at reasonable cost, while making sure that their clients understand the risks.
Post-retirement

5. No. of Americans turning 60 each five years (mn)

25 20 15 10 5 0
1976-1980 1981-1985 1986-1990 1991-1995 1996-2000 2001-2005 2006-2010 2011-2015 2016-2020 2021-2025 2026-2030

Source: United Nations

One of the key issues here is that, with bond yields at such low levels, annuities in bonds no longer work. The concept that, in retirement, you should stick to bonds for income and avoid risky assets such as equities is a non-starter. Moreover, life expectancy has improved: a US male aged 60 can expect to live at least another 20 years. In 1971, he would have expected to live only to 76. Increasingly, fund managers are telling retirees not to cash in all their growthy assets. Could there even be a market for longevity insurance?

Wealth management
It is very hard to know exactly how much private wealth there is out there (and it depends on how you define it). Estimates put the total at between USD26trn and USD120trn. What is clear, though, is that the wealth is growing rapidly (mainly in emerging markets) and that the wealthy are becoming more demanding about the sort of investment products they want. We will not run through here all the data for the number of high net worth individuals around the world. Suffice it to say that Wealth-Xs World Ultra Wealth Report 2012-2013 estimates the total wealth this year of ultra high net worth individuals (UHNWI) at USD25.8trn. Of that, USD8.9trn is in the US and USD3.4trn (13%) in

With a large cohort of retirees over the next few years, investment managers also sniff a big opportunity in post-retirement products: providing annuities, or other regular income-yielding strategies, for people whose DC pensions reach maturity. In the US, for example, 19 million people will turn 60 between 2011 and 2015, compared to 13 million a decade ago (Chart 5). Increasingly, investment managers are selling toand-through products, where holders of DC pensions are automatically tipped into a postretirement roll-over product.

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emerging markets (Chart 6). But, over the next five years, wealth in emerging market is expected to grow faster that that in developed countries: at an annual rate of 7.9% a year in Asia and 12.1% in Latin America, according to the report. At these growth rates, by 2017 emerging markets will represent 16% of global UHNWI wealth, or USD5.5trn out of USD33.9trn.
6. Estimated ultra high net worth individual wealth by region

confidence to start to buy stocks and to go to a private bank. In the US, for instance, almost 70% of household wealth is held in financial assets (as opposed to non-financial assets such as real estate); the corresponding percentage in China is 22%, in India 5% and Indonesia 2% (Chart 7). Over the next few years, high net worth individuals will also demand the sort of products institutions have previously been offered. They tend to be relatively risk-averse and so want riskminimising investments that nonetheless offer a decent return. They, too, are looking to separate alpha from beta, for example by placing a portion of their portfolio with hedge funds and leaving the rest in equity index funds. While this market offers juicy prospects for investment managers, it is not easy to access this wealth. Setting up private bank offices in Hong Kong, Singapore or Miami is all very well, but that misses a lot of the potential wealth. The Chinese and India domestic markets are still very hard for foreign investment institutions to enter. Those who have done so via joint ventures have, on the whole, not seen great success. But, given the potential size of assets to be gathered, they will not stop trying.

12 10 8 6 4 2 0
North America Latin America Middle East

2012

2017

USDtrn

Source: Wealth-X World Ultra Wealth Report 2012-2013

Increasingly, that wealth will be held in securities, and managed by professional fund managers. The usual pattern is that, as individuals in emerging markets first achieve wealth, they typically buy real estate and leave the rest of their money in the bank deposit. Only when their wealth grows and they became more sophisticated, do they gain the
7. Household wealth distribution by country

100 90 80 70 60 50 40 30 20 10 0 USA Taiw an UK Japan Singapore Germany China India Indonesia Non-Financial assets as % total assets Financial assets as % total assets

Source: The World Distribution of Household Wealth by James B. Davies, Susanna Sandstrom, Anthony Shorrocks, and Edward N. Wolff, University o9f Ontario, New York University, UNU-WIDER (2006), HSBC

40

Oceania

Europe

Africa

Asia

Multi Asset Strategy Global September 2012

Sovereign wealth funds


Sovereign wealth funds (SWFs) have been one of the big growth areas for investment managers in recent years. The total assets of sovereign funds, broadly defined, have grown to an estimated USD20trn at the end of last year, up from USD16trn only four years ago. Pure SWFs constitute only USD4.8trn of this, but FX reserve managers and other sovereign investment vehicles such as pension reserve funds, are increasingly important clients for international money managers (Chart 8). This is a particularly attractive area since the money is stable, these funds often have a fairly broad mandate (including the ability to buy into illiquid positions) and they are not liability constrained. Some CIOs argued to us that SWFs have been the main buyers of developed market equities over the past dew years.
8. Assets of sovereign wealth funds and similar (USDtrn)

and an investment tranche with the latter aiming to generate higher returns over the long run. Some of the pure SWFs have very adventurous asset allocation. At the conservative extreme, Chiles Economic and Social Stabilization Fund has 20% of its assets in cash and 80% in bonds (Chart 9). But a number of funds have high equity allocations (Norways USD525bn fund, for example, 60%). And several (for example, Irelands National Pensions Reserve Fund) have a significant allocation to alternative assets. Of course, we do not know the allocation of more secretive funds, such as the Abu Dhabi Investment Authority or Government of Singapore Investment Corp.
9. Selected SWFs asset allocation, end-2010

100% 80% 60% 40% 20% 0%


Australia Ireland Canada China Norway

Commodity Official FX reserv es, 8.1 SWFs, 2.7 Noncommd. SWFs, 2.1 Other sov ereign inv estment v ehicles*, 7.2
Source: TheCityUK estimates (*includes development funds, pension reserve funds, state-owned companies, reserve investment corporations)

Cash
Source: IMF

Equities

Fix ed income

Alternativ e assets

But SWFs face similar issues to other types of investors. How do they continue to generate returns with interest rates so low? Reserve managers which traditionally bought only highquality, liquid fixed income securities in major currencies (such as US Treasury bonds) are more and more being forced to look at other currencies and even at credit. Some central banks have split their reserves into a liquidity tranche

But it is not all good news for investment managers. The more sophisticated SWFs are bringing more funds back in-house, figuring they can manage the money more cost effectively by hiring experienced fund managers on attractive salaries. They may leave some money with external managers only to provide a benchmark to compare their internal managers against. There are also questions over how quickly SWFs can grow in future. Their rapid expansion of the past few years was due to high oil prices and to currency management by non-commodity producers, notably China. These conditions may not continue.

Korea

Chile

NZ

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The challenge of ESG


Pension plan sponsors, especially in Europe, are increasingly focusing on environment, social and governance issues So far, most fund managers pay only lip-service to this But momentum is building, and companies with superior ESG policies and disclosure might start to outperform

Unavoidable momentum
ESG (environmental, social, governance) and SRI (socially responsible investment) are buzzwords that have a lot of investment managers scratching their heads. They know that plan sponsors particularly for public pension funds in Europe increasingly take these concepts seriously, but many investment managers dont quite know how to respond.
1. SRI assets under management (USDtrn)

defined as a simple screening of companies (for example, excluding some on ethical grounds), integrating SRI principles into the fund managers processes, and engaging with management. Most fund managers would claim they do that. Core SRI, which includes positively screening for bestin-class companies or running an SRI thematic fund, totals USD1.7trn. And the SRI principles themselves as defined by the United Nations Principles for Responsible Investment (PRI) are hardly earth-shattering (Table 2). Most prudent fund managers would find they follow them without consciously having an SRI focus. But there is no doubt that ESG is becoming more important. Broad SRI assets in Europe have grown from almost zero in 2005 to USD8trn. Another estimate suggests that institutions managing funds totalling USD30trn have signed up to the UNs PRI. Public pension funds increasingly demand ESG compliance when putting out mandates for tender. One European investment manager told us that the firm already pays 20% of broker commission based on ESG service and expects this to rise to 40%.

10 8 6 4 2 0 2005 US SRI AUM ($tn)


Source: US SIF, Eurosif (definitions differ slightly)

2007

2010 Europe SRI AUM ($tn)

On the surface, assets managed under SRI principles are big: over USD8trn in Europe (notably, USD2.6trn in France) and around USD3trn in the US at end-2010 (Chart 1). But the definition of what comprises SRI is vague: 76% of the European SRI assets are broad SRI, which is

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2. United Nations Principles for Responsible Investment, and examples of possible actions 1 We will incorporate ESG issues into investment analysis and decision-making processes Address ESG issues in investment policy statements Support development of ESG-related tools, metrics, and analyses Assess the capabilities of internal investment managers to incorporate ESG issues 2 We will be active owners and incorporate ESG issues into our ownership policies and practices Develop and disclose an active ownership policy consistent with the Principles Exercise voting rights or monitor compliance with voting policy (if outsourced) Engage with companies on ESG issues 3 We will seek appropriate disclosure on ESG issues by the entities in which we invest Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative) Support shareholder initiatives and resolutions promoting ESG disclosure 4 We will promote acceptance and implementation of the Principles within the investment industry Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates, monitoring procedures, performance indicators and incentive structures accordingly (for example, ensure investment management processes reflect long-term time horizons when appropriate) 5 We will work together to enhance our effectiveness in implementing the Principles Support/participate in networks and information platforms to share tools, pool resources, and make use of investor reporting as a source of learning 6 We will each report on our activities and progress towards implementing the Principles Disclose how ESG issues are integrated within investment practices Disclose active ownership activities (voting, engagement, and/or policy dialogue) Report on progress and/or achievements relating to the Principles using a 'Comply or Explain'1 approach
Source: www.unpri.org

US investment managers are more ambivalent. ESG is growing much more slowly in the US although some labour unions are pushing for it in company pension schemes. Non-US clients often ask questions about ESG policies when offering mandates, and a number of US fund managers have signed up for the SRI principles without substantially changing their investment processes. More cautious or, perhaps, more punctilious US investment managers have set up internal committees to see what they need to do to adhere wholeheartedly to the principles. But the momentum is building. Pension consultancy firm Mercer will include its proprietary ESG ratings of investment managers in client reports related to manager searches and performance by the end of 2012. Mercer ranks investment firms from 1 (the highest rating) to 4 based on their incorporation of ESG factors in the generation of investment ideas, construction of portfolios and implementation of active ownership practices. Ratings are currently dismal: among equity managers worldwide, only 2% score a 1, and 7% a 2, with 44% rated 3, and 47% 4. Another pension consultant, TowersWatson,

also recently published a major report on sustainable investment. Most investment managers take the view that ESG is a positive force, as long as it is about adding value, for example engaging with companies on improving their policies on pay, governance, environmental compliance, corruption or treatment of employees. Which fund manager, after all, wants to buy a company that has problems in these areas? But many, especially in the US, worry that, taken too far, ESG can get in the way of making good investment returns. Exclusion is a step too far for many: avoiding investment in tobacco companies or arms manufacturers, for example, could damage performance. Increasingly, though, the trend in ESG is towards integration and governance (and in all asset classes, not just equities), with exclusion and environmental factors lagging. A further difficulty is that it is not easy to invest along SRI lines using passive strategies. There are only a few SRI indexes: for example, Dow Jones Sustainability World Index (W1SGI), Calvert Social Index (CALVIN), iShares MSCI USA ESG Index (KLD US) and MSCI World ESG Index

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(GSIN). There are also a number of specialist funds, such as the Domini Social Equity Fund (DSEFX US), and managers such as Zurich-based Sustainable Asset Management. But the performance of the SRI indexes has been lacklustre relative to their comparable main market indexes (Table 3). How much performance are investors or plan sponsors willing to give up in return for the satisfaction that their investments are doing no harm?
3. Performance* of SRI indexes Index Relative perf Compared 1Y 2Y to 5Y

Implications for asset prices


In our view, ESG is a concept that will expand further. Retail investors like the idea that they hold only honourable companies. So do governments and other public fund sponsors. Fund management firms will increasingly adjust their processes to take these preferences into account. Pressure will also increase on companies to be become more transparent on their ESG performance: the Hong Kong Stock Exchange, for example, recently announced that it will oblige listed companies to make certain ESG disclosures (or explain why they cannot) from 2015, with a recommendation that they do so from next year. The European Union has also published proposals for ESG disclosure by investment managers. With a recent focus on poor governance (notably in China), we think it likely that investors will start to focus more on ESG issues in the investment decision-making process. This may mean that companies with strong ESG disclosure and top-quality practices will outperform. This is certainly an area that fund managers will need to spend more time on.

Dow Jones Sustainability World Index Calvert Social Index iShares MSCI USA ESG Index MSCI World ESG Index

MSCI ACWI

-3.2% -5.8% -11.2% 1.9% n/a n/a

MSCI US 1.5% -0.2% MSCI US -3.7% -4.1% MSCI World -1.0% -1.9%

Source: HSBC, Bloomberg, MSCI (Total gross return inUSD)

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Notes

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Multi Asset Strategy Global September 2012

Disclosure appendix
Analyst Certification
The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Garry Evans

Important disclosures
Stock ratings and basis for financial analysis

HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions, which depend largely on individual circumstances such as the investor's existing holdings, risk tolerance and other considerations. Given these differences, HSBC has two principal aims in its equity research: 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon; and 2) from time to time to identify short-term investment opportunities that are derived from fundamental, quantitative, technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating. HSBC has assigned ratings for its long-term investment opportunities as described below. This report addresses only the long-term investment opportunities of the companies referred to in the report. As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at www.hsbcnet.com/research. Details of these short-term investment opportunities can be found under the Reports section of this website. HSBC believes an investor's decision to buy or sell a stock should depend on individual circumstances such as the investor's existing holdings and other considerations. Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations. Investors should carefully read the definitions of the ratings used in each research report. In addition, because research reports contain more complete information concerning the analysts' views, investors should carefully read the entire research report and should not infer its contents from the rating. In any case, ratings should not be used or relied on in isolation as investment advice.

Rating definitions for long-term investment opportunities


Stock ratings

HSBC assigns ratings to its stocks in this sector on the following basis: For each stock we set a required rate of return calculated from the cost of equity for that stocks domestic or, as appropriate, regional market established by our strategy team. The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon. The performance horizon is 12 months. For a stock to be classified as Overweight, the potential return, which equals the percentage difference between the current share price and the target price, including the forecast dividend yield when indicated, must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile*). For a stock to be classified as Underweight, the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile*). Stocks between these bands are classified as Neutral. Our ratings are re-calibrated against these bands at the time of any 'material change' (initiation of coverage, change of volatility status or change in price target). Notwithstanding this, and although ratings are subject to ongoing management review, expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change.

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Multi Asset Strategy Global September 2012

*A stock will be classified as volatile if its historical volatility has exceeded 40%, if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility. However, stocks which we do not consider volatile may in fact also behave in such a way. Historical volatility is defined as the past month's average of the daily 365-day moving average volatilities. In order to avoid misleadingly frequent changes in rating, however, volatility has to move 2.5 percentage points past the 40% benchmark in either direction for a stock's status to change.

Rating distribution for long-term investment opportunities


As of 26 September 2012, the distribution of all ratings published is as follows: Overweight (Buy) 48% (27% of these provided with Investment Banking Services) Neutral (Hold) Underweight (Sell) 38% 14% (26% of these provided with Investment Banking Services) (22% of these provided with Investment Banking Services)

Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues. For disclosures in respect of any company mentioned in this report, please see the most recently published report on that company available at www.hsbcnet.com/research. * HSBC Legal Entities are listed in the Disclaimer below.

Additional disclosures
1 2 3 This report is dated as at 26 September 2012. All market data included in this report are dated as at close 19 September 2012, unless otherwise indicated in the report. HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or price sensitive information is handled in an appropriate manner.

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Multi Asset Strategy Global September 2012

Disclaimer
* Legal entities as at 8 August 2012 Issuer of report UAE HSBC Bank Middle East Limited, Dubai; HK The Hongkong and Shanghai Banking Corporation The Hongkong and Shanghai Banking Limited, Hong Kong; TW HSBC Securities (Taiwan) Corporation Limited; 'CA' HSBC Bank Canada, Corporation Limited Toronto; HSBC Bank, Paris Branch; HSBC France; DE HSBC Trinkaus & Burkhardt AG, Dsseldorf; 000 Level 19, 1 Queens Road Central HSBC Bank (RR), Moscow; IN HSBC Securities and Capital Markets (India) Private Limited, Mumbai; Hong Kong SAR JP HSBC Securities (Japan) Limited, Tokyo; EG HSBC Securities Egypt SAE, Cairo; CN HSBC Investment Bank Asia Limited, Beijing Representative Office; The Hongkong and Shanghai Banking Telephone: +852 2843 9111 Corporation Limited, Singapore Branch; The Hongkong and Shanghai Banking Corporation Limited, Seoul Telex: 75100 CAPEL HX Securities Branch; The Hongkong and Shanghai Banking Corporation Limited, Seoul Branch; HSBC Fax: +852 2596 0200 Securities (South Africa) (Pty) Ltd, Johannesburg; HSBC Bank plc, London, Madrid, Milan, Stockholm, Tel Website: www.research.hsbc.com Aviv; US HSBC Securities (USA) Inc, New York; HSBC Yatirim Menkul Degerler AS, Istanbul; HSBC Mxico, SA, Institucin de Banca Mltiple, Grupo Financiero HSBC; HSBC Bank Brasil SA Banco Mltiplo; HSBC Bank Australia Limited; HSBC Bank Argentina SA; HSBC Saudi Arabia Limited; The Hongkong and Shanghai Banking Corporation Limited, New Zealand Branch incorporated in Hong Kong SAR This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (HSBC) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers; it is not intended for and should not be distributed to retail customers in Hong Kong. The Hongkong and Shanghai Banking Corporation Limited is regulated by the Hong Kong Monetary Authority. All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong. If it is received by a customer of an affiliate of HSBC, its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate. This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified; HSBC makes no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness. Expressions of opinion are those of the Research Division of HSBC only and are subject to change without notice. HSBC and its affiliates and/or their officers, directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment). HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of companies discussed in this document (or in related investments), may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those companies. HSBC Securities (USA) Inc. accepts responsibility for the content of this research report prepared by its non-US foreign affiliate. All U.S. persons receiving and/or accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc. in the United States and not with its non-US foreign affiliate, the issuer of this report. In the UK this report may only be distributed to persons of a kind described in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001. The protections afforded by the UK regulatory regime are available only to those dealing with a representative of HSBC Bank plc in the UK. In Singapore, this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited, Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (SFA) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA. This publication is not a prospectus as defined in the SFA. It may not be further distributed in whole or in part for any purpose. The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore. Recipients in Singapore should contact a "Hongkong and Shanghai Banking Corporation Limited, Singapore Branch" representative in respect of any matters arising from, or in connection with this report. In Australia, this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970, AFSL 301737) for the general information of its wholesale customers (as defined in the Corporations Act 2001). Where distributed to retail customers, this research is distributed by HSBC Bank Australia Limited (AFSL No. 232595). These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law. No consideration has been given to the particular investment objectives, financial situation or particular needs of any recipient. This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited, New Zealand Branch incorporated in Hong Kong SAR. In Japan, this publication has been distributed by HSBC Securities (Japan) Limited. It may not be further distributed in whole or in part for any purpose. In Korea, this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited, Seoul Securities Branch ("HBAP SLS") for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (FSCMA). This publication is not a prospectus as defined in the FSCMA. It may not be further distributed in whole or in part for any purpose. HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea. In Canada, this document has been distributed by HSBC Bank Canada and/or its affiliates. Where this document contains market updates/overviews, or similar materials (collectively deemed Commentary in Canada although other affiliate jurisdictions may term Commentary as either macro-research or research), the Commentary is not an offer to sell, or a solicitation of an offer to sell or subscribe for, any financial product or instrument (including, without limitation, any currencies, securities, commodities or other financial instruments). Copyright 2012, The Hongkong and Shanghai Banking Corporation Limited, ALL RIGHTS RESERVED. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, on any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of The Hongkong and Shanghai Banking Corporation Limited. MICA (P) 038/04/2012, MICA (P) 063/04/2012 and MICA (P) 206/01/2012

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Garry Evans* Global Head of Equity Strategy The Hongkong and Shanghai Banking Corporation Limited +852 2996 6916 garryevans@hsbc.com.hk Garry heads HSBC's equity strategy team worldwide. His previous roles at HSBC include Asia Pacific Equity Strategist, Head of Pan-Asian Equity Research, and Japan Strategist. Garry began his career as a financial journalist and was editor of Euromoney magazine for eight years before joining HSBC in Tokyo in 1998. Garry is based in Hong Kong.

*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations.