Global Investor 1.15, May 2015
Expert know-how for Credit Suisse investment clients
INVESTMENT STRATEGY & RESEARCH
Unwrapping alternative returns
Roger Ibbotson Are investors rewarded or penalized for holding illiquid stocks?
Sven-Christian Kindt Exploring the upside of new illiquid alternatives.
Alexander Ineichen Hedge funds overcome recent challenges.
Carol Franklin Trees represent a growth opportunity for the patient investor.
Important information and disclosures are found in the Disclosure appendix
Credit Suisse does and seeks to do business with companies covered in its
research reports. As a result, investors should be aware that Credit Suisse may
have a conflict of interest that could affect the objectivity of this report.
Investors should consider this report as only a single factor in making their investment
decision. For a discussion of the risks of investing in the securities mentioned in
this report, please refer to the following Internet link:
GLOBAL INVESTOR 1.15 — 03
Photos: Martin Stollenwerk, Gerry Amstutz
Responsible for coordinating the focus
themes in this issue:
Oliver Adler is Head of Economic
Research at Credit Suisse Private Banking
and Wealth Management. He has a
Bachelor’s degree from the London
School of Economics, as well as a Master
in International Affairs and a PhD in
Economics from Columbia University
in New York.
Markus Stierli is Head of Fundamental
Micro Themes Research at Credit Suisse
Private Banking and Wealth Management.
His team focuses on long-term investment
strategies, including sustainable
investment and global megatrends. Before
joining the bank in 2010, he taught at
the University of Zurich. He previously
worked at UBS Investment Bank. He
holds a PhD in International Relations
from the University of Zurich.
Standard financial theory tells investors to carefully assess the tradeoff
between return and risk. Liquidity is a third key consideration. This
Global Investor (GI) is about the liquidity and illiquidity of individual
assets and overall financial markets. Just as risk and return are uncertain
before the fact, so is liquidity. Some assets may appear highly
liquid, only for their liquidity to suddenly vanish. Moreover, changes
in liquidity often correlate with shifts in risk. As our article on fixed
income (page 62) points out, some more exotic bonds become very
hard to sell just as their perceived risk increases, and when less liquid
assets are pooled in typical (open-end) funds, such difficulties can
be amplified (see page 24).
This does not imply at all that we would advise against investing
in illiquid assets. In fact, assets that eventually generate high returns
are very often highly illiquid. Those who invested in Apple, Google
or Microsoft when they were small (unlisted!) ventures run out of
“garages” garnered huge returns. Apart from private equity, this GI
covers a broad range of other more or less illiquid assets – ranging
from forests to farmland to infrastructure, and from real estate, the
most common of illiquid assets, to the most exotic “passion” investments.
We also look at the pros and cons of investing in hedge funds,
which are not necessarily particularly illiquid, but where the sources
of return are often harder to identify than those of other more visible
Adrian Orr, CEO of the New Zealand Superannuation Fund, known
for its innovative investment philosophy, points out (page 26) that
even investors with long horizons should gauge the liquidity of their
overall portfolio carefully: investments in illiquid assets should be
balanced by some that can be easily sold. This rule is of even greater
importance for private investors whose investment horizon is
typically shorter and where the potential for a drastic change in
personal circumstance (and thus need for liquidity) is that much more
pronounced. The temptation of abandoning such caution seems particularly
high at a time when both nominal and real expected returns
on the most liquid of assets are so meager. Conversely, investors
should avoid overpaying for liquidity: Professor Ibbotson (page 10)
argues that investors tend to overrate (and thus overpay for) the
benefits of owning large cap stocks. The fact that these assets can
be traded in almost any circumstance may not only render them
more expensive but also prone to excessive price gyrations. In sum:
make sure that the analysis of risk and return is complemented with
a careful review and “stress test” of the liquidity of assets and
Giles Keating, Head of Research and Deputy Global CIO
GLOBAL INVESTOR 1.15 — 04
THE ALLURE OF
CURSE OR BLESSING?
TEXT MARKUS STIERLI Head of Fundamental Micro Themes Research
ILLUSTRATION FRIDA BÜNZLI
What do we know
A particular focus of this Global
Investor is on market liquidity.
By this we mean the presence –
or absence – of the ability to
sell (liquidate) an asset quickly,
without impacting the market
price significantly, and without
For many asset classes, bid-ask spreads are
a convenient and straightforward way to measure
market liquidity, with declining (tightening)
spreads indicating greater liquidity, and
vice versa. The spread is simply the cost that
you would incur if you were to sell an asset
on the market and immediately purchase it
back. But, as we will discuss throughout this
Global Investor, the concept of market liquidity
is more complex than that. To start with,
the bid-ask spread is not easy to measure for
many assets, such as real estate. Moreover,
market liquidity typically varies dramatically
across the cycle. Some assets
are highly liquid in
the upswing or the top of the
cycle, but become less liquid
in a downswing. Lastly, instruments
matter. For example,
closed-end funds can deviate
from the value of the underlying
assets, which is bad in some ways,
but may also help protect long-term
investors. Some vehicles, such as private
equity funds and hedge funds, may impose
so-called “gates” on their investors to limit
In the wake of the financial
crisis, the liquidity of the
financial system became
synonymous with its “lifeblood.”
Large injections of
liquidity by central banks (the
ultimate creators of liquidity)
were necessary to save those who “bled”;
the provision of liquidity to safeguard the
economy has remained paramount ever since.
In this context, macroeconomic liquidity does
GLOBAL INVESTOR 1.15 — 05
Investors and firms share a common problem:
liquidity risk premiums are hard to gauge, both
across different types of assets and over time.
Liquidity does not manifest itself in standard
measures of risk, such as price volatility. In
fact, in normal times, illiquid investments are
not necessarily more volatile than liquid ones.
Of course, price volatility may simply be hidden
because illiquid investments are priced
at lower intervals – turnover is itself a definition
of liquidity. However, even in equity markets,
as we learn from Yale’s Roger
Ibbotson (see page 10), lower turnover
stocks actually proved more resilient
(and less volatile) during the financial
crisis in 2008 than their highly liquid peers.
Bringing it all together
not really refer to
the availability of cash
in the economy, but rather
to the smooth functioning of financial markets
and thus the economy as a whole. To a financial
firm, liquidity refers to the ability to meet
its debt obligations without becoming insolvent.
While cash holdings (a liquid balance
sheet) provide a buffer against losses, the
ability to convert assets into cash to meet
current and future cash flows – its funding
liquidity – can prove critical for survival in the
event of stress. Therefore, funding liquidity is
now a key regulatory imperative. Nevertheless,
central banks ultimately will always need
to act as a backstop to commercial banks; as
the role of commercial banks is typically to
invest clients’ liquidity (deposits) in less liquid
assets, they would structurally not have sufficient
liquidity to withstand a bank run.
On premiums and risk
While the different concepts of liquidity are
often treated in isolation, it is essential to try
to understand how they interact. We know
that liquidity black holes wiped out entire
markets, such as the junk bond market in
the mid-1990s, and the subprime mortgage
market more recently. We understand that the
deterioration of balance sheets forced banks
to cease lending, resulting in a vicious liquidity
squeeze that required significant policy
intervention to restore confidence so that the
financial system could fulfill its most basic
purpose. The most challenging part of the
liquidity discussion is that it depends heavily
on circumstances. The financial crisis was
such a profound event that it still has a significant
impact on investors’ attitudes toward
illiquid investments. Consequently, entire asset
classes are being shunned, sometimes
unjustifiably, and genuine opportunities will
be exited prematurely or missed altogether.
In other cases, investors may actually end up
paying too much for liquidity. If history has
taught us one thing about liquidity, it is that it
is often self-fulfilling, and at times a mirage.
GLOBAL INVESTOR 1.15 — 06
GLOBAL INVESTOR 1.15 — 07
GLOBAL INVESTOR 1.15 — 08
GLOBAL INVESTOR 1.15 — 09
Global Investor 1.15
Psychology and (il)liquidity
Liquidity has its price. But, says Roger
Ibbotson, with equities the popular choice
has a premium that may be too high.
Liquidity trends in illiquid
Amid rising interest in less liquid alternatives,
Sven-Christian Kindt points out the
reward for sacrificing unneeded liquidity.
On doing your homework
If you’ve first done your research, says
Alexander Ineichen, hedge funds may
bring higher end returns with less volatility.
Liquidity – a key to hedge fund
It’s a key factor. Marina Stoop examines
the role that liquidity plays in hedge funds
and for their investors.
Open-end versus closed-end funds
The right investment, say Giles Keating
and Lars Kalbreier, is a function of the
underlying asset type and the kind of fund.
At the helm of the New Zealand Superannuation
Fund, Adrian Orr talks about
patience, opportunity and very long horizons.
She has branched out. Carol Franklin has
a diverse background including language,
insurance and plantation ownership.
It’s not easy going green. Gregory Fleming
explains why institutional investors
see timberland as a growth opportunity.
Farmland – a fertile investment
With dairy farming interests, and over 20
years in asset management, Griff Williams
knows plenty about farmland investment.
Ins and outs of real estate
It’s an illiquid asset, but real estate is
attracting growing interest. Philippe
Kaufmann offers his insights and advice.
Infrastructure on the rise
Institutional investors are flocking toward
infrastructure. Robert Parker explains why
building for the future is a big deal today.
Looking beyond liquidity
Felix Baumgartner and Patrick Schwyzer
reflect on client perspectives of the illiquid
In passion we trust
Art, antiques and collectibles: Art Market
Research and Development looks at
a different kind of alternative investment.
From illiquid assets to profitable
The European Central Bank is working
to restore the European securitization
market, report Christine Schmid and
Carla Antunes da Silva.
There’s lower and more volatile liquidity in
the corporate bond markets. Jan Hannappel
outlines the causes and the implications.
Disclaimer > Page 65
GLOBAL INVESTOR 1.15 — 10
Photos: Robert Falcetti
Roger Ibbotson, founder, chairman and CIO of Zebra Capital Management.
GLOBAL INVESTOR 1.15 — 11 >
Maintaining a certain amount of liquidity in a portfolio is fully justified, but investors tend
to pay up too much for it while underestimating the extra returns from holding illiquid assets.
The overpricing of liquidity seems to be greater in equities than in bonds, in part because
in equities the price is strongly influenced by “stories,” whereas in bonds it is dry mathematics.
INTERVIEW BY OLIVER ADLER Head of Economic Research, JOSÉ ANTONIO BLANCO Head Global MACS,
SID BROWNE CIO and Head of Research Liquid Alternatives
Sid Browne: Economic theory states that
there should be a premium available for
accepting illiquidity. You’ve studied premiums
– and associated risks – attached to
both illiquid and liquid assets. What can you
tell us about your findings in general within
a portfolio context? How should institutional
and private investors invest?
Roger Ibbotson: Let me start off by
saying that the stocks that I study are actually
publicly traded stocks. They may be less
liquid than the most liquid stocks, but they’re
all liquid stocks. There’s a strong theoretical
reason why you’d expect less liquid stocks,
in fact less liquid assets of any type, to be
lower valued. People want liquidity, and
they’re willing to pay for it. They pay a higher
price for the most liquid assets, and therefore
the less liquid assets sell at a discount.
That discount means that, for the same
cash flows, you pay a lower price and
sub sequently you get higher returns. Now,
what’s especially interesting in liquid markets
is that giving up a little bit of liquid -
ity actually can have a surprisingly big
impact – by buying stocks that trade every
hour, say, as opposed to every minute.
José Antonio Blanco: From an investor’s
perspective, could you call the effect you’ve
just described a risk premium, or is it
instead the result of market inefficiency in
the sense that investors focus on certain
companies and disregard the rest?
Roger Ibbotson: It could be both.
You can create a risk factor from a liquidity
premium. But I am rather thinking of
something I call a “popularity” premium,
which I’ve expanded on in recent papers.
The stocks that trade the most are the
most popular. And those are the ones
where there is mispricing because they get
to be “too” popular, as measured for example
by their heavy trading. Interestingly, our
measures of stocks that trade less show
lower volatility. So these stocks don’t really
seem more risky. Therefore I don’t really
like calling the extra return a risk premium.
Sid Browne: What about in the event of a
squeeze, when all of a sudden you want
liquidity and rush to sell your illiquid stocks?
Isn’t there that flight-to-quality risk?
Roger Ibbotson: There could be the risk
of having to sell quickly. In actual experience,
though, for example in 2008 when you had
a kind of a liquidity crisis, it was the most
liquid stocks that were sold and dropped the
most. So even in a financial crisis, the less
liquid stocks do relatively well compared to
the more liquid stocks. Now it is true that it
is more difficult to sell the less liquid, and
GLOBAL INVESTOR 1.15 — 12
people chose not to sell them. But it is still
a fact that their prices fell much less than
those of more liquid stocks.
Sid Browne: So would it make sense to
have a very large exposure in your portfolio
to these types of stocks?
Roger Ibbotson: If you’re a day trader,
you don’t want to buy these kinds of stocks
because they’re going to have higher trading
costs. It really depends on your horizon.
If you have a longer horizon, then buying
less liquid stocks can make sense.
Oliver Adler: Could you discuss the parallels
in the bond market, or segments of the
bond market, in terms of what those
liquidity or illiquidity premiums would look
Roger Ibbotson: Well, first of all, bond
markets are in the fortunate position of
having yields to maturity that you can actually
see. You know that if the bond doesn’t
default, you’re going to get a specific return
in that particular currency. And you know
it in advance.
In the equity market, you can’t see the
forward returns in the same way. You only
see the result. And since returns themselves
are very volatile, it’s hard to discern
what the result really is. Moreover, the return
measures differ strongly over different
periods. That’s why we can debate which
of these premiums really exist and how high
they are. This is quite different in bond
markets where maturities are normally fixed.
Oliver Adler: Would you say that the stock
market gives rise to more irrational behavior
in some sense than the bond market?
Roger Ibbotson: I’m sure there is irrational
behavior in the bond market, too. But
yes, there is behavior in the equity market
where essentially people are attracted to
stocks that trade a lot. And they’ll pay more
for them, just as you would do with brands
in the consumer market. Consequently,
the return structure is going to be different
among the less popular and the more popular,
and that leads to mispricing. Of course,
you’re also going to see mispricings in
the bond market, but they may be smaller
there and they’re more visible and thus
easier to take advantage of.
Sid Browne: You’re saying that something
could be more popular in the equity market
than it would be in the bond market.
So Apple stock, for example, could go
“hot” and very, very liquid, but the debt,
because it’s traded less and because
it is a discounted flow of more certain
is that giving
up a little
bit of liquidity
can have a
cash payments, would actually not be
impacted by this popularity phenomenon.
Roger Ibbotson: It could be affected,
but it would not be affected by as much
because you can see the pricing exactly in
a yield spread. And so you know exactly
what you’re paying for.
José Antonio Blanco: Are you saying that
we have more serious information issues
in the equity than in the bond market?
If you compare two bonds, it’s relatively
easy to find the one that is paying too
much, or too little. Whereas, for a stock,
you might look at the past, but the future
is much more difficult to assert. So, as
an investor, you tend to grab things that are
a bit easier to recognize, like brand names,
along the lines “if something is popular,
it’s probably better.”
Roger Ibbotson: Yes. In the equity
markets, you can tell stories about
the stock. And the stories can be very interesting.
And you can pay a lot for stories.
That’s why, for example, value tends to
have higher returns than growth. Growth
gets highly priced because growth
companies have much more interesting
stories than value companies. In the bond
market, all these same phenomena may
exist, but there is more information.
It’s much more mathematical. The spreads
Oliver Adler: How about areas like private
equity, or hedge funds, where you need
a lot of knowledge and can’t easily
tell stories? Might it therefore be fair to
say that mispricing phenomena occur
less frequently here?
Roger Ibbotson: Well, mispricing can
be pretty frequent in private equity as well
because there’s actually less information
for the buyer. You need more specialized
expertise to understand the specific stocks.
Also, in private equity, the presumption is
that the private equity manager not only
identifies undervalued stocks, but actually
changes the company in some way to make
it more valuable, perhaps by getting tax
benefits, restructuring management or
altering incentives. So there are potentially
more possibilities for profit if you’re really
good at doing that.
Hedge funds typically buy publically
traded equities or bonds – more or
less liquid securities. When you invest in
a hedge fund, you are essentially buying
the manager who is buying liquid
continued on page 14 >
GLOBAL INVESTOR 1.15 — 13
In periods of market stress, investor scrutiny
often moves onto lower-rated financial
instruments that have been issued
with a premium yield level attached.
Concerns about the ability of issuers to meet
ongoing cash obligations for coupon payments
can lead to investor flight from speculative
bonds, just at the moment when those issuers
most need to shore up their finances to remain
in business. Classic examples might be riskier
consumer finance companies, smaller oil and
gas firms, and heavily leveraged property
developers. If the stress period persists, such
issuers are often unable to raise suffi cient
short-term debt to maintain their trading
activities and, if undercapitalized, they may
Defaults in this riskier zone can prove contagious,
both because of the effect on other
parties exposed to a given sector or deal, and
due to the psychological effect on the general
investing public. A vicious illiquidity circle
can develop, as occurred in real estate loans
in 2008–2009, and may require government
intervention and ultimately debt write-downs.
Liquidity, a key element of credit analysis
In order to provide additional transparency in
its existing liquidity assessment process and
arm investors willing to hold speculative- grade
debt against falling foul of rapid shifts in market
sentiment, the rating agency Moody’s
began assigning Speculative Grade Liquidity
(SGL) ratings in 2002. Loss of access to funding
remains a risk criterion in any assessment.
Defining speculative-grade liquidity
risk as “the capacity to meet obligations,”
SGLs describe an issuer’s intrinsic liquidity
posi tion on a scale of 1 (very good) to 4 (weak).
Assignment of a rating is carried out under
detailed criteria for measuring a company’s
ability to meet its cash obligations through
cash, cash flow, committed sources of external
cash, and potentially available options for
raising emergency cash through asset sales.
SGLs are a measure of issuers’ intrinsic
liquidity risk – meaning Moody’s assumes
companies do not have the ability to amend
covenants in bank facilities or raise new cash
that is not already committed. Such conditions
are not typical in normal market environments,
but can occur in periods of economic and
credit market stress when companies need
liquidity support the most to avoid default.
Because Moody’s factors market access and
the ability to amend covenants into its longterm
ratings, the assumptions utilized in analyzing
liquidity are more stringent.
One proviso that Moody’s noted from the
outset is that liquidity assessments focus on
corporate capacity to meet obligations. Willingness
to default remains a management
issue that is not factored into SGL ratings, but
is separately evaluated as part of the longterm
ratings analysis. Ratings are dynamic and
may be modified ad hoc, as with bond ratings.
To date, Moody’s assigns SGL ratings to
US and Canadian issuers alone, although
the framework is used in most other regions
as well. Moody’s maintains SGL ratings on
appro ximately 840 issuers, with USD 1.8 trillion
in rated debt.
Index summarizes the market conditions
Moody’s also created the Liquidity Stress
Index (LSI) to provide a broad indication of
speculative-grade liquidity. The LSI is the percentage
of SGL issuers with the weakest
(SGL-4) rating. Changes in corporate earnings,
borrowing costs and ease of new debt
issuance are critical drivers of changes in the
LSI over time. Credit cycles tend to lead the
economic cycle because willingness to leverage
into expanding economic activity has to
occur before the activity itself gets underway
in the real economy.
Speculative-grade companies do not have
access to the commercial paper markets, so
they are generally unable to quickly raise new
financing in crisis moments. Measuring their
riskiness essentially boils down to gauging
the free cash flow from operations, cash on
hand, and committed financing from other
sources such as revolving credit facilities (the
latter is not part of the SGL analysis.)
More than 12 years after the introduction
of SGLs, the track record now includes both
extended periods of more-than-ample liquidity
and phases of unprecedented risk and
market stress. The LSI’s long-term average
value since inception is 6.8%, with a record
high reading of 20.9% in March 2009 at the
height of the financial crisis in the US. The
lowest level reached by the index was 2.8%
in April 2013, with default and illiquidity risks
exceptionally low. At the start of 2015, the
index was still very benign at 3.7%, indicating
a below-average forecast of the default rate
of speculative-grade companies in the course
of this year. Higher risks from falling oil prices
were balanced against the steady earnings
gains from US consumer spending.
John Puchalla, Senior Vice President,
Corporate Finance Group at Moody’s
+41 44 334 78 93
GLOBAL INVESTOR 1.15 — 14
Oliver Adler: What sorts of issues come
up in terms of liquidity and premiums
with some of the more obscure asset
classes, like infrastructure, or the
not-so-obscure ones, like real estate?
Roger Ibbotson: Well, of course, something
like real estate is by its nature very
illiquid. But there are structures that you
can buy, like REITs (real estate investment
trusts), that make it more liquid. If you put
real estate into a structure that makes it
more liquid, it tends to be more highly valued.
A REIT is a more expensive way to buy
real estate, but of course it has the benefit
of being liquid. On the other hand, if by
buying real estate you actually get involved
in managing it, it’s a much more complicated
thing. That’s more like private equity.
All of these things are less liquid, and they
all should have illiquidity premiums. I suspect
that a lot of the return from real estate
comes from its illiquidity premium.
Oliver Adler: Given that the different asset
classes seem to have different characteristics,
how do you deal with the liquidity
issue when you put everything together
into a portfolio?
Roger Ibbotson: People need a certain
amount of liquidity. If you’re going to have
a lot of illiquid assets, you also need some
liquid assets to meet your liquidity needs.
On the one hand, people should not pay
for liquidity they don’t need. On the other
hand, they may need more liquidity than
There’s a danger in going into too many
illiquid assets, like real estate and infrastructure
and private equity. Some of
the universities, for example, did get into
a bit of a squeeze in the financial crisis.
They could not get very good prices for
their private equity investments. One of the
benefits of the kinds of stocks I’ve been
talking about is that they can easily be
sold in any crisis without paying much of
a discount at all.
Oliver Adler: But might it be possible
to argue that illiquid assets could help to
put a break on investors’ impulses
to sell at the wrong time and save them
from making mistakes?
Roger Ibbotson: That’s an interesting
argument. And, of course, there is evidence
that overall stock market trends go in the
opposite direction of what retail investors
do: retail tends to sell after the crash and
buy after the rise. So if retail investors were
somehow prevented from overtrading, they
might perform better. But the truth is that
people want liquidity even though it sometimes
leads them to take the wrong actions.
José Antonio Blanco: Once you know
what your liquidity needs are, is there a fair
reward for real illiquidity? Or could you
also achieve a higher return by structuring
liquid assets, for example by exploiting
anomalies or special effects, as you’ve
described (I don’t want to call it risk
premiums)? In other words, do you think the
illiquidity premium is overestimated?
Roger Ibbotson: I think one aspect
of what you are speaking about is the ability
to achieve “alpha” (a measure of outperformance
relative to some asset class or
benchmark). To get a lot of alpha, you may
need to do a lot of trading. People are
overconfident, of course, of their ability to
achieve alpha. But the more you believe you
can create alpha, the more you want liquidity
because it is the lower-cost assets that
may allow you to achieve alpha.
In contrast, if you have long horizons,
then you’re the natural type of investor
to go after illiquidity premiums. The fact is,
though, many people believe they can
create alpha – some legi timately, and others
who just think they can – and they will pay
up for it. I don’t see that going away. So,
the market will tend to pay too much for
liquidity, and conversely underestimate the
The founder of Zebra Capital Management
in 2001, Roger Ibbotson is also
Professor in the Practice Emeritus
of Finance at the Yale School of
Management. He has written numerous
books and articles, including “Stocks,
Bonds, Bills and Inflation” with Rex
Sinquefield (updated annually), which
serves as a standard reference for
information on capital market returns.
GLOBAL INVESTOR 1.15 — 15
Fundamental Micro Themes Research
+41 44 334 88 57
Fundamental Micro Themes Research
+91 22 6607 3707
The untapped potential
of emerging markets
Emerging markets make up:
of global output
of global stock market capitalization
of global private equity fund-raising
of global private equity investments
At USD 29 billion, emerging market private equity
fund-raising has been concentrated in emerging
Asia, but growth has been the fastest in Africa.
USD 4 bn
USD 29 bn
In the USA, private equity achieved annual returns
of around 16% over 2009–2014. Only 39% of
limited partners surveyed expect that the USA
will be able to sustain that level in 2015. 57%
of limited partners expect emerging market private
equity portfolios to achieve net returns of 16%
or greater in 2015. Historical annual returns for
emerging market private equity were around
13% over 2009–2014. Emerging market equities
only returned around 4% over the same period.
In comparison, US private equity trailed US equity
markets in terms of returns.
The promise of venture capital
Emerging market private equity investments
increased by 60% in value between 2009 and
2014. In the same period, venture capital investment
value increased sevenfold, now making up
more than 20% of total private equity investments
in emerging markets. Technology investments
have more than tripled in the same period.
Emerging market private equity by strategy, USD bn
* 2014 vs 2009
Buyout Growth PIPE Venture capital
Data sources used for the article: Datastream, Emerging Market Private Equity Association, Preqin
Not all markets are equal
Private equity investments expanded rapidly
in China, Brazil and Nigeria, shrank slightly in
India and collapsed dramatically in Russia
and South Africa between 2009 and 2014.
Private equity capital invested
in key emerging markets, USD bn
In search of exit
Asian venture capital investments have started
to find viable exits through IPO routes. The
aggregate value of venture capital exits quadrupled
over 2013–2014 to reach USD 38 billion.
Number of Asian venture capital exits
USD 9 bn
Aggregate exit value
Trade sale IPO
Write-off Sale to GP
USD 38 bn
Moving up the value chain
African private equity is moving up the value chain,
away from extractive industries.
PE investments in 2014,
Oil and gas
PE investments in 2009,
GLOBAL INVESTOR 1.15 — 16
Investors are increasingly showing appetite to commit to less-liquid alternatives. This includes
investment opportunities in areas such as private equity, private debt and real assets. According
to a recent study, shifting from liquid assets in which the primary investment return results
from the market’s (or benchmark’s) movements to less liquid investments in which the primary
source of the return is due to a fund manager’s skill at navigating an investment to a successful
outcome typically results in a median return premium of 20%–27% over a fund’s life, and
more than 3% per year. This illiquidity premium can be further enhanced by investing with the
best-performing managers. These managers typically generate top-quartile investment returns
and outperform the median performance benchmark by as much as 20 percentage points.
Despite the opportunity to enhance overall portfolio returns (while reducing exposure to daily
market volatility), individual investors tend to be under-allocated to illiquid alternatives relative to
institutional investors. One oft-cited reason is the restriction on withdrawals of ten years or
longer before fully returning capital and profits to investors. However, the recent growth of shorter
duration and yield-producing investment strategies, such as direct lending to small and mediumsized
enterprises, coupled with the emergence of a secondary market for early liquidity,
may result in greater comfort with and more appropriate allocations to illiquid alternatives.
AUTHOR SVEN-CHRISTIAN KINDT
Head Private Equity Origination & Due Diligence, Credit Suisse
Photo: Biwa Studio / Getty Images
GLOBAL INVESTOR 1.15 — 17
The illiquidity premium
The term “liquidity” refers to the ease with which
an asset can be converted into cash. Assets
or securities that can be easily bought and sold,
such as bonds and publically traded stocks, are
considered liquid. Private equity, private debt
and real assets, in contrast, are said to be illiquid.
Investment returns tend to increase with the
degree of illiquidity of the asset. A recent study
of nearly 1,400 US buyout and venture capital
funds found that the aggregate performance
of these funds has consistently exceeded the
performance of the S&P 500 by 20%–27% over
a fund’s life, and more than 3% annually.
Investment returns generally
increase with illiquidity
Compound gross annual returns in %
1 2 3 4 5
The manager premium
An increase in illiquidity shifts the primary source
of the investment return from movements of
the market itself (or beta) to a fund manager’s
knowledge or skill at navigating an investment to
a successful outcome. Manager skills influence
the returns of illiquid alternatives primarily
through strategic and/or operational improvements
brought to portfolio companies. For example,
a manager may be particularly able to increase
portfolio company sales, reduce operating expenses,
optimize asset utilization or exploit leverage.
The potential for upside in illiquid alternatives is
therefore driven not only by exposure to a specific
illiquid category but also by investing with the
best-performing managers. This is evident in the
graph below, which shows that the return difference
between top and bottom quartile managers
can be over 30 percentage points in private equity.
increases as illiquidity grows
Return differential vs median in %
Median 2nd quartile
–10 bottom decile
fixed income equity
Individual investor allocation
Relative to individuals, many institutional investors
with long investment horizons, such as
pension plans (with their liabilities for retirees)
and endowments (with their ongoing operating
budgets), have built up significant allocations
to illiquid alternatives, as shown over the last
two decades. In 2013, the average US endowment
held a portfolio weight of 28% in alternative
assets, versus roughly 5% in the early 1990s.
A similar trend is evident among pension plans.
In the early 1990s, pension plans held less
than 5% of their portfolios in less liquid alternatives;
today the figure is close to 20%.
Having a long-term investment horizon may give
more patient investors an edge in harvesting
the illiquidity premium. They can be rewarded for
sacrificing liquidity that they do not need.
Allocation to alternatives
% of investment portfolio
Source: Illiquidity estimates taken from “Expected Returns” by
Antti Illmanen, 2011. 1994–2014 return data taken from Bloomberg,
Citigroup, Barclays Capital, J. P. Morgan, Bank of America Merrill Lynch,
NCREIF, Hedge Fund Research, Cambridge Associates, Russell 2000.
Source: Taken from “Patient Capital, Private Opportunity” by The
Blackstone Group, Private Wealth Management, 2013. Return data drawn
from Lipper, Morningstar, Preqin and Tass.
Source: Allocation data drawn from Cerulli Research, National
Association of College and University Business Officers 2013/14
Studies, Pensions & Investments 2013 Annual Plan Sponsor Survey.
Historically, illiquid investment propositions such as venture capital and private equity funds required ten years or longer before fully returning capital
and profits to investors. However, the growth of shorter-duration and yield-producing investment strategies and a secondary market for early liquidity may
result in greater comfort with allocations to illiquid alternatives. The strategies outlined below are only a small subset of more liquid options available to
the investment community. These, and others, should make it easier for individual investors to sacrifice liquidity that they do not need in order to capture
(some of) the illiquidity premium.
Private debt strategies
The private debt market has seen strong growth since 2008, primarily
driven by direct lending funds. According to alternatives data provider Preqin,
over 200 private debt funds have raised in excess of USD 100 billion of
new capital commitments in 2013–2014. Private debt is characterized by
shorter investment duration relative to venture capital and private equity
funds, and in the case of direct lending, funds can be combined with regular
yield payouts to investors. The outlook for investing in the direct lending
space remains positive due to persistent structural factors preventing middle
market companies from accessing the broader traditional credit markets.
While credit supply remains tight, demand for middle-market credit remains
strong due to the expected deployment of committed, uninvested capital
(also referred to as “dry powder”) and the refinancing overhang of middlemarket
The secondary market in illiquid alternatives has been fueled in the recent
past by new regulations (e. g. the Volcker Rule), by record amounts of
dry powder and by improving economic conditions. A record USD 42 billion
of assets have traded on the secondary market in 2014, up from USD 9 billion
in 2009. Investors increasingly see secondaries as a viable channel to
generate liquidity before fund lockups expire. They are using the secondary
market to rebalance their illiquid portfolios, exit poorly performing investments,
reduce capital costs or comply with new regulations. In order to
increase liquidity for investors, some managers are now proactively offering
the possibility of exiting their funds early. For example, in its latest flagship
fund, a US buyout manager committed to selling fund stakes twice a
year to a preselected group of preferred buyers. Other managers have
started to provide interested sellers with a list of potential buyers.
GLOBAL INVESTOR 1.15 — 18
On doing your
TEXT BY ALEXANDER INEICHEN
GLOBAL INVESTOR 1.15 — 19 >
Photo: Gerry Amstutz
Recent skeptical reports in the press about
hedge funds, and a high-profile divestment
or two, have prompted speculation that hedge
fund returns are in “structural” decline. Not
so fast, says Alexander Ineichen. For investors
willing to get off the couch, a careful study
of hedge funds shows that they actually deliver
higher-end returns than US equities do,
with less volatility.
Many seasoned investment professionals argue that liquidity
is an illusion. It is something you think you have, and
can measure in good times, but it vanishes immediately
during a perfect storm. It is a bit like your path toward
the emergency exit in a concert hall: under normal circumstances you
can run toward the exit within seconds; when fire breaks out, you
cannot. Liquidity is something everyone seems to require at the same
time. The financial crisis of 2008 is a good example. Markets literally
disappeared for a while. So-called market makers would delete their
prices on their screens and not pick up the phone, even in markets
that were considered liquid prior to the market disturbance. Another
example is the more recent decision by the Swiss National Bank to
drop its quasi-peg to the euro in January 2015. For a short time, the
foreign exchange market – considered as the most liquid market in
the world – stopped functioning properly.
Hedge funds – a “quasi-liquid,” superior return profile
Alexander Ineichen started his financial
career in derivatives brokerage and
origination of risk management products
at the Swiss Bank Corporation, UBS
Investment Bank and UBS Global Asset
Management. In 2009, he founded
Ineichen Research and Management
AG, a research boutique focusing
on absolute returns, risk management
and thematic investing.
In his 2000 book “Pioneering Portfolio Management”, David Swenson,
the CIO of Yale University’s endowment fund, distinguishes between
liquid and illiquid. But, for hedge funds, he creates something
in between that he calls “quasi-liquid.” This is a very elegant turn of
phrase. Hedge funds are indeed not as liquid as US large-cap stocks,
but are also not as illiquid as, say, private equity or real estate.
In the last couple of years the gloss has come off hedge funds.
Earlier, the high returns had turned a niche product into a flourishing
industry. For example, an investment of USD 100 in the S&P 500
Index at the beginning of 2000 was at USD 89 (–11%) five years later,
including full reinvestment of the dividends. The same investment of
USD 100 in an average hedge fund portfolio, after all the fees everyone
complains about, stood at USD 141 (+41%) five years later. This
is a big difference.
Hedge funds did well in the second part of the last decade too. In
the five years to December 2009, a long-only investment in the S&P
500 went from USD 100 to USD 102 (+2%), whereas an investment
GLOBAL INVESTOR 1.15 — 20
of USD 100 in the average hedge fund portfolio went to USD 132
(+32%). This is still a big difference, but it had gotten smaller. In the
five years to December 2014, a USD 100 investment in US equities
more than doubled to USD 205 (+105%). However, USD 100 in the
average hedge funds portfolio “only” rose to USD 125 (+25%). As an
investor, which sequence do you prefer: –11%/+2%/+105% or
+41%/+32%/+25%? The second sequence is superior in two ways:
higher-end return with less volatility. I like to think of the first sequence
of returns as “nature.” That is what you get if you do not apply
risk management: moderate overall return with high volatility.
Hedge funds can improve this sequence with active risk management.
The second sequence does not appear in nature, it is man-made.
Hence the fees.
Challenges big and small
The biggest challenges hedge funds face today are linked to the
smaller managers. First, they find it very difficult to raise capital
because the financial crisis and the Madoff incident caused private
investors to more or less disappear. They are coming back only very
slowly. This means the main source of capital comes from institutional
investors who have a more sophisticated decision-making process.
They expect a hedge fund to have at least USD 100–150 million under
management and three years of proven real returns. Furthermore,
institutional investors conduct due diligence with their managers, because
a lack of it was one of the sources of disappointment in 2008.
Institutional investors also expect various layers of operational excellence,
adding to the cost base of hedge fund operators. This means
that the barriers for smaller, less-established managers have risen.
Finally, regulation has intensified. Large hedge funds can deal with
the added bureaucracy more efficiently than smaller managers.
But large hedge funds also face challenges, and one of them is
related to regulation. The financial crisis, and the regulation wrath
that it triggered, resulted in investment banks downsizing their trading
operations. Liquidity in many markets went down. Because of the
winner-takes-all effect that resulted in large hedge funds getting
larger and larger, these growing hedge funds see dwindling liquidity
as a challenge. A less liquid market means diminished opportunity
and is more prone to gap risk.
Are hedge funds a good/bad investment?
“Over the last decade
or so, the conceptual
arguments for investing
in hedge funds have
not changed by much.
However, the market
place has changed.”
I always recommended to everyone willing to listen that they move up
the learning curve with respect to risk management, absolute returns
and hedge funds. Knowledge beats ignorance every time. An educated
investment is better than an uneducated investment. And education
compounds. At the end of the day, an investment decision is
binary: either a position is established or it is not. This means the
various trade-offs, the pros and cons, need to be carefully weighed
against each other. This requires an effort, i.e. learning. Whether a
nice chap recommends hedge funds is not that relevant for most
investors. An investor needs to reach a level of comfort before investing,
and a conviction once acquired requires ongoing reconfirmation.
Both are a function of learning and effort.
The late Peter Bernstein, author of one of the best books on the
history of risk, once wrote that “liquidity is a function of laziness.”
What he meant is that liquidity is an inverse function of the amount
of research required to understand the characteristics of an investment.
As he put it: “The less research we are required to perform,
the more liquid the instrument.” An investment in US Treasuries requires
less research than an investment in US equities. An investment
in US equities requires less research than an investment in
hedge funds and so forth. In sum, hedge funds are not for the lazy.
Why I want hedge funds in my portfolio
Hedge funds originally marketed themselves as absolute return products
that deliver positive performance in any market environment.
Now, in the wake of the financial crisis, hedge funds focus on their
diversification benefits and risk-adjusted performance. A portfolio of
hedge funds does not obviate any alternative or “classical” way of
portfolio construction. However, hedge funds have properties that
you do not find in other areas of finance. For example, trend-following
managers have had a positive return in 17 out of 19 major corrections
in the equity market since 1980. This is unique. There is nothing
else in finance that has such favorable correlation characteristics.
Among other asset classes, measured low correlation more often than
not turns into an illusion when it is most needed, somewhat akin to
Over the last decade or so, the conceptual arguments for investing
in hedge funds have not changed much. However, the market
place has changed. For example: hedge funds as a group are larger;
the largest funds are larger; some trades are more crowded; liquidity
in some market areas is lower due to Dodd-Frank; yields are lower
and IT is more important. But again, conceptually, an intelligently
structured portfolio comprising independent returns and cash flows
is as worth considering by every thoughtful and diligent investor as it
was in 1949, when the first hedge fund was launched. If you know
the future, invest in what goes up the most. If you do not, construct
a portfolio where the source of returns and cash flows are well balanced
and the risk is actively managed, while not forgetting that perceived
liquidity can turn into an illusion.
GLOBAL INVESTOR 1.15 — 21
a key to
Whether it’s related to an investor’s risk tolerance, or a
fund manager’s decision on the appropriate trading strategy,
the management of liquidity issues is a vital consideration
when investing in hedge funds. And while illiquidity can be a
source of risk, it can also be a source of additional returns.
Liquidity is an important aspect to consider
when investing in hedge funds.
Liquidity issues have to be managed
by both investors as well as hedge fund
managers. While it is true that hedge fund
liquidity has generally improved for investors
since the global financial crisis, hedge funds
are still less liquid investments than equities.
To use Alexander Ineichen’s term, they can
be called “quasi-liquid.” In the following, we
take a closer look at the role liquidity plays
for hedge funds and their investors. A key
conclusion is that illiquidity is not only a drawback,
but also a potential source of returns,
which still has to be managed.
Illiquidity as a source of return
Hedge fund returns can be divided into three
components: (1) returns from general market
performance (also called beta factors), (2)
returns from exploiting risk premia, including
illiquidity factors (alternative beta), and (3)
returns related to manager skills (e.g. in selecting
securities and timing entry and exit
into an investment, called alpha.)
The performance of equity and fixed income
markets to which hedge funds have
exposure are typical beta drivers. The sensitivity
toward these drivers varies across hedge
fund strategies. While long/short equity strategies
(which belong to the fundamental style,
see box) have a relatively high sensitivity to
equity market performance, the influence on
managed futures (a tactical trading strategy)
or fixed income arbitrage (a relative value
strategy) may be minor.
Hedge funds provide advantages
Tactical trading 5.5%
Relative value –1.9%
Event driven –2.6%
Directional investing –4.6%
Tactical trading 9.1%
Directional investing 7.4%
Event driven 7.3%
Relative value 5.8%
Best trading strategy is a function of market liquidity
In periods of low liquidity, tactical trading strategies have performed best. Particularly in an environment
of low liquidity, this style stands out as the only one delivering positive returns. Source: Datastream, Credit Suisse
Directional investing 15.3%
Event driven 14.6%
Tactical trading 11.9%
Relative value 11.6%
Directional investing 18.5%
Event driven 17.0%
Tactical trading 13.6%
Relative value 9.5%
Generally, it is easy to gain exposure to traditional
beta drivers. However, alternative
sources of beta may not be as easily accessible
through commonly traded instruments.
Default risk and illiquidity premiums fall in
this type of category, and hedge funds can
be one way to access this type of return. For
example, the distressed debt strategy in -
vests in illiquid, distressed securities that are
not commonly accessible to investors. In
contrast, mutual funds have more stringent
liquidity requirements and are usually restricted
to invest at most in low-rated credit,
while their structural setup allows hedge
funds to take on such credit risk. Moreover,
distressed debt hedge funds have a longer
time horizon, which allows them to hold on
to investments for longer and to wait until the
company that issued the distressed security
gets back on track.
GLOBAL INVESTOR 1.15 — 22
Glossary of liquidity provisions
Redemption notice period Minimum period for
advance notice prior to redemption.
Redemption period Frequency with which
investors can withdraw their funds.
Lock-up Time period from the initial investment
until it is possible to make a first withdrawal.
Gates A gate limits withdrawals to a certain
percentage of assets under management during
any redemption period.
Side pockets A provision that allows the manager
to keep particularly illiquid holdings in a separate
account. There is usually no liquid market for
these holdings. It may be difficult to establish the
holdings values and may be difficult to sell
them. Hence, if an investor places a redemption
request, the manager does not need to liquidate
positions in a side pocket immediately. Pro rata
proceeds of these holdings are only distributed to
investors once these holdings have been sold –
which can be long after an investor has withdrawn
Investments in more illiquid securities on the
side of hedge fund managers have implications
for investors too. Since the forced selling
of securities can mean selling at unfavorable
prices, hedge fund managers can set up
a range of provisions to avoid losses due to
this. Liquidity provisions can take the form of
redemption restrictions, lock-ups, gates, side
pockets or a combination thereof (see glossary
at the left hand side). It is no surprise
that the strategies investing in the most liquid
assets (managed futures and global macro)
tend to be the strategies that offer the highest
liquidity for investors. As a result of the bad
experiences made during the financial crisis,
with many investors not fully aware of such
provisions, investors now desire a higher degree
of liquidity. Consequently, more liquid
strategies as well as structures like UCITS
(undertakings for the collective investment in
transferable securities), which are designed
to accommodate this desire, have attracted
While barriers of withdrawal can protect
investors from redeeming funds at the most
unfavorable terms, there can also be arguments
raised against such policies. Investors
may get the impression that hedge funds are
using such provisions as an excuse to earn
further fee income before their capital is eventually
returned. It is thus important that investors
are assured that long lock-up periods are
well justified – e.g. because the hedge fund
is holding illiquid investments such as overthe-counter-traded
distressed debt securities.
Generally, investors eager to benefit from illiquidity
premia should be prepared to take a
longer investment horizon and be willing to
accept more stringent liquidity provisions. In
any case, it is important that investors clearly
understand the fund terms in order to avoid
unpleasant surprises later on.
Liquidity requirements and return potential
As Alexander Ineichen points out, hedge
funds used to be known as an asset class that
delivers superior returns at lower volatility.
However, our view at this time is that lower
expected upside from traditional asset classes
(i.e. weaker beta drivers) in combination
with structural changes is likely to dampen
the return potential of hedge funds. With regard
to structural changes, the investor base
of hedge funds is increasingly made up of
institutional investors, while private investors
previously played a larger role. Tougher requirements
regarding liquidity and transparency
have made it easier for institutional investors
to include hedge funds in their
portfolios. Further, the shift toward a more
institutional investor base has increased the
focus on the role of hedge funds in a portfolio
context: low correlations with other asset
classes and more stable return patterns have
become the key differentiating feature rather
than the delivery of high returns. With tough-
Hedge Fund Barometer variables: Liquidity
Hedge funds thrive when liquidity conditions improve and are exposed to liquidity shocks
when conditions tighten. Source: Credit Suisse/IDC
Percentile rank value
Jan. 96 Jan. 00
Jan. 04 Jan. 08 Jan. 12
Liquidity composite 13-week moving average composite
GLOBAL INVESTOR 1.15 — 23
er regulatory requirements, operating costs
have risen, which in turn has left some smaller
hedge funds unprofitable. Conversely, institutional
investors have been willing to sacrifice
high returns for lower risk as long as
their needs for liquidity and transparency are
fulfilled. For these structural reasons, we
think that the return potential of hedge funds
has generally decreased.
Liquidity drives our hedge fund strategy
The Credit Suisse proprietary Hedge Fund
Barometer is our main tool to assess the
broad investment environment for hedge
funds. The tool is an early warning framework
that should help avoid unnecessary risks. Besides
volatility, the business cycle and systemic
risk, the tool also assesses liquidity
conditions. While we have observed a general
increase in risk starting in late 2014,
tightening liquidity conditions began to draw
our attention in early 2015. As the second
chart shows, liquidity conditions deteriorated
around the turn of the year. While tighter liquidity
is generally a concern for hedge funds,
some strategies are less affected and can
even thrive in such an environment (see first
chart). Given the divergences in monetary
policies between the main regions and, in
particular, the likely approach of rate hikes by
the US Fed, we do not expect liquidity conditions
to improve materially in the near future.
Therefore, we adjusted our hedge fund strategy
in early 2015 and began to focus on
strategies that are less sensitive to liquidity
conditions, e.g. tactical trading strategies. At
the same time, our outlook worsened for
relative value strategies, particularly those
that are active in fixed income investments.
These strategies typically apply higher leverage
and/or invest in more illiquid securities,
and are thus at greater risk when liquidity
In sum, when investing in hedge funds,
investors should not just take traditional market
drivers into account, but also focus on
liquidity considerations. Illiquidity can be a
source of risk, but also a source of additional
returns for investors. Careful analysis of
the role of market liquidity in an investment
strategy can help avoid unnecessary risks and
Cross Asset and Alternative Investments Strategist
+41 44 334 60 47
The different hedge fund styles
and how they deal with liquidity
Tactical trading strategies are resilient when liquidity is scarce
Tactical trading strategies include global macro and managed futures.
In this style, managers try to exploit trends in equity, fixed income,
currency and commodity markets. Analysis of macroeconomic variables
rather than corporate transactions or security-specific pricing discrepancies
distinguishes tactical trading from other styles.
Tactical trading strategies trade in all major markets. However, one
major difference between managed futures and global macro is that
managed futures focus on trading futures contracts, the most liquid instrument.
In contrast, global macro managers have the widest investment
universe trading a broad range of different market instruments.
Another key aspect of the tactical trading style is that some strategies
are purely model driven. Within managed futures, trend-following strategies
are probably the best-known example of this strategy. A model generates
trading signals upon which trades are executed. Human discretion and
emotions are negated, which helps explain why tactical trading strategies
are well positioned to navigate through crisis periods. While discretionary
managers may rely to some degree on models, they can use their own
judgment when making investment decisions, and may be more prone to
making irrational decisions in a tough investment environment.
Fundamental strategies have various degrees of sensitivity to liquidity
Fundamental strategies focus on individual securities, mostly in the equity
and fixed income areas. While directional strategies usually build a broader
portfolio of more liquid securities and thus deliberately take directional
market exposure, event-driven strategies often build a more concentrated
portfolio of securities depending on a specific catalyst (event). Directional
strategies tend to take positions in more liquid publicly traded securities,
while event-driven styles often engage in illiquid securities (e.g. distressed
debt, special situations and activist investors with longer holding periods).
While liquidity sensitivity depends on the underlying investments, the
leverage applied is typically lower than in the relative value segment.
Relative value strategies depend on a favorable liquidity environment
Relative value strategies include fixed income arbitrage, convertible
arbitrage and equity market neutral strategies. They aim to exploit pricing
inefficiencies between related or unrelated securities and try to avoid
directional market exposure. Forgoing returns from beta drivers, returns
of these strategies would naturally be lower (yet more stable and with very
low correlation to movements in major asset classes). Leverage is a way
to enhance returns. It can be high, particularly for fixed income strategies
where targeted pricing inefficiencies can be small. But this makes the
strategy sensitive to liquidity conditions. While these strategies tend to do
well as long as markets move in their favor, volatile markets with scarce
liquidity can mean that positions need to be sold at unfavorable prices –
or worse, cannot be sold at all. This left many investors with large losses
during the financial crisis. It is thus vital to keep an eye on market liquidity.
GLOBAL INVESTOR 1.15 — 24
Making what turns out to be the right investment
decision can hinge upon the underlying asset
type, and understanding the fundamental
differences between open-end and
In good times
On the upward trend,
investors see the discount
narrowing noticeably for
closed-end funds as the
In times of crisis
The discount of closedend
funds mirrors the
development of the overall
market. The discount
increases as the crisis
unfolds, but is quick to
revert again as recovery
begins to take hold.
Discount to NAV in %
01.05 07.05 01.06 07.06 01.07 07.07 01.08 07.08 01.09 07.09
MSCI World Average discount 3m MA (rhs)
Average discount to net asset value for US closed-end investment funds
Through the worst of the Global Financial Crisis, the average discount on closed-end funds dipped from roughly – 7% to – 11% in January 2008
before rebounding sharply, but briefly – after which it fell to –18% before recovery at the start of 2009. Source: Bloomberg, Credit Suisse
GLOBAL INVESTOR 1.15 — 25
Investors have many choices when selecting
a pooled investment fund: regional
versus global, active versus passive, bonds
versus equities, famous manager versus
start-up, and so on. But one choice can be
overlooked: open-end versus closed-end
funds. On occasion, this may be the most
As we will show, the practical difference
for investment returns may not be great under
normal market conditions, but can become
significant at times of market stress, especially
for funds investing in illiquid assets such
as real estate, small caps, or specialized credits.
In such cases, a closed-end fund may be
the better structure.
Closed-end funds have a fixed asset pool.
This can grow (or shrink) due to good (or bad)
investment performance, but normally no extra
capital is added from investors or paid out.
An existing investor who wants to exit must
sell on the open market to another investor
who wants to put money in. In contrast, the
assets in open-end funds can change because
of shifts in market prices as well as due
to net inflows or outflows of capital from investors.
When net new money comes in, the
manager invests in extra underlying assets,
while exiting investors sell units back to the
fund manager, who disposes of underlying
investments to meet net redemptions.
Operation under normal market conditions
Investors in open-end funds buy and sell units
at a level equal to the underlying asset value
(subject to enough liquidity, see below). By
contrast, the price of closed-end funds is typically
at a premium or discount to the underlying
assets, reflecting the balance between the supply
from exiting investors versus demand from
those entering. Academic studies have argued
that a premium might reflect the skill of the
manager or the rarity of the underlying assets,
while a discount might indicate lack of confidence
in the manager. Morningstar data shows
that, over the long term, closed-end US funds
have on average traded at a slight discount.
This tends to deepen when markets go down,
while it narrows or moves to a premium when
markets go up and investors become more
Some closed-end funds buy back their
own shares to try to narrow the discount, enhancing
value for remaining investors. Sometimes,
external predators try to gain control
and liquidate the fund at the market value,
thus effectively eliminating the discount.
Despite these measures, discounts and premiums
rarely disappear completely, perhaps
because demand for most closed-end funds
is dominated by retail investors who tend to
When money flows in or out of open-end
funds, the dealing costs are in many cases
spread among all investors. The impact of these
costs may be negligible in large funds with
little movement, but can be a noticeable burden
on performance in small, fast-growing funds.
Perhaps, more importantly for an open-end
fund with specialist strategies in relatively illiquid
assets like small-cap or frontier-market
stocks, a good performance in the early years
when the fund is small may be difficult to replicate
later if large amounts of new money are
attracted by the good results, but are not easily
investible in the same way. So many successful
open-end fund managers in specialist
areas close their funds for new investments to
protect existing investors as they approach
capacity limits. If a manager does not do this,
there can be style drift, making the track record
of a fund manager less relevant.
Operation in stressed markets
When markets become stressed, such as during
the financial crisis, some assets may become
illiquid, while others remain easy to sell.
When this happens with an open-end fund,
the first investors to exit will tend to receive
cash obtained by the manager from sales of
the more liquid assets. While this is good for
these faster-moving investors, slower-moving
investors are left with units in an imbalanced
fund that holds mainly illiquid assets that cannot
be readily sold and for which the theoretical
valuation may fall further than the more
balanced portfolio existing before the stress
began. Well-known examples in recent years
include some frontier-market, real estate and
credit funds. Fund managers may have some
ability to restrict (“gate”) withdrawals. If this
is done early in the stress situation, it in effect
temporarily makes the fund closed, protecting
remaining investors. But in a worst-case scenario,
this closure happens after the faster
investors have left, which leaves remaining
investors trapped with a pool of illiquid underlying
assets that may then eventually be sold
as soon as some limited liquidity reappears,
which unfortunately is likely to be near the
bottom of the market.
Clearly, this process simply cannot happen
in a closed-end fund. Faster investors who
try to exit will likely find few buyers, forcing
the fund price down to a substantial discount
to the apparent net asset value. In the middle
of the financial crisis in early 2009, the average
discount of the largest US-listed closedend
funds rose as high as 25%. But the fund
manager is not forced into selling the underlying
assets to meet withdrawals. Investors
who are prepared to hold their nerve through
the phase of stress will still own a share in
the balanced pool of assets selected by the
manager, with a good chance of recovery after
the stress has passed, and they will not
be forcibly liquidated near the bottom of the
market by the selling actions of other investors
in the fund. Indeed, after the financial crisis,
the average discount narrowed quickly as
markets recovered, providing an additional
return driver for these funds on top of the rise
in price of the underlying assets.
Conclusion: Horses for courses
The conclusion is that investors should choose
between open-end and closed-end funds
largely on the basis of the underlying asset
type. For investments in mainstream, liquid
markets like developed economy large-cap
equities, an established large open-end fund
is probably the better choice in most cases.
It avoids the fluctuating premiums/discounts
of closed-end funds and should be large
enough to avoid issues of dealing cost attribution,
although it would likely not have leverage
In contrast, closed-end funds are likely to
be the better choice for underlying assets
such as real estate, frontier markets, small
caps and low-grade credit, since these are,
or are at risk of becoming, illiquid with all the
potential issues described above (see article
on Swiss real estate funds on page 47 for
Head of Research and
Deputy Global Chief Investment Officer
+41 44 332 22 33
Head of Mutual Funds & ETFs
+41 44 333 23 94
GLOBAL INVESTOR 1.15 — 26
Liquidity issues in an institutional portfolio context
Patient, yet opportunistic. Those are two key characteristics
of the New Zealand Superannuation Fund, whose very long-term
investment horizon allows it to pursue contrarian and illiquid
strategies if the price is right, all while managing liquidity at the
INTERVIEW BY OLIVER ADLER Head of Economic Research
JOSÉ ANTONIO BLANCO Head Global MACS
Oliver Adler: From the point of view of
a private client, what’s special about
the New Zealand Superannuation Fund
(NZ Super Fund), as a national
sovereign wealth vehicle?
Adrian Orr: We are a “buffer” fund.
Our aim is to smooth the increasing financial
burdens for future generations. For
that reason, we have a very long-term
investment horizon: no money will come out
of the fund until at least 2031. That provides
us great certainty around our investment
horizon and our liquidity needs. These
“endowments,” as we call them, together
with our governance and our ownership
(i.e. our control over our capital) allow us a
very high level of risk appetite and also
the ability to invest in what can be called
Oliver Adler: How do you decide
your investment strategies?
Adrian Orr: We have a number of
investment beliefs against which we continuously
test ourselves, for example, that
there is some concept of fair value for an
asset, and that prices may deviate from
fair value, but should also revert to it over
time. These beliefs give us the confidence
to pursue contrarian strategies, as well
as illiquid strategies, if we think the price is
right. All potential investments, regardless
of asset class, are measured in terms of
their attractiveness – either as a diversifier,
or as a (mispriced) opportunity – and, more
generally, their consistency with our beliefs.
Oliver Adler: Isn’t that what the vast
majority of funds do?
Adrian Orr: Most funds have specific
strategic asset allocations (SAAs) to which
they are always rebalancing, whereas
we are opportunistic: we are continuously
shifting from the least attractive to the most
attractive asset classes or assets, based
on our confidence in our strategies. We are
least invested in black-box hedge-fund-type
strategies that are purely skill-based. We
have low confidence in skill as a basis for
adding investment value because we really
struggle to be able to assess it, and we
also have low confidence in its consistency.
José Antonio Blanco: What kind of horizon
do you use to estimate the attractiveness
of an asset mispricing? How much do
you want to have in illiquid assets? And how
much in liquid ones?
Adrian Orr: We define a long-term investor
as someone who has command over
the capital. So at any point in time, we >
GLOBAL INVESTOR 1.15 — 27
Photos: Jamie Bowering
Adrian Orr is CEO of the New Zealand Superannuation Fund, which has posted annualized returns between 17% and 25% over the last five years.
GLOBAL INVESTOR 1.15 — 28
José Antonio Blanco
Head Global Multi Asset Class Solutions
+41 44 332 59 66
Managing portfolios –
a quest for value
Credit Suisse Private Banking follows a structured investment approach,
which starts by defining a suitable strategic asset allocation (SAA) for its
clients and then actively managing the mandate portfolio in a disciplined
way around this SAA. However, the SAA is periodically checked and
adjusted (see interview). Although financial markets in some broad sense
tend to be efficient, there are costs to finding relevant information quickly
and acting on it appropriately; so price movements in response to events
are sometimes neither instantaneous nor always correct. This opens
opportunities to improve the return and risk characteristics of portfolios
over time by deviating from the strategic allocation in various ways.
We therefore manage portfolios actively, generally in all dimensions
across asset classes, markets, currencies and individual securities.
In our quest to add value, we combine in-house insights with added
value provided by other parties as long as their investment style fits
with the logic and structure of the mandate portfolios and the requirements
of the client. Unless specifically instructed to do otherwise, discretionary
portfolios for private clients are predominantly invested in fairly liquid
assets, in the sense that we focus on assets that are easy to trade and
monitor, although we will take some limited liquidity risk by investing some
of the portfolios in asset categories (like high-yield bonds) and strategies
(hedge funds, for example) that are less readily tradable and should
therefore generate a liquidity premium on top of their other characteristics.
Our prudence with regard to illiquid assets is the result of regulatory
considerations (some asset categories cannot be offered to private
investors because they require very specialized know-how and may entail
high and unusual risks) and the fact that investments in illiquid assets
limit our ability to adapt the portfolios to the changing environment and
client needs. These types of assets are therefore best managed separately
from the liquid part of the portfolio.
should have the ability to buy or sell on our
own terms. When you apply that definition
of a long-term investor, what it means is that
we manage our liquidity at the whole-fund
level. We want to make sure that we don’t
suddenly find ourselves in a situation where
we’ve got a fund full of illiquid assets and
have to shed assets in a fire-sale. We always
want to preserve the ability to buy assets
at opportunistically favorable times, for
example, when they are poorly priced by
Oliver Adler: How do you price liquidity?
Adrian Orr: We have an absolute level
of liquidity that we wish to maintain at
any point in time for the fund. And we have
a pricing schedule for that liquidity as we
approach that must-have level. The level
for the fund as a whole is established
through specific scenario shock analysis,
so that we are always in a position to buy
assets at the markets’ darkest moment,
as opposed to having to sell assets. Having
a moving price structure rather than a
defined target quantity of specific illiquid
assets tends to create the right incentives
within the fund.
Oliver Adler: Might it mean that, in a market
stress period, your liquidity level actually
falls? And could that also mean that
you may not be able to then invest in the
opportunities you had thought you
might want to invest in?
Adrian Orr: Well, we try to anticipate
and pre-empt exactly that. We are thinking:
what does this portfolio look like in bad
times? And that consideration sets the price
or the “hurdle rate” we are prepared to
accept for making that investment. In other
words, we have a “waterfall” of liquidity,
starting from the highest, mostliquid investments
through to the leastliquid asset
structures. We have a pricing structure
and a management structure for the whole
fund that allows us to work our way through
that waterfall. By the time you get down
to the leastliquid assets, you are in a very,
very strange world, one where liquidity
would probably be the least of your concerns.
José Antonio Blanco: A look at the
current structure of your fund shows that
the allocation to what might be called
less liquid investments is very broad and
relatively small (about 20%). Why do
you diversify broadly on the illiquid side,
while having quite significant chunks on
the more liquid side?
GLOBAL INVESTOR 1.15 — 29
Adrian Orr: You have to take your
mind out of an SAA framework. We asked
ourselves, how could we achieve our purpose
in the least-cost, simplest manner?
That means going out and buying listed,
low-cost liquid assets to create what we
call our reference portfolio. It ends up being
effectively 80% equity, 20% fixed income,
globally diversified. And we think of that
reference portfolio as delivering a Treasury
bill plus 2.5% return, on average, over
20 years. We then get out of bed every
morning and say: how can we outperform
that reference portfolio? How can we
José Antonio Blanco: Adding value
Adrian Orr: Improving the Sharpe ratio,
a higher return for the same risk, or the
same return for less risk. And that is when
we start actively investing.
Oliver Adler: If you compared your actual
allocations with a typical SAA for a balanced
fund, how marked would the deviations
be, say, in the main asset classes from any
kind of starting or “reference” point?
Adrian Orr: The deviation is quite big,
and has become more visible since about
2007, when we shifted away from our
SAA (we had one once!) and got far more
active and more direct in our investment
strategies. This is also the period of
high growth in the value-add of the fund.
So I would compare our strategy style to
a growth fund’s, not a balanced fund’s.
We have performed exceptionally strongly
over the last five years or so, with
annualized returns anywhere between
17% and 25%.
Oliver Adler: What about illiquid asset
classes such as real estate, which
is probably very local? Or infrastructure,
which everyone is talking about?
Adrian Orr: Many of our illiquid assets
have entered the portfolio as diversifiers
(like timber) or because there was a
significant market mispricing, or a specific
asset mispricing (like Life Insurance Settlements).
Infrastructure has been the real
tough one. Infrastructure assets have been
very sought after; so we rarely see a
mispricing opportunity, and they aren’t as
good a diversifier as people claim unless
they are true infrastructure.
José Antonio Blanco: How do you handle
the delicate question of ethical and
sustainable investment vis-à-vis illiquid
“We then get out of
bed every morning and
say: how can we
outperform that reference
portfolio? How can
we add value?”
CEO of the New Zealand Superannuation
Fund, which he joined in February 2007,
coming from the Reserve Bank of New
Zealand where he was Deputy Governor.
He has also held the positions of
Chief Economist at Westpac Banking
Corporation, Chief Manager of the Economics
Department of the Reserve Bank
of New Zealand and Chief Economist at
The National Bank of New Zealand.
Adrian Orr: A big part of our emphasis
on consistency is related to environmental
and social governance issues. We will
not enter into an external manager contract
if we cannot get the transparency we
need and the behaviors and reporting and
performance that we expect.
Oliver Adler: Would you agree that the
set of opportunities for you has diminished
over the last few years generally, if you
look across most investable assets?
Adrian Orr: Very much so. Our big valueadd
came from being able to be a contrarian
investor. Now equity prices are broadly
at fair value, globally. There are still some
opportunities in Europe and Japan, but
that’s where we have lower confidence.
José Antonio Blanco: In principle,
does the current situation favor illiquid
assets relative to traded assets?
Adrian Orr: I would say the illiquidity
premium has declined. There’s so much
global capital chasing illiquid assets,
that we just think, why bother? Why take
on illiquidity and all of the governance
challenges that come with direct investing
when you’re not being rewarded for it?
So we can be patient and await better
opportunities over time.
GLOBAL INVESTOR 1.15 — 30
GLOBAL INVESTOR 1.15 — 31
Trees are a fixture of the
physical landscape, inspiring
the human imagination, and
their products are a ubiquitous
component of everyday life.
Small wonder that they also
constitute a vehicle for investment.
Teak is particularly
prized for its beauty, spiritual
associations, durability and ease
of workmanship. A teak tree
matures in about 20 years and
is fairly easy to grow, though
the locations where it thrives
pose their own challenges.
Nonetheless, in the right hands,
teak offers an interesting
pro position for the patient
INTERVIEW BY GISELLE WEISS
PHOTOGRAPHY LUCA ZANETTI
GLOBAL INVESTOR 1.15 — 32
Chairman of the Board of Forests for
Friends and of the Tree Partner Company,
she earned her PhD in English literature
before assuming a series of management
positions at Swiss Re over the course
of 20 years. She subsequently became
the Executive Director of WWF (World
Wide Fund for Nature) Switzerland.
Giselle Weiss: You describe “falling into”
the business of growing trees but finding it
Carol Franklin: Investing in trees
means you give your money away for
20 years. The concept is difficult to sell
in the sense that if you go about it properly,
it really is illiquid. Most of our competitors
say that you will get a first payout after
three to five years, and that they will
reimburse your investment if necessary,
which is absolute rubbish. They also
tell you that returns are between 9% and
15% a year, which is also rubbish. We
compare our return to what you used to
get on a savings account – so something
like 6% to 7% per annum, 85% of
which comes in after 20 years when
the trees are harvested.
How does it work?
Carol Franklin: The basic concept
is that the investor pays all the money
up front, on a shareholding basis. In other
words, we have enough money for the
20 years it takes for the trees to grow.
We buy the land, plant the trees, and maintain
them very carefully. If all goes well,
we have the first non-commercial thinning
after four to five years. Then after eight,
14, and the final harvest after 20 years.
Let’s backtrack just a bit. Why trees, as
opposed to vineyards or fancy cars or
Picassos or a nice little chemical start-up?
Carol Franklin: I personally have always
been interested in ecology. And trees are
vital for our survival. They help slow down
climate change by capturing CO 2 . They
are something that you can see and touch,
as opposed to, say, derivatives. Why teak?
After 20 years you can sell the wood.
There are a lot of beautiful and interesting
trees, but they have no international market,
whereas there is a functioning international
teak market. At the moment, we are selling
all our wood to India, which could buy
the entire worldwide harvest. Recently, the
markets of Vietnam and China have been
growing, and some of the wood is going
to these countries to make very nice
garden furniture, doors, cabinets, whatever.
It would be nice if the US and European
markets became stronger again in the
Just to be clear, we’re talking about tree
plantations, not tropical forests, right?
Carol Franklin: Yes. We plant the trees
on former cattle land. Plantations are not
ecological, although ours are all certified by
FSC (Forest Stewardship Council). What
plantations do is to take the pressure off
the primary forests, as people no longer
have to go and cut trees in the jungle.
And the reason for doing it in Panama?
Carol Franklin: Teak only grows in
tropical regions, but you probably wouldn’t
want to invest your money in many of the
countries along the equator. Panama has a
relatively reliable legal system and, due to
its narrow shape between two oceans,
there is always a port nearby. If you plant in
Brazil, for example, and people do, the
nearest port can be 3,000 kilo meters away.
Getting the timber there costs a fortune.
Unlike overland transport, sea transport is
not very expensive. Panama also has tax
incentives for reforestation.
Who should invest in a teak plantation?
Carol Franklin: It’s not about quick
money. So patient money, possibly. People
who have an affinity for trees. People who
are ecologically minded and who want
to do something to save the world. Pension
funds would be ideal because it’s a longterm
asset and pension funds have calculable
long-term liabilities. It’s well suited
to family offices: traditional families used to
have their own woods, and some still do.
We have many grand parents! They think
long-term, and teak is a shorter return than
German forests, for example. A German
oak takes 100 years to mature.
And who should not invest?
Carol Franklin: Someone who might
need the money in the next 20 years.
I’d also never invest more than 10% of my
available money in something like this.
We’re not listed, which means the investment
is even more illiquid. But this also
means we are decoupled from the financial
markets. So if everything goes down,
which it will again of course, at least your
trees will continue to grow. And if the wood
price happens to be unattractive at any
given moment, we can just let the trees
stand and wait. It’s not rice or oranges or
Could you describe the planting cycle?
Carol Franklin: You buy the land.
You prepare the land. You plant the trees.
You have to get the right soil and the right
seedlings. Over the past ten years, seedlings
have improved dramatically. Because
our plantations are ecologically certified,
you can’t use certain pesticides and herbicides,
so you have to keep the grass and
shrubs down with the machete.
GLOBAL INVESTOR 1.15 — 33
“There are a
lot of beautiful
trees, but they
have no international
is a functioning
As the trees grow, you cut the branches to
avoid knots in the wood. You usually plant
between 800 and 1,100 trees per hectare,
with the trees spaced about 3 meters apart.
After four years, you thin the trees to give
them enough room and light to grow and
become tall, strong and straight trees.
And you continue to thin as the trees grow?
Carol Franklin: Yes. The next thinning
is usually after eight years. This is the
first commercial thinning and the wood is
used for doorframes, tongue-and-groove
walls, indoor floorboards or furniture. As we
now get more money than we pay for the
thinning, we can use the proceeds for
the maintenance. So in the cash plan this
is income, but we do not distribute it to
the shareholders – unlike some companies
who use this money to keep their shareholders
happy and have to look for additional
income for maintenance. There’s another
thinning at 14 years, and the final harvest
at 20, but it could be 18 or 22, depending
on the growth of the trees and the state
of the market.
Aren’t the trees vulnerable to weather
or natural enemies?
Carol Franklin: For the first four or
five years, you have to be careful about fire.
So we have fire breaks, usually roads.
And we have people living in the plantation
to watch. Panama has no hurricanes.
We do have local windhoses, and sometimes
a bunch of young trees will fall over.
But you can put them back up and they
continue to grow. There’s also a type
of fungus, but it’s fairly limited, and we
are on the lookout for it.
What should investors know or consider
before they make such an investment?
Carol Franklin: The main thing is that
they should realize that the money is out
of their portfolio for 20 to 24 years. And
they should check us out because you
invest in people and not in things. It’s like
re-insurance. It seems very technical, but
in the end, you underwrite the underwriter.
Do you worry about climate change?
Carol Franklin: Well, there are general
concerns about the unpredictability of
the rains. And, naturally, if the tropics were
to become colder, that would be an issue.
But on a day-to-day basis, I think political
risks tend to be higher than natural risks.
Panama is probably more stable than some
of the other countries in the tropics.
Do people come to see the trees?
Carol Franklin: We organize investors’
trips including visits around Panama –
to the canal, an indigenous village, the old
fortress near Colón and our sheep and goat
farm. We have quite a few people who
just want to have a look and not invest, or
who want to get a feel for who we are
before they invest. We’re happy with that.
If you were starting over, would you do
Carol Franklin: My first experience with
this type of investment was actually sitting
on the board of a company that failed. It’s
a long story. My husband and I made it our
business to rescue it – now called Forests
for Friends – which was a huge gamble and
the odds were against us. But if we hadn’t
accepted the challenge, two-and-a-half
thousand people would have lost their money.
We succeeded, and that effort, as well
as starting The Tree Partner Company, has
changed my life.
GLOBAL INVESTOR 1.15 — 34 3
GLOBAL INVESTOR 1.15 — 35
Shareholders’ investment 2014: CHF 4,207,407
1 The Tree Partner Company comprises two teak plantations totaling 170 hectares, located within three hours driving distance of Panama City.
2, 3 Engineers periodically gather statistics on how well the trees are growing. The first commercial thinning occurs at about eight to ten years, when the tree
trunks measure 40 centimeters circumference minimum.
GLOBAL INVESTOR 1.15 — 36
GLOBAL INVESTOR 1.15 — 37
4 Trees cut from the first thinning will be made, for example, into door frames. 5 Panama’s proximity to ports is a huge advantage in terms of cost. 6 Harvest takes place
around 20 years after the planting, when the entire plantation is felled, or “clear-cut.” 7 The plantations provide jobs and learning opportunities to the local communities.
8 The fruit of 10 years’ labor: the wood from thinnings is collected at the entrance to the plantation, then loaded into 12-meter containers and shipped, primarily to India.
GLOBAL INVESTOR 1.15 — 38 8
GLOBAL INVESTOR 1.15 — 39
through vehicles known as “TIMOs” – timber
investment management organizations. These
intermediate investment funds make exposure
to timberland simpler for non-specialist institutions,
but the larger pools of capital often
prefer purchasing the assets directly. Returns
for institutions that acquired undervalued
holdings have been strong, initially driven by
a lower discount rate boosting long-duration
assets like timber, and recently supported by
better wood demand.
Current market situation and outlook
Land devoted to investible timber worldwide
amounts to 165 million hectares
(408 million acres), roughly equivalent
to the land area of Alaska. Institution al
investors now own timberland in Argentina,
Australia, Brazil, Canada, Chile, New Zealand,
South Africa, the United States and Uruguay.
Just under half of these assets (by area) are
in North America. There is much less harvestable
timberland worldwide than forested land.
In Australia, only 1% of forested land is developed
as timber plantations.
Broadly defined institutions, such as the
military, universities and even royalty, have
held exclusive property rights in forests for
centuries. Interest in timber assets by purely
financial institutions developed in the 1980s
in response to both the growth of institutionally
managed retirement accounts seeking
diversification, and a wave of forest divestments
by large forest-product companies.
Institutions enter into forestry
In the first two decades of investment by institutions
outside the wood-products industry,
activity was confined to large university endowment
funds. US timber companies using
GAAP accounting had to pay tax on forest
owned – even when it was not being logged,
thus incentivizing them to sell such plantations
to US tax-free pension funds. Preferential tax
treatments for real estate investment trusts
(REITs) also encouraged corporate divestment.
During a period of strong equity market
returns and declining inflation, the motivation
for institutional investment was limited to
those with a long time horizon for returns and
an unusually broad mandate on alternative
investments, enabling direct holdings of unlisted
assets. This led the same institutions
interested in pioneering private equity to explore
the scope for investing in timberland, as
a component of natural resource portfolios.
Front-runners were the endowment managers
for Yale and Harvard Universities. Yale alone
holds three million acres of forests.
Harvard’s Head of Alternative Assets,
Andy Wiltshire, worked in the New Zealand
forests sector early in his career, and drove
the 2004 purchase of a 408,000-acre New
Zealand timber estate by the Harvard Management
Company. Kaingaroa Forest was the
largest commercial forest property on the
country’s North Island. A 30% share of this
huge forestry block was divested two years
ago to the Canadian Public Sector Pension
Investment Board with an additional stake
taken up by the New Zealand Superannuation
Fund. Broadening of interest from private institutional
to public institutional investment is
thus well underway.
Timber has appealed to observers noting
long-run real annual returns of 10%–15% on
intensively managed, short-rotation plantations.
Seeing the very positive returns from
timber and its low volatility, sovereign wealth
funds and large public pension funds have
been acquiring exposure to commercial forest
assets. Corporate pension plans now own
around 10% of the asset class.
Based on measured returns on investment,
timber is not positively correlated with
other assets. But, because the timber price
is responsive to house-building cycles, the
run-up to the credit crisis in 2008 saw timberland
prices climb and then drop sharply.
The sluggish recovery in US housing led to
a multiyear opportunity for pension funds
to acquire timberland assets at reasonable
valuations, and most have entered the market
The US housing market has traditionally led
timber demand and is now in a gradual recovery.
The Australia-New Zealand region has
enjoyed resilient building activity that is expected
to continue, driven by immigration. In
China and India, continuing urbanization and
construction means these markets are still
growing. Chinese plantations cannot meet
demand and are under some pressure to be
converted into development land.
Increasing institutional investment is a
safe prediction due to low current allocations
within alternative asset portfolios and since
wood usage follows wealth development.
Thus, there is growing orientation toward
the Southern Hemisphere. Recent surveys
indicate that investor interest in emergingmarket
forests is primarily European, and
that smaller-scale investors favor emergingmarket
timberlands. Sustainability is a critical
concern – particularly with indigenous
hardwood trees – but a wide range of tools
are at hand, including forest and manager
certification, NGO oversight and replanting
+41 44 334 78 93
Find additional details on
our map on pages 40–41
GLOBAL INVESTOR 1.15 — 40
Timberland is the investment term for
harvestable forests, as is farmland for agriculture
investment. Both types of investments act
as portfolio diversifiers, satisfy investors’
desire for “real” assets and have
emotional and social resonance.
But they do require patience.
Canada exports USD 4 bn worth of l umber and wood pulp to China
China imports USD 13.3 bn worth of soybeans from the USA
EU28 exports USD 2.6 bn worth of paper and paperboard to the USA
China imports USD 2.6 bn worth of cotton from the USA
Product mix – forestry
Tree products include hardwoods
such as mahogany (used for
furniture) and softwoods such
as pine (used for building and
paper production). Woodchips
may be sourced from either,
though softwood is a cheaper
source. South-East Asia
produces 90% of the world’s
Statistics Canada, Rubber Manufacturers
Association, New Forests Asset Management
worth of lumber to the USA
Canada exports USD 15.8 bn
USA Export 10%
China imports USD 3.7 bn worth of soybeans from Argentina
China imports USD 19.1 bn worth of soybeans from B razil
EU28 imports USD 2.9 bn worth of soybeans from Brazil
SOUTH AMERICA Export 100%
ASIA Export 100%
CANADA Export 87%
NEW ZEALAND Export 50%
A US TR ALIA E xport 65%
GLOBAL INVESTOR 1.15 — 41
NZ timber destinations
Logs constitute New Zealand’s third-largest export
industry. New Zealand is also now the world’s
leading log exporter (as of 2012) and the biggest
supplier of softwood logs to China (as of 2013).
JAS: Standard units. Source: UN Comtrade, New Zealand MPI
NCREIF Timberland TR Index
Returns as measured by a diversified index of
timberland investments. Timber serves as a good
diversifier, remaining stable during the financial
crisis of 2008 as shown in the index.
Source: Bloomberg, Credit Suisse/IDC
Volume (million JAS)
The USA imports USD 2.9 bn worth of paper and paperboard from China
EU28 exports USD 2.6 bn
worth of paper and paperboard to Russia
03 04 05 06 07 08 09 10 11 12 13
China India Japan
Korea Taiwan Other
03.87 03.95 03.03 03.11
NCREIF Timberland TR Index
The USA exports USD 3.3 bn worth of meat to Japan
Australia exports USD 1.6 bn worth of meat to Japan
China imports USD 3.3 bn worth of dairy products from New Zealand
Investing in farmland means
investing in rural land along
with specific crop and livestock
assets. Crops may be row crops
like soybeans or permanent
fruit and nut crops.
Paper and paperboard
and emerging timberland
With most US forestry assets
already in institutional ownership,
investor interest has turned
to non-US markets, e.g. Asia. In
Europe, forests are generally in
Australia exports USD 1.7 bn worth of cotton to China
Excellent climate for
agriculture, total annual
Agricultural productivity is
greatest in the world’s temperate
zones. Nonetheless, other
regions, such as South America
and Africa, where water is still
plentiful, are drawing investor
475–4974 millimeters rain
agri-trade flows in USD
39 and 42
GLOBAL INVESTOR 1.15 — 42
Harvesting yields from agriculture
One doesn’t often think of institutional investors and farmland
in the same breath. Yet, global population growth and the
accompanying demands on our food supply have made agriculture
an asset class worth considering. But bridging the worlds of
farming and financial services requires rather specific expertise.
INTERVIEW BY GREGORY FLEMING Senior Analyst
is set to grow
by over 60%
as the world
our map on
to increase by
Gregory Fleming: Griff, you have moved
from a traditional investment career in
pensions and investment funds into advising
on and structuring of farmland
investments. What motivated this move?
Griff Williams: A desire to make agriculture
investment accessible to institutional
investors. Agriculture is an asset class that
delivers real benefits to savings and retirement
portfolios, but lamentably, it is very
difficult to access it in a pure-play format.
It is also an asset class that requires specific
expertise that generally does not reside
in the financial services sector. As a farmer
who has spent over 20 years in the asset
management sector, I am blending the two
worlds to deliver this objective.
What kind of investor considers farmland?
Griff Williams: Investors seeking exposure
to assets that benefit from long-term
secular themes such as population growth,
changing dietary habits, growing middle
classes, water and conservation management.
Farms offer a hedge against inflation,
combined with an income yield. At the
same time, investors need to be able to
trust the farm managers, or at least the
partner selecting them. No one really wants
to have to go down to the farm and
check what’s happening there in person.
Is agriculture sufficiently exposed to
the modern, services-based economy to
offer good returns?
Griff Williams: The global population
is expected to increase by 50%, to more
than nine billion in the next 40 years, while
food demand is set to grow by over 60%
as the world becomes wealthier. Shifts in
diet preferences toward protein foods are
well-attested in enriching societies, and this
will increase the demand for land resources.
So investors can potentially benefit from
value-added gains in food or crop quality,
but also from the very limited expected
increase in the world’s available arable land.
The investment time frame is important
in illiquid assets. What is the best time
frame for taking a stake in farming?
Griff Williams: Farming lacks the thrills
of daily commentaries on network television.
The farmer is almost the archetype of
a patient investor, and non-farmers also
need some patience. Much depends on the
mode of investment, but an investment
horizon of five to ten years or a longer-term,
strategic allocation is reasonable. For investors
preferring the fund route to a direct
investment, between three and five years is
GLOBAL INVESTOR 1.15 — 43
the shortest time frame to see results, but
that renders the investment rather prone to
the fortunes of just a few growing or production
seasons. Capital gains on farmland
are also likely to accrue more reliably over
What kind of return can investors expect?
Griff Williams: A good internal rate of
return would be around 12% to 15% per
annum. This is likely to be split between a
cash yield on the farm products of 6% to
8% and a similar appreciation in the capital
value of the farmland, as it is improved.
Would you say that any one kind of crop
or product is superior, from an investor’s
point of view?
Griff Williams: I have looked at opportunities
in dairy, livestock, cotton, sugarcane
and fruit, soya, grains, and other rotational
crops. Each has unique and demanding
characteristics that require very solid experience
on behalf of the farm managers.
Investors may have an affinity with a particular
farm product, which is legitimate, but
it shouldn’t bias the objective judgment of
their returns and risk levels across the cycle.
All the farm products benefit from intractable
global demographic trends, but within
this rising demand trend, some crops are
considerably more volatile. Alternatively,
some are more demanding – for instance,
dairying requires much more investment
and stock management than sheep farming.
What approach should investors take?
Griff Williams: Maximizing sustainable
yield and minimizing environmental risks
means that it is critical to partner with real
farm operators. The skills the investor
should try to access are centered on rural
productivity, rather than on land speculation
or investment vehicles that mainly back
trades in the agricultural futures markets.
These markets have quite distinct returns
time frames and performance drivers from
the farmland itself.
What are the special characteristics of
investing in farmland globally?
Griff Williams: The key point is that
agriculture, in many countries, remains a
politically defined investment universe.
Certain governments restrict direct farm
ownership to residents, while others link
subsidy payments to the farm’s output. A
set of agricultural economies, however, has
liberalized its farming sector to reflect global
market prices, and these countries have
seen substantial efficiency gains. New
Zealand is the classic example here, ditching
yield and minimizing
environmental risks means
that it is critical to
partner with real farm
The New Zealand national comes from
a farming family on the North Island,
where he continues to have dairy farming
interests. At Milltrust he is responsible
for designing and co-managing the
globally diversified agricultural strategy
with special focus on Australia and
New Zealand. Prior to Milltrust, he was
Head of Europe and Interim CEO of Itaú
farm subsidies virtually overnight in the
mid-1980s. The New Zealand dairy sector is
now the most efficient in the world, and few
farmers would seek a return to government
involvement in the price-setting process.
Australia has also largely cut out farm
support. Other countries, such as the USA,
have more recently and gently modified
farming subsidies. The 2014 US Farm Bill
took the positive, though modest, step of
lowering direct payments and replacing them
with crop insurance provisions. Globally,
rich-country transfer payments to the agriculture
sector have been a major obstacle
to free trade agreements. It’s important
to stress that agriculture can survive and
thrive in a high-income country, without
state price support. Finding those liberalized
land opportunities, and conducting the vital
due diligence on legal systems, security of
title, environmental and marketing systems,
does require a broad range of skills.
Have you identified some best-practice
markets, or does it vary from farm to farm?
Griff Williams: The set of undistorted
farm product opportunities is quite small, in
country terms. The best operating environments
are seen across Australasia and in
selected Latin American countries such as
Uruguay, Paraguay and Brazil. Once a
number of farmers in a given country adopt
the best technologies and practices,
the pressure on the other farmers builds up
rapidly. This is as true of yield-enhancement
techniques as it is of sustainable
farming practices. Still, there are enough
underper forming farms in countries with sufficiently
good investment conditions to provide
opportunities for a portfolio approach.
GLOBAL INVESTOR 1.15 — 44
Trends in real estate investment
Ins and outs
of real estate
As an illiquid asset, real estate takes time to sell and the length of the selling period can
vary heavily. For indirect investments in particular, there may be regulatory frameworks and
the possibility of pooling properties that moderate the negative effects, but there will
still be a certain risk of illiquidity due to the inherent hetero geneous characteristic of real
estate. However, investors with a sufficiently long time horizon can cope with these
risks and are compensated by a potentially higher return compared to more liquid assets.
Photo: Gregor Schuster/Getty Images
GLOBAL INVESTOR 1.15 — 45
Hints for investors
1 / Adopt a long investment
horizon. Transaction costs
are best absorbed by having a
long investment horizon.
2 / Mind the leverage. Sufficient
own funds help to avoid
fire sales as price and liquidity
cycles can be long.
3 / Know your product.
Legis lation is very different for
distinct types of real estate
funds and country-dependent.
Some setups are more
exposed to liquidity problems.
4 / Take your time. Avoid
making your decision to buy
or sell too quickly. This could
turn out to be very costly.
5 / Add real estate to your
port folio. Do not be frightened
of illiquidity. Real estate is
a good diversifier in portfolios.
01_Allocation to property in
UHNWI investment portfolios
While residential property (main residence and
any second homes) makes up almost 30% of
the total net worth of UHNWIs, real estate also
plays an important role when it comes to making
investments. On average, property accounts
for 24% of UHNWI investment portfolios.
In over 40% of all cases, this share has even
increased in recent years.
Source: Knight Frank, The Wealth Report 2014
When talking about illiquid assets,
real estate is at the forefront as
it belongs to the most prominent
of illiquid assets. In developed
markets, real estate is the most important
wealth contributor in household portfolios and
adds up to enormous amounts of wealth. It is
not surprising that regulators and central
banks pay a lot of attention to real estate
markets. Residential real estate accounts
for almost 30% of net worth in portfolios of
ultrahigh-net-worth individuals (UHNWIs) (see
Figure 1), and pension funds also have a substantial
share of their allocation in real estate
(see Figure 2).
Causes of illiquidity of real estate assets
The illiquidity feature of real estate results
from a combination of several characteristics.
To begin with, real estate assets are always
tied to a certain location. The combination of
a particular location and a specific object
quality creates a unique tangible asset. Consequently,
every building requires a one-off
analysis and, on a microlevel, prices can even
differ heavily on the basis of, for example,
exposure to noise or view. All this is reflected
in the valuation of a property: there is no true
02_Asset allocation of
Swiss pension funds as
of September 2014
Swiss pension funds traditionally have a substantial
allocation to real estate. As of September
2014, almost 20% of their funds were invested
in real estate. This number typically decreases to
some degree when equity markets are doing
particularly well and therefore make up a larger
part of the asset allocation.
Source: Credit Suisse Swiss Pension Fund Index, Q3 2014
Liquidity Bonds Equities
Alternative investments Real estate
or objective price. Target prices depend on the
type of valuation model used and on investorspecific
preferences. Finding a price becomes
even more difficult when there is only limited
data available on similar transactions and if
assets have rare characteristics. This often
makes price negotiations time-consuming, and
adds to illiquidity. Determining a fair price is
especially important when one considers the
large size of the transaction.
Several other real estate characteristics
contribute to illiquidity, mostly from a cost
perspective. For example, the design and, to
some degree, the location of a building predetermine
its suitability for certain activities.
The conversion of a big department store
into many small retail units is relatively costly,
and regulation must also be taken into account.
Changing the use of a property from
a legal point of view, such as the conversion
of apartments into shops and vice versa, may
be difficult or even impossible. Investors must
bear this in mind and should therefore have a
clear strategy when investing in real estate.
Other costs include legal expenses and taxes
at the transaction stage. In total, there are
five steps in the acquisition of a commercial
building (see Figure 3). At each step, different
types of costs occur. Purchasing a commercial
real estate building typically needs a
negotiation time of about three months, plus
several months to conclude the transaction.
One last reason for the illiquidity of real estate
is simply the state of the market, which can
dry up quickly in periods of excess demand
(when nobody wants to sell a property) or,
more seriously, in a situation of weak demand.
Investors are facing difficult decisions
The main question for investors is whether it
is worth accepting this disadvantage from
a risk-return perspective. This depends on
the time horizon. As high transaction costs
associated with illiquidity are fixed costs,
it makes sense to hold such an asset for a
longer period. Therefore, pension funds and
other institutional or private investors with
a long time horizon are typical real estate investors.
In addition, these investors need to
accept that their real estate positions may not
be 100% liquid at any time. For wealthy investors,
these constraints are easier to cope with
(a fact that is reflected in the higher real estate
allocations of UHNWIs, see Figure 1). For
these investors, it makes sense to accept the
illiquidity and be compensated for it. For example,
the historical average premium to the
intrinsic net asset value (NAV) for listed >
GLOBAL INVESTOR 1.15 — 46
03_Real estate transaction process
A typical transaction process for commercial real estate consists of five steps and may last up to
six months. Expenses, such as search or transaction costs, may incur at each step. Steps 2, 3 and 4
could run simultaneously. Due diligence thus makes up most of the time and costs.
Source: Credit Suisse
– Search costs
– 2–4 weeks
Swiss real estate funds has been 7% since
January 1990. Direct real estate investors
can avoid this premium. In addition, although
direct real estate cannot be traded on a daily
basis, this may be a good thing from a behavioral
finance perspective. Most investors tend
to underestimate transaction costs and in turn
reduce their performance by trading too often.
Since the real estate transaction process
takes time, investors are automatically prevented
from excessive trading.
Preliminary check and
– Agency costs
– 1–2 weeks
Negotiation and final offer
– Negotiation costs
– 2–4 weeks
– Market, legal, tax, technical
and environmental due diligence
– 1–3 months
– Additional costs
– 1–2 weeks
Implications of illiquidity on markets
In the case of illiquid assets, the problem
is that investor interests do not necessarily
align with market conditions. While it may be
highly rational for an investor to buy or sell a
property, too many investors acting in the
same manner at the same time can reduce
the liquidity of the whole market. In the end,
investors behave in a pro-cyclical manner because
they take more extreme positions and
trade more often when liquidity is high and
revise their ideas if liquidity drops. From a
long-term perspective – and this is the horizon
of most direct real estate investors – this is
irrational. Theoretically, there should be a
similar number of transactions in each stage
of the cycle. But this is clearly not the case.
Between the peak in Q1 2007 and Q1 2009,
quarterly commercial real estate transactions
in the USA fell by 91% in terms of volume,
and they increased by 691% by Q3 2014.
Illiquidity is often amplified in abnormal
market situations. Moreover, not all real estate
segments are affected by illiquidity in the
same way. Down markets trigger a flightto-quality
effect. Most investors will focus on
core properties in prime locations of favored
cities such as London or New York – if they
are still buying real estate assets at all.
Negative consequences are not a given
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29
Investment solutions to meet the illiquidity
challenge are very different from country to
country, but generally adhere to the same
simple idea: pool some properties, securitize
them and distribute the shares. Then create
a market for these shares. This can be a stock
exchange or not. In either case, the shares
can be traded more or less continuously
and the properties are thus effectively more
liquid. Sometimes, a market maker is needed
to make the market fully liquid. This not only
applies to properties but also to mortgages
that are backed by properties. The legal structure
of such transactions can be very differ -
ent depending on the number of owners and
GLOBAL INVESTOR 1.15 — 47
properties. For all these structures, trust is of
key importance, which implies a certain degree
of transparency when it comes to valuation
Sometimes illiquidity conflicts with certain
investment goals. For example, one concept
is to reduce liquidity slightly by increasing
transaction costs in order to curb speculation.
This may help to lock out investors that have
a very short time horizon and are prone to
selling assets when the first headwinds occur.
Limits to liquidity
Even if liquidity is enhanced by pooling properties,
there is still no guarantee that this
will work all the time. Sometimes pooling
properties only results in “pseudoliquidity,”
which works when markets are rising (see
also “Open-end versus closed-end funds”,
page 24). In contrast, in times of falling markets,
the number of potential sellers surpasses
the number of potential buyers. This can
also happen for complex real estate-related
financial instruments such as residential and
commercial mortgage-backed securities
(RMBS /CMBS) as investors learned in the
aftermath of the financial crisis. Confidence
could not be restored on short notice. The
risk of moving from a liquid to an illiquid market
environment depends on the legal framework,
as seen in the case of German openend
real estate funds. The announcement of
possible regulatory changes to the corresponding
legal framework triggered massive
redemptions by investors who wanted to retrieve
their capital before the new regulation
was introduced. In contrast, listed fund structures
with a fixed capital base such as in
Switzerland are less exposed to such risks.
Selling real estate may become easier
As long as properties are tied to specific locations,
real estate will face liquidity issues. But
we believe that real estate properties will become
a priority for investors in the coming
decades. First, real estate still does not have
the appropriate or optimal weight in many asset
allocations. Second, interest rates may
stay at low levels for an extended period of
time, which makes real estate returns attractive
and should help to improve liquidity from
the seller’s perspective.
Head Real Estate Investment Management Switzerland
+41 44 333 92 42
Swiss real estate funds:
Liquidity and diversification
Real estate funds are an interesting alternative to investing into physical
real estate as they typically offer investors access to diversified real estate
portfolios that are managed by experienced real estate professionals.
However, the way the product structure deals with in- and outflows
of investor liquidity can impact the funds’ returns. Generally, one can
distinguish between open-end and closed-end funds. As described in the
article by Giles Keating and Lars Kalbreier (see page 24 for more details),
these two contrasting structures have both advantages and disadvantages
in times of market stress.
Swiss real estate funds aim to create a structure that captures
advantages from both types, while limiting the disadvantages by having
a semi-open-ended structure. This means that funds are opened up to
investors during periods of capital-raising activity, but that shares of the
funds are otherwise exchanged between investors on secondary markets
(with the majority of funds being listed on the SIX Swiss Exchange).
Whenever there is strong investor appetite for real estate funds, any
excess demand on the secondary market leads to an increase in unit prices
and vice versa. However, this excess liquidity does not flow directly
into the product and, as such, can neither impact the underlying portfolio
nor potentially affect operations, as it is fully absorbed by supply and
demand on the secondary market. Typically, this often leads to fund units
either trading above (agio) or below (disagio) par to the net asset value
of the underlying real estate portfolios. If true investment opportunities
arise in target markets, the funds can be reopened for subscription
of fresh capital for newly issued units, which can then be put to work.
This structure thus enables controlled and healthy organic growth, while
also providing a certain degree of liquidity to investors.
We also advise real estate investors to diversify internationally.
Since real estate market cycles tend to vary between different countries,
adding international real estate to a domestic portfolio can significantly
enhance the risk-return profile of a real estate portfolio. There are
several Swiss real estate funds with an international focus. While such
products are denominated in Swiss francs and foreign currencies are
mainly hedged, we believe the approach of globally diversified real estate
portfolios offers value to investors beyond Switzerland.
Head of Global Real Estate Research
+41 44 334 32 89
GLOBAL INVESTOR 1.15 — 48
Taking a long-term view
on the rise
Transport sectors Telecommunications Energy Social infrastructure
USD 94 bn of
USD 282 bn of
of surveyed investors plan
to invest at least USD 50 mn
each over the year 2015
of surveyed investors plan
to invest over USD 400 mn
each over the year 2015
Illustration: -VICTOR-/Getty Images
GLOBAL INVESTOR 1.15 — 49
Largely due to the current low interest rate
environment, institutional investors such
as insurers and pension funds are increasingly
moving toward allocation into longer-term
illiquid assets, in particular into infrastructure
as an asset class. This trend has been a
significant one. In fact, global infrastructure
assets under management have seen a
300% increase over the past seven years.
Investors are increasingly putting their money
into the transport, tele communications,
technology, energy and resources sectors,
and backing the large-scale construction
projects these sectors require. While not
without risk, such investment is supported by
governments and supranationals alike.
There is clear evidence that insurers and pension funds
with long maturity liabilities are increasing their asset allocation
to infrastructure as an asset class. Other categories
of investors are larger family offices and sovereign wealth
funds. The investment case is that infrastructure projects or businesses
offer long-term yields that are theoretically fairly stable
and normally can provide inflation protection. Typically, investors
are taking a seven- to ten-year view on the risk / reward of investing
in infrastructure assets, but frequently the time horizons can be
considerably longer. According to Preqin, global infrastructure
assets under management in unlisted funds are at a record high of
USD 282 billion, having increased threefold since 2007. Of the investors
surveyed by Preqin, 25% plan to invest over USD 400 million
each over the next year in infrastructure, and 90% plan to invest at
least USD 50 million. Preqin estimates that “dry powder”, i. e. uncalled
capital already committed, could be USD 107 billion, while insurance
companies are planning to increase their asset allocation to infrastructure
Infrastructure: The different components
Infrastructure covers a range of differing assets, but can be broadly
disaggregated into the transport sectors, telecommunications and
technology, energy, social infrastructure, and resources and waste
management. Examples in the transport sector will include the
construction of new railways / mass transit systems and trains, ports
and shipping, airports, roads, bridges and tunnels. Telecommunications
and technology investments range from relatively simple, such
as mobile phone masts and fiber-optic cable, to complex projects,
such as server or other tech cluster farms. The energy sector is very
broad, but will include conventional assets such as pipelines, storage
facilities, refineries, support infrastructure for oil and gas fields, the
nuclear sector, energy transmission systems and alternative energy
assets. There has been significant investment in alternatives such as
on- and offshore wind farms, hydroelectric systems, solar and biomass
plants. Social investments are typically defined as the construction
and maintenance of schools, universities, hospitals and prisons.
Although there is some overlap with the energy sector, resources
and waste management infrastructure includes water management
systems, sewerage, waste collection and the recycling sector.
Typical infrastructure investment vehicles
In an unlisted fund, it is normal for the general partners to manage the
infrastructure assets and to appoint management teams as relevant
to the day-to-day management of individual assets or projects. Limited
partners will have made an initial capital commitment, and capital
will be called as and when funds are invested. There is typically an
initial investment period, and if the general partner has not invested
funds prior to the maturity of this investment period, then capital
commitments are waived or the limited partners can vote on granting
an extension. There will be clear guidelines on the fund’s turnover,
on investment concentration, leverage, planned repayments to limited
partners, and how, if necessary, the limited partners can vote on
a change in asset manager or general partner. Leverage has to be
carefully monitored since funding can be at the fund level or more
normally embedded in the actual projects or assets being invested
in. Leverage levels will typically be higher than what is normally found
in the private equity industry on the assumption that cash flows have
a lower degree of volatility than that in private equity. Sources of >
GLOBAL INVESTOR 1.15 — 50
performance will be cash flows from projects, the improvement or
upgrading in infrastructure assets with new management, leverage
and over the long term the disposal of assets to new investors.
Investor demand: Existing assets versus greenfield projects
The infrastructure industry is dominated by investment in existing
infrastructure with a focus by general partners to improve the cash
flows from existing assets, to improve the financing structures,
to upgrade assets and to sell on what were originally purchased
as undervalued assets. In some cases, publicly listed infrastructure
companies will be taken private with a view that management change
can be more easily effected in a private structure. One key problem
is that although 70% of infrastructure requirements are estimated
to be in greenfield projects, investor demand is primarily for existing
assets. The rationale for this reluctance lies in the fact that investors
do not want to carry the initial construction period risk where cash
flows will be negative, and where investors have limited direct control
over issues such as cost overruns, construction failures, environmental
risks, supplier failures, etc. Greenfield project risks are typically
carried out by companies with a long history of involvement in
the construction of infrastructure, and they may be supported by
government, bank or supranational institution guarantees. In emerging
economies, many projects have only taken place backed by, for
example, guarantees from the Asian Development or the Inter-
American Development Bank. In Europe, the European Investment
Bank has played a key role, not just in financing projects, but by
Financing can be divided into a variety of constituent elements –
including equity – typically with pension funds and insurance companies
acting as limited partners in unlisted funds, companies involved
in the infrastructure sectors providing equity, bank financing, the
developing infrastructure bond market and the provision of guarantees
from banks, governments or supranational institutions. Given the
long-term and illiquid nature of the assets, it is generally agreed that
it is inappropriate to have infrastructure assets in mutual funds where
short-term liquidity is provided to investors. If retail investors want
to access the infrastructure industry, the most appropriate route is
to purchase the equity or bonds of infrastructure construction and
Apart from equity investing on the part of long-term investors, there
is a clear recognition among investors that the infrastructure bond
market requires further development. Historically, infrastructure was
financed either by bank lending or by bond issues made by supranational
institutions, governments, or companies involved in the construction
or maintenance of projects. Investor risk was limited to a direct
credit risk on the issuer without any recourse to the project assets.
With banks deleveraging and reducing maturity mismatch risk by
focusing on floating-rate rather than fixed-rate assets and reducing
proprietary positions, bank financing for infrastructure will decrease
on trend, and therefore lead to greater reliance on access to funding
from investors and the bond markets. Since investors are reluctant
to act as equity providers in greenfield projects, they likewise will not
be providers of longer-term financing for new projects. They will, however,
be active participants in bond issues made by existing infrastruc-
1 Workers laying railway track in northwest
China. 2 Pipeline pipes at the ready with
oil rig in background. 3 Bales of paper ready
GLOBAL INVESTOR 1.15 — 51
Photos: Imaginechina, Lowell Georgia, Anna Clopet/Corbis
ture management companies such as train operators, pipeline managers,
etc., while they will also purchase bonds where there are credit
guarantees either by government, supranational institutions or banks.
While the current low interest rate environment encourages increased
allocation into longer-term illiquid assets such as infrastructure, it is
important to focus on the risk factors in the industry and highlight
some examples where investor losses have been generated. For
new projects, the obvious key risk is that projects are either not completed
or have serious delays and / or cost overruns. Recent examples
include escalating costs of building new nuclear plants, projected
overruns in high-speed train lines and toll road tunneling projects.
Political risk has to be carefully assessed; there have been a number
of instances, notably in mining projects in higher-risk emerging markets,
where a change of government has led to contracts / concessions
being cancelled and assets sequestered. Another example of political
risk is the possible change in government subsidies and / or support.
A number of alternative energy projects and notably wind farms have
faced deteriorating economics as government subsidies have been
withdrawn, and likewise social infrastructure projects, which might be
in the form of a public / private partnership, can suffer from reduced
government funding. Environmental issues are critical, notably in the
transport, energy and waste management sectors. Examples of problems
have been the imposition of environmental fines on projects and
infrastructure assets and projected cash flows being delayed because
of disputes over environmental issues. Certainty of cash flows is
obviously important, but in a number of cases, cash flow projections
have been too optimistic. One example has been in toll roads where
they have competed with toll-free roads and traffic has not switched
to the toll roads, with a mediocre outcome for revenues and cash
flows. Another risk is the threat from new technology. For example,
in telecommunications, the future viability of mobile masts has to be
questioned, while initially the excessive installation of fiber-optic
cabling led to major losses. Market price movements can change the
economic viability of infrastructure. At present, the sharp decline in
oil prices is challenging a number of alternative energies, and investment
in oil and gas fracking is becoming less attractive.
Financial risks involve the threat of higher interest rates and / or
wider credit spreads. Increased financing costs will challenge the
economics of infrastructure, make alternative asset classes more
attractive and could delay projects if refinancing needs are not met.
Other market-related risks can be changes in foreign exchange rates
where hedging longer-term assets can be problematic, shifts in
yield curves (which might affect swap pricing where swaps have been
used to hedge borrowing risks) and the use of excessive leverage.
In 2008–09, a number of infrastructure funds had to be restructured
since reduced cash flows could not meet increased borrowing costs
and / or refinancing could not be successfully achieved. The final risk
is that, in “easy” markets backed by quantitative easing, valuations
may become stretched and there is some initial evidence of this occurring
with current transactions in the ports and trains sectors being
effected at values significantly higher than those that took place over
the last five years.
In the recent G20 communiques, the G20 stated “we are working
to facilitate long-term financing from institutional investors and to
encourage market sources of finance, including transparent securitization,
particularly for small and medium enterprises and we endorse
the multiyear program to lift quality public and private infrastructure
investment.” It is obvious that at the level of individual governments
and also the IMF, OECD and EU, accelerating infrastructure projects
is a clear macropolicy objective. S & P has estimated that infra structure
financing needs worldwide could total USD 3.4 trillion annually until
2030. For governments, infrastructure investment is clearly attractive
given the initial positive impact on employment and the longer-term
multiplier effect on the economy.
There are a number of clear trends in the infrastructure sector. First,
new investment from investors such as pension funds that need
long-term assets and do not need liquidity will increase significantly.
Second, investment in infrastructure will have the support of governments
and supranational institutions given the strong economic
multiplier effects. Third, the environment for investing in greenfield
projects / start-ups will remain challenging and will require project and
credit support. Fourth, investors will focus on areas where there is
inflation protection, minimal systemic risk, and where leverage and
financial risk is intelligently managed. Finally, the flow of equity capital
will be matched by the development of the infrastructure bond
market as an alternative to bank financing.
+44 20 7883 9864
GLOBAL INVESTOR 1.15 — 52 >
Advising on illiquid assets
Global Investor asked two Credit Suisse wealth managers
to describe the illiquid asset landscape from the point of
view of investors. Do clients feel it is worth trading liquidity
for additional returns? How much of their portfolios do clients
allocate to illiquid assets? Are some assets more popular
than others? And how does culture affect asset choices?
INTERVIEW BY MANUEL MOSER Senior Financial Editor, Credit Suisse
Manuel Moser: What does a typical client’s
portfolio allocation look like?
Felix Baumgartner: My perception
is that “this” client is invested approximately
40% to 50% in equities and 30% in cash.
The cash tends to come from fixed income.
In other words, when a bond expires, the
money goes into the cash portion of the
account owing to the lack of opportunities
in fixed income. Now, clients are a bit
worried about staying in cash, and consequently
they’re looking for other opportunities,
including illiquid assets.
Are some investors more open
to illiquid assets than others?
Patrick Schwyzer: There are different
ways of characterizing investor preferences:
by geography, by what stage investors are
in in their lifecycle, by their background
and by the country they live in. For example,
the USA is certainly more open to illiquid
asset investment. Switzerland not so much.
There are a number of reasons for the difference,
one of which could be that in the
USA, people have to administer their own
pension money. That means thinking through
the range of investments for the best yield
and return, whereas in Switzerland we
still delegate the entire business of pensions
to outside parties or the companies’
What about preferences for various kinds
of illiquid assets, such as real estate or
Felix Baumgartner: The order of
pre ference that we observe is: real estate,
then hedge funds, followed by private equity.
Traditional Swiss investors, in particular,
look for real estate in Switzerland. But there
is not much left here. It’s all been bought
up. Some traditional investors still like gold,
which is not an illiquid asset, of course,
but still very volatile.
How satisfied are clients with the
returns on their investments in illiquid
Felix Baumgartner: I’d say they’re
satisfied with real estate, and with hedge
funds. Private equity could be the next
boom in the coming years because it offers
a long-term investment, diversification and
good returns. But clients are too little invested
in it at present to reap the benefits.
For Swiss-based investors, I would estimate
that private equity currently represents
only about 1% or 2% of their portfolio.
Patrick Schwyzer: I would say it’s more
GLOBAL INVESTOR 1.15 — 53
Photos: Luca Zanetti
Patrick Schwyzer (left) and Felix Baumgartner from Private Banking & Wealth Management, Credit Suisse, take a moment to exchange viewpoints.
GLOBAL INVESTOR 1.15 — 54
What additional return would a client
typically expect in private equity versus
traded equity, after fees?
Patrick Schwyzer: It’s difficult to price
the illiquidity premium. Research shows that
private equity does create a positive outperformance
over the classic equity market in
the long run. For example in a traditional
buyout private equity fund, a client would be
looking for annual double-digit returns over
the lifetime of the fund.
How realistic are those returns?
Patrick Schwyzer: What’s key in
private equity is to invest in what we call
top- quartile performers. So you tend to
go with managers who have proven that
they can achieve the double-digit return in
any particular strategy. Needless to say
that expertise and knowledge of the private
equity universe are key in identifying
Where would you rank expectations for
hedge funds compared with cash, bonds,
equity or private equity?
Patrick Schwyzer: Again, it’s difficult
because hedge funds are not a homogeneous
asset class. We group hedge funds
into four different styles, so to speak.
And every style has its own risk/return
profile. For an equity long-short manager,
for example, a rule of thumb is that you
participate in two-thirds of the upside and
one-third of the downside compared
to traditional equity. There’s no such thing
as a free lunch, as you know. There are
other styles, e.g. managed futures, strategies
that tend to be uncorrelated to an
equity market. Keep in mind that any broad
hedge fund index is just the amalgamation
of all these different styles.
Nobody assumes that hedge funds are fully
liquid. But what about bonds? The financial
industry is reporting big rushes into high
yields and very high-risk bonds. Do you see
a risk that clients may have bought things
that they thought were liquid, but that may
end up not being liquid?
Patrick Schwyzer: Education is key.
Absolutely key. This is one of the lessons of
the financial crisis of 2008. Sometimes
a product behaves just like it is designed
to, but a different perception was linked to
the product and therefore caused irritation
with clients. An explanatory discussion with
a specialist typically helps in such situations.
Also, secondary market liquidity can be
provided for alternative solutions. While this
generates liquidity, it is not inherent in the
“What I see in most
discussions is that clients
want to understand
the thought process and
how we do things.”
is a Managing Director of Credit Suisse
in the Private Banking & Wealth
Management division, Zurich, and Head
of Alternative Investments for Private
Banking clients Switzerland and EMEA.
He was previously with GAM Global
Asset Management London. He graduated
from the University of St. Gallen
with a special focus on Finance and
is a Managing Director of Credit Suisse
in the Private Banking & Wealth
Management Division, Zurich, and
Co-Head Premium Clients Switzerland.
He was previously a Director at Credit
Suisse First Boston in Global Foreign
Exchange (GFX) and a member of the
GFX management team. He is a graduate
of the Zurich and the London Business
GLOBAL INVESTOR 1.15 — 55
product, and the liquidity provider will
typically buy at a discount to the actual net
asset value of the product.
Are entrepreneurs more likely than other
investors to favor illiquid assets?
Felix Baumgartner: It’s a good question.
As owners of their own company, they’re
more open to illiquid investments. They
probably have 80% of their total wealth invested
in the company, and they’re comfortable
with that because they know what
is going on with it. Of course, if they already
have 80% invested in their company, it
makes no sense to put the rest in illiquid
assets as well. So we would tend to advise
them to maybe put 5% in private equity,
if they really want that, and keep the rest
in cash or in liquid assets.
How much do clients want to know before
they decide on an illiquid investment?
Patrick Schwyzer: What I see in most
discussions is that clients want to understand
the thought process and how we
do things. They want to understand how
we come to the selection of a particular
manager, be it in the private equity or the
hedge fund space. They don’t really want
to receive the full package on the due diligence
report and go through it themselves.
That’s exactly why they come to us.
In terms of cycles, is it fair to say that
investor appetite is back where it was
before the financial crisis?
Felix Baumgartner: Absolutely. Investors
are looking for opportunities. Clients,
and especially Swiss clients, often want to
leverage their portfolio, also the illiquid
parts. It’s analogous to taking out a mortgage
on real estate. And banks are increasingly
amenable to offering credit (assessed
on the basis of loan to value, or LTV) on
illiquid assets. We clearly limit the risk in the
interests of both the client and the bank.
Patrick Schwyzer: Another cycle- related
example: before the 2008 financial crisis,
there was a lot of movement into the socalled
fund of hedge funds space, particularly
in Switzerland. After the crisis, those
private investors left that space. And now
we see them coming back, as providers
begin to offer a selection of carefully vetted
single-manager hedge fund products or
Has the rise of family offices played
a big role in increasing the allocation
to illiquid assets?
Patrick Schwyzer: It depends on the
type of family office. The smaller ones that
literally are a family of two or three people
have one investment specialist who needs
to cover everything from bonds to alternatives.
In that case, they’re looking to us to
help them put together their own portfolio of
hedge funds. Bigger family offices typically
employ their own private equity specialist
or hedge fund specialist, but like to talk to
us as a “sparring partner.”
Felix Baumgartner: Investment behavior
and interest can also change dramatically.
We’ve seen that over the last one or
two years. Some family offices that previously
invested only in traded equities with no
allocation in private equity because of
worries over illiquidity, decided to go into it
within the space of three or six months.
Are fees an issue for clients?
Patrick Schwyzer: Certainly, pre-2008,
the predominant means of investing in
hedge funds for the private sector was fund
of hedge funds. And there you had a double
layer of fees: the underlying managers
who on average were going to charge you
a 2% management fee and a 20% performance
fee; and the additional level on
the fund of hedge funds where the manager
would pick and choose those funds. We
have seen a clear trend toward single funds,
which has removed one of the fee layers.
The second layer is also under pressure.
It comes down to performance. Good
performance is clearly needed to justify the
“The order of preference that
we observe is: real estate,
then hedge funds, followed
by private equity.”
GLOBAL INVESTOR 1.15 — 56
AMRD 2003 = 1000
Indexes compare each sector’s
growth over a ten-year period,
using the central 80% of
data and a 14-month moving
Chinese Contemporary Art
AMRD Contemporary 100
05 06 07 08 09 10 11 12 13 14
The idea of objects of desire as investments of passion took off in the UK in the late 1970s
with the publication of “Alternative Investment.” As an investment analyst in the City of London,
the late Robin Duthy noticed that, while conventional investments were intensely studied for
past performance and future potential, no systematic analysis of the markets for art, antiques
and collectibles had been undertaken. Working with the late Sir Roy Allen at the London School
of Economics, he devised a sophisticated methodology of trimming and smoothing mechanisms,
which eliminated seasonal and other distortions. It is important to remember that when the
media reports eye-catching prices for collectibles sold at auction, the prices paid by the buyer
will be substantially higher than the cash received by the seller; transaction costs in these
markets (e. g. auctioneers’ or agents’ commissions) can be sobering, reflecting the price paid
to overcome the illiquidity inherent in trading high-value idiosyncratic items.
AUTHOR ART MARKET RESEARCH & DEVELOPMENT (AMRD)
Photo: malerapaso / Getty Images Sources: Art Market Research & Development (AMRD)
GLOBAL INVESTOR 1.15 — 57
be based on confidence,
in a dealer or
in oneself, and
the only basis
Robin Duthy “Alternative Investment” –
Founder of Art Market Research
Drawing attention: The rise of
Chinese contemporary art
In 2007, art collector Howard Farber sold Wang
Guangyi’s “Great Criticism: Coca-Cola (1993)”
for USD 1.59 million at Philips, having claimed to
have paid just USD 25,000 ten years earlier.
The painting was sold in late 2007 as the market
neared its peak for 63 times the reported acquisition
cost. After 2005, the auction market for
Chinese contemporary art entered a phase of rapid
development. Two years later, Charles Saatchi
was noted for selling off some of his younger
German artists collection in order to fund his
interest in Chinese contemporary art. The painting
“1998.8.30” by Lijun sold at Sotheby’s Hong
Kong in 2010 for over USD 1.2 million. Last year,
his “Publication 2 No. 4” sold for over USD 7.6
million. AMRD’s methodology enables comparison
with other art sectors, for example, as represented
by the AMRD Contemporary 100, a leading
benchmark. Set against an overview of sales of
contemporary artists across the globe, the index
reveals that sales of top Chinese contemporary
artists have been outperforming the competition
for the last five years.
Chinese Contemporary Art
versus Contemporary 100
The index, calculated on a 14MMA basis, shows
that the Chinese contemporary sector has grown
29% in the last 14 months and is back to where it
was in early 2007.
01.05 01.08 01.11 01.14
Chinese Contemporary Art top 25%
AMRD Contemporary 100 top 25%
Chinese Contemporary Art bottom 25%
AMRD Contemporary 100 bottom 25%
Italian classics in pole position
Most of us past a certain age are likely to have
owned and subsequently lost a prized possession
that has gone on to become a valued collectible.
It seems that a combination of rekindling one’s
youth and the empty nester’s disposable income
enables enthusiasts to purchase rare items,
and this is nowhere more obvious than in the
classic car market. Prices for some classic cars
are going through the roof, and it is the Italians
that continue to lead the market. Ferrari’s
1959–1982 models have seen a 1,350% increase
in the last ten years. Maseratis produced between
1958 and 1982 have also seen some action in
the last six months, having increased in value by
over 23%. The 1946–1977 era British Triumphs
have almost flatlined in comparison, but have
continued to rise slowly, with a compound growth
rate of 3.9% over the last ten years.
Ten years of market growth on a 14MMA basis
shows Ferrari outperforming Maserati by 55%
and Triumph by 84%. The Classic Car Index was
rebalanced to 1000 in 2003.
01.04 01.06 01.08 01.10 01.12 01.14
Ferrari 1959–1982 Maserati 1958–1982
Growth by brand from January 2004 to December
2014 using the central 80% of data from the
AMRD Watch Index, calculated on a 14MMA basis.
The index was rebalanced to 1000 in 2003.
01.04 01.06 01.08 01.10 01.12
Patek Philippe Cartier Rolex
Some watches ticking upward
Luxury items tend to be one of the first things
to suffer during tough economic times. The last
financial crisis was no exception, with the highend
watch market taking a steep plunge. The Swiss
watch market is especially sensitive to economic
depressions, regularly having to target new money.
High-end wrist watches are generally a poor
economic investment. People buy them for their
beauty, but not because they think the watches
will hold or increase their value. Yet Patek Philippe,
Rolex and some Cartier watches can be exceptions,
as they have shown solid value retention.
A person buying a new Rolex or Patek Philippe
watch today has a reasonable chance of losing
little or no money on selling it in a few years.
There is a healthy auction market for vintage Rolex
and Patek Philippe watches, and a few rare models
do fetch very high prices at auction, such as the
sale of a Patek Philippe 1933 “Henry Graves
Jr. Supercomplication” pocket watch, which sold in
2014 at Sotheby’s in Geneva for CHF 23.2 million
(USD 24 million). This set a new record for any
timepiece ever sold at auction.
Pearls are a girl’s best friend
Jewelry has performed extremely well in recent
years, with the emphasis being on signed pieces,
colored gemstones, and pearls in particular. Names
like Cartier, Van Cleef & Arpels or Boucheron are
sought after as such a source usually ensures good
quality design and manufacture, as well as having
a signature and normally a unique number. This
emphasis on signed pieces is a reaction to the large
quantity of unsigned and recently made pieces on
the market imitating vintage European pieces.
Pearls have increased in value more than any other
gemstones. Historically, the world’s best pearls
were collected along the Persian Gulf especially
around what is now Bahrain by breath-hold divers
until oil exploration in the 1930s disrupted the
oyster beds. The fact that no more natural pearls
are being harvested, combined with strong interest
from the Gulf States, which value the acquisition
of heritage objects, has forced pearl jewelry prices
up to unprecedented levels – increasing by 405%
in the last ten years. With world records being
set every year, the finest jewels and gemstones
continue to be objects of desire, having the advantages
of displaying wealth, wearability, portability
and scarcity value.
AMRD Pearl Jewelry Index vs AMRD General
Jewelry Index on a 14MMA basis over ten years.
The index was rebalanced to 1000 in 2003.
01.04 01.06 01.08 01.10 01.12 01.14
GLOBAL INVESTOR 1.15 — 58
From illiquid assets to
To foster economic growth, the European Central Bank needs to revive the securitization market.
This market is currently down to 25% of precrisis volumes or only 14% of US issuance in 2013.
Improved transparency, the clearing of bank balance sheets and improved regulatory rules are expected
to provide a catalyst for the securitization market going into the second half of 2015, offering
attractive yield opportunities for investors.
Illustrations: Frida Bünzli
GLOBAL INVESTOR 1.15 — 59
In the aftermath of the financial crisis, the European securitization
market collapsed. New issuance in European securitization decreased
by more than 75% compared to volumes in 2008 and has
not recovered since then. Primary market activity in 2013 was below
EUR 200 billion, corresponding to only 14% of US issuance over
the same time period (see Figure 1). The lack of a functioning securitization
market is a major disadvantage for European banks, the
economy and investors. Regulatory-forced deleveraging and its negative
impact on lending and economic growth could have been better
mitigated, in our view.
For the European Central Bank (ECB) to be successful in fostering
economic growth, the current pool of assets for Quantitative Easing
(QE) might prove to be too narrow, so that the issuance of securitized
investment products based on high-quality assets – so-called Qualifying
Securitization (QS) – needs to pick up in order to broaden the
ECB’s investment base. As the ECB is pressuring interest rates and
yields into negative territory, banks are in need of margin expansion.
If structured correctly, this can be achieved by QS and align the banks’
need to earn profits with the ECB’s need for economic growth and
the investors’ need for attractive yield opportunities.
To make the securitization market grow in Europe, it must become
economically attractive for banks. So far, the maths have not quite
worked out, mainly due to regulatory rules with respect to securitization
that result in a lack of “capital relief” for the banks (see box on the
risk capital treatment of different loans and securitizations on p. 61).
Given their need to remain exposed to the part of the securitized assets
with the highest risk, to which a risk weight of 1,250% is applied, the
transaction simply lacks economic appeal for the banks.
ECB as an asset-backed securities buyer
In 2014, the ECB released details of its asset-backed securities (ABS)
purchase program, which was followed by the release of a legal act
enabling implementation of the purchase program with actual purchases
having started. The ECB has appointed four executing asset
managers for the purchase program. The asset managers will conduct
the purchases on behalf of the Eurosystem and undertake price checks
and due diligence prior to approving the transactions. The program
will involve the purchase of senior tranches and guaranteed mezzanine
tranches of loans originated in the euro area. Greek and Cypriot ABS
will also be included in the purchase, albeit with tighter provisions.
The combined size of the ABS purchase program and covered bond
purchase program will reach EUR 1 trillion.
Several other measures have also been taken in the meantime
to facilitate the development of the securitization market in Europe.
Among them, we would highlight the changes to Solvency II >
Turning an illiquid asset into an investment opportunity takes time
The ECB is in the middle of a multiyear process to regain investors’
and market trust, as well as to foster economic growth. In our view,
the basis for regaining investor trust – including the ECB as an investor
– was provided by the comprehensive asset quality review (AQR)
and the stress test carried out by the ECB and the European Banking
In October 2014, following a yearlong analysis of over a million
pieces of data, the ECB and EBA published the much-awaited results
of the AQR and stress test. The AQR exercise covered 130 banks
within the Eurozone’s 18 countries, with total assets of EUR 22.0
trillion accounting for around 82% of total banking assets under the
European Single Supervisory Mechanism (SSM). The EBA stress
tests covered 123 banks across 22 of the 28 EU countries, including
banks from the UK and the Nordic region. Overall, 25 of the 130 banks
failed, with an identified capital shortfall of EUR 24.6 billion. More
specifically, 13 banks were identified to face capital shortfalls totaling
EUR 9.5 billion.
We believe that the ECB/EBA announcement struck the right balance
between being too harsh and being too lenient, notably highlighting
areas of vulnerability for some of the examined banks. Despite not
forcing them to take immediate action, the ECB made it very clear that
the adjustments would become part of its ongoing supervision of capital
requirements as it continues to forge ahead with the agenda
of improving the quality of European banks’ balance sheets. More
importantly, we believe that the process toward a European Banking
Union has significantly contributed to increased disclosure and transparency,
which is building the basis for a greater investor attraction
toward banking assets.
01_Primary market activity of
European and US asset-backed securities
New issuance of asset-backed securities (ABS) remains subdued in
Europe compared to the US. The European market is, however, forecast
to pick up during the course of the year following the launch of the
ECB’s purchase program. Source: AFME, Credit Suisse
in EUR bn
2006 2007 2008 2009 2010 2011 2012 2013 2014
Total European ABS placed Total US ABS placed
European ABS placed in % of US ABS placed (rhs)
GLOBAL INVESTOR 1.15 — 60 The bank then bundles a number of home loans –
How does securitization work?
The following illustrations show how loans can be turned into tradable securities:
When a bank grants a mortgage to a borrower,
the bank earns an interest income.
both risky and less risky – into a pool of mortgages.
The bank places these pools of mortgages
into a trust. The trust then sells bonds, which
are secured by the mortgages.
The return and the risk of the bonds depend on the
riskiness of the mortgages which secure the bonds.
To create different risk categories of bonds, the
bank divides the mortgages into risk groups called
tranches. Rating agencies such as Standard &
Poor’s or Moody’s then often rate the tranches to
reflect the risk of default. The bank is required by
regulation to keep a tranche of the highest risk
The newly created bonds are sold to private and
institutional investors and even central banks.
Thus, the bank has earned a fee for originating
mortgages, but sold the risk and rewards of these
mortgages to investors through the process of
converting them into tradable securities (bonds).
GLOBAL INVESTOR 1.15 — 61
regulatory rules for insurance companies, which made the capital
charges less onerous for high-quality securitization. Further, rules on
the Liquidity Coverage Ratio (LCR) for banks have also allowed some
high quality securitization to qualify under certain criteria. However,
there is still considerable debate on whether the existing rules on
securitization still make the capital treatment too onerous for the issuing
banks and this is an area that needs to see some change to
help revive the European securitization market.
Securitization market with significant volume
We believe that the data published by the EBA and ECB on banks’
risk exposures and risk-weighted assets should allow the market to
better understand and quantify the eligible securities. From an issuer’s
point of view, we conclude that there are currently situations where
an unsecuritized portfolio may require less capital than a securitized
portfolio (see adjacent box). As a result, the loan portfolio to be
securitized might contain a higher proportion of assets with a higher
risk weight attached to it. Thus, we believe that securitization may
take place in regard to high-quality small and medium enterprise (SME)
loans due to the higher risk weights applied. This is precisely the
area where the ECB is trying to unlock the funding gridlock.
With securitization accounting far from clear under International
Financial Reporting Standards (IFRS) and a likely piecemeal
approach to capital relief, we have tried to estimate the potential
size of qualifying securitization assets for Europe. Depending on the
range of assets taken into account, we have adjusted the data for
asset encumbrance and estimate that the market could range from
a minimum of EUR 1 trillion (including mainly SME loans) to EUR 2.4
trillion (including lower risk-weighted asset categories such as securitized
or collateralized lending). From the asset breakdown, we
predict that securitization is more likely to reopen bank funding channels
for SMEs and corporate lending as we would expect the capital
relief to transmit into lower sustainable funding costs in these sectors.
We therefore believe that securitization can play a key role in
serving the macroeconomic policy objectives of the ECB to foster
Given the completion of the AQR and the launch of the ABS
purchase program, we believe that these are supportive steps toward
a fully fledged securitization market throughout 2015. In turn, we
continue to believe this will provide a positive backdrop for the
Eurozone by releasing capital pressure from banks’ balance sheets,
reducing the cost of borrowing for SME clients and providing lending
to the economy. In an environment of very low yields, investors
(including the ECB) will gain access to higher-yielding assets, which
we expect to be attractively priced at the beginning to reopen the
Head of Global Equity & Credit Research
+41 44 334 56 43
Carla Antunes da Silva
Head of European Banks
Investment Banking Equity Research
+44 20 7883 0500
The risk capital treatment
of different forms of
loans and securitizations
In this box we compare the capital requirement for
a securitized portfolio (leaving 5% on the book as
per retention rules) with that of the underlying loan
portfolio. In the analysis, we have assumed that
the bank uses the standardized approach for the
calculation of risk-weighted assets.
Capital requirements for typical loan portfolios
We take three types of loan portfolios and apply the
risk weights under the standardized approach. We
take a secured residential mortgage, a commercial
mortgage and an unsecured corporate loan,
and present our capital charge analysis below:
1 RESIDENTIAL MORTGAGE – RISK WEIGHT = 35%
CAPITAL REQUIREMENT = 0.08 × 35 = 2.4%
2 COMMERCIAL MORTGAGE – RISK WEIGHT = 100%
CAPITAL REQUIREMENT = 0.08 × 100 = 8%
3 UNSECURED CORPORATE LOAN – RISK WEIGHT = 150%
CAPITAL REQUIREMENT = 0.08 × 150 = 12%
Capital requirement for a typical securitization
For a bank that keeps 5% of the portfolio on its
books, the maximum capital charge would be
1 RISK WEIGHT = 5 × 12.5 = 62.5
2 CAPITAL REQUIREMENT = 0.08 × 62.5 = 5%
We can see that a bank does not always gain capital
relief from securitization. For residential mortgages,
for example, the capital requirement is greater for
the securitized asset than for the underlying loan
portfolio. This difference in capital treatment might
encourage securitization of high risk assets, i.e.
on a risk-based measure, a higher risk-weighted
SME asset would generate more capital relief for a
bank than a lower risk-weighted residential mortgage.
Regulators thus have to address the risk weight
applied to securitization of assets more closely
compared to the underlying risk of the assets.
GLOBAL INVESTOR 1.15 — 62
Illiquidity in corporate bond markets
The efforts of regulators to strengthen the financial system
have led to both lower and more volatile liquidity in the corporate
bond markets. As a result, investors could potentially find
themselves in a situation where no one will buy. To properly
manage expectations, and to be able to plan ahead, investors
need to understand this new landscape and what it means.
financial crisis in 2008/2009: global market
activity is concentrated more in the most
liquid securities like sovereign bonds, and less
in riskier securities such as corporate bonds.
According to the paper, this trend suggests
an increased fragility of the latter. As data
availability is limited, the International Capital
Market Association, a self-regulatory organization,
conducted a series of interviews with
market participants to analyze the topic from
a market view. The study, titled “The Current
State and Future Evolution of the European
Investment Grade Corporate Bond Secondary
Market,” finds that liquidity in secondary
European corporate bond markets has declined;
interviewees described the decline
ranging from “significantly” to “completely.”
Another survey of large banks published by
the European Central Bank (ECB) in January
2015 focused on Euro-denominated markets
and arrived at similar results. More banks reported
that their market-making activities for
credit securities had decreased during 2014
rather than increased, and a further decrease
is expected in 2015. The study also found that
participants’ confidence in their ability to act
as market makers in turbulent times had
diminished in 2014 compared to 2013.
Since the financial crisis in 2008,
regulators have tightened rules
on financial institutions to improve
the stability of the financial system.
Banks and dealers have subsequently
strengthened their financial profiles and
scaled back risky capital market activities.
This structural change is especially important
to bond markets as they depend on intermediaries
willing to warehouse risk and facilitate
trading activity. As a number of studies by
governing institutions suggest, liquidity in
bond markets has decreased since 2008:
investors now find it harder to enter and exit
positions or are incurring higher transaction
costs. This could increase the risk of more
severe price swings. In an extreme scenario,
investors might find themselves trapped as
nobody is willing to buy. Here, we take a
closer look at this structural change in bond
markets and how it interacts with current
market conditions, and analyze what investors
Corporate bond markets
Compared to equities, the fixed income
market relies more on dealers and over-thecounter
structures, which makes it more decentralized
and dependent on functioning
intermediaries. Further, the market for corporate
debt is much more fragmented than
the market for equities as companies usually
offer very few classes of equity, but a large
number of different debt instruments. Within
the bond market, different classes of debt
exhibit different liquidity characteristics. The
market for government bonds is perceived as
more liquid compared to the market for corporate
bonds, partly due to the different structures
of securities issued. Governments issue
in larger lots, have fewer maturities and usually
do not add exotic features to their debt.
The corporate bond market is much more
fragmented and thus shallower. Moreover, in
the corporate bond market, different risk segments
exhibit different liquidity traits. Investment-grade
debt is usually more liquid, while
high-yield and emerging-market debt are
perceived as less liquid.
Declining liquidity raises awareness
A number of recent publications by regulatory
institutions and think tanks suggest
liquidity in bond markets has changed. In
November 2014, a paper published by the
Bank for International Settlements on marketmaking
activities found that liquidity in debt
markets has shown a diverging trend since the
Regulatory tightening a driver
We believe that the decline in corporate bond
market liquidity can be attributed to an increase
in regulation in the financial sector.
This matches with the ECB survey results
mentioned above, as banks most often cited
regulation and balance sheet capacity as reasons
for a decline in market-making activities.
The financial crisis in 2008 revealed a
number of shortcomings of financial regulation.
Since then, governing institutions have
been actively improving and tightening the
regulatory framework, thus leading to a reduction
of market-making and trading activities
by banks. The Basel regulations for banks
have increased the amount of equity banks
need to hold against their risky positions. This
makes market-making activities, which require
sizable balance sheet capacity, less
profitable. Additionally, the newly introduced
Liquidity Coverage Ratio and Leverage Ratio
are steering banks toward holding more
liquid securities, reducing high-volume/lowmargin
business such as trading activities,
and limiting their reliance on short-term funding.
Moreover, banks have cut proprietary
trading in view of, for example, the Volcker
Rule in the USA. Proprietary trading has
been a source of liquidity, especially during
GLOBAL INVESTOR 1.15 — 63
volatile markets. As a result, banks and dealers
have reduced their fixed income trading
activities since 2008 as well as their ability to
warehouse risk and facilitate capital market
Conditions affecting structural changes
The structural change stemming from financial
regulation comes at a time of historically
low interest rates fueled by quantitative easing
programs adopted by central banks around
the globe. On the one hand, we believe that
this accommodative stance has reduced market
uncertainty and thus eased investors’
concerns about liquidity. On the other hand,
low interest rates have increased the corporate
debt markets as companies take advantage
of the lower funding costs. In Figure 1, we
show the increasing gap between primary
dealers’ inventory and the size of the US corporate
debt market. Moreover, investors’ motivation
to drop low-yielding government debt
and pile into higher risk and most often less
liquid securities has also risen due to monetary
policy, in our view. This in turn adds to liquidity
concerns again (see Figures 2 and 3).
Liquidity most relevant in times of stress
So far, the decline in bond market liquidity
has not caused much of a headache for investors
as corporate bonds are in good demand.
However, it is quite easy to imagine a scenario
of many investors exiting at the same
time with no one willing to buy or provide
market-making activities. In this case, liquidity
would evaporate quickly, leaving investors
high and dry. The modest decrease in liquidity
in the last few years might therefore not
be a good indicator of what to expect during
turbulent times or in case demand for corporate
bonds falls. This could, for example, occur
when interest rates increase from their historic
lows. We believe the asset management
industry is particularly exposed to a sudden
drop in corporate bond market liquidity. Investors’
expectations of their ability to redeem
mutual fund shares or sell ETFs (exchangetraded
funds) on a daily basis could reveal the
low liquidity of the underlying bonds bundled
into these funds. In case of a pronounced
outflow from funds, many asset managers
could be forced to sell into dry markets and
incur significant losses.
The Bank of England’s Financial Stability
Report, published in June 2014, aims at extracting
the liquidity premium inherent in bond
prices by comparing credit derivatives and
actual bond prices. The analysis found that
the liquidity premium increased in European
investment grade issues from approximately
50 basis points in 2007 to 200 basis points
the following year. For European high-yield
issues, the rise was even more extreme, from
approximately 100 basis points to almost
1,200 basis points during the same period.
This suggests that, in times of crises, investors
chase liquidity and also quality. Furthermore,
according to the study, the liquidity
premium is fairly low at the moment. To us,
this raises concerns that current market prices
influenced by low volatility and low interest
rates do not compensate investors enough
for the ongoing decline in liquidity and a potential
hike in turbulent times.
Implications for investors
We believe that investors need to recognize
the structural change toward lower liquidity
as well as the volatile nature of liquidity, especially
buyers of higher-yielding corporate
bonds. Certainly, liquidity is more relevant in
turbulent market times, but we think investors
should plan ahead and assess to what degree
they rely on markets. If holding fixed income
securities to maturity is an option, investors
can shrug off liquidity concerns. If not, investors
should analyze each case to see if they
are rewarded for the risk of not being able to
sell at their convenience.
Investors are not alone. Supervisory institutions
are increasingly aware of the structural
changes in bond markets. A policy response
to cushion abrupt movements is not
unlikely, in our view. In the long term, we
believe that the gap left behind by banks will
be filled or that banks will adjust their trading
activities to cater to their clients more specifically.
As traded corporate debt is a substantial
part of the financial system, new forms of
trading are evolving quickly. Electronic platforms
that rely on peer-to-peer trading instead
of dealers already exist and are likely to grow.
Another approach would be to standardize the
corporate bond market more to reduce complexity
and simplify trading and market making.
A combination of both seems pragmatic to us
as electronic trading requires standardized
units to flourish. In the meantime, a closer look
at how much an investor relies on liquidity
when a security is purchased will help to avoid
most of the concerns.
Equity and Credit Research Analyst –
European and US Banks
+41 44 334 29 59
01_Corporate debt market up
A growing gap between primary dealers’ inventory
and the size of the US corporate debt market is
fueling liquidity concerns.
Source: Credit Suisse, Federal Reserve, SIFMA
Federal Reserve data
2001 2004 2007 2010 2013
Outstanding corporate debt USD bn (US)
(left-hand axis) Primary dealer inventory USD bn
(US) (right-hand axis)
02_Turnover ratio down
The turnover ratio of corporate debt is much lower
than the ratio of Treasuries and the total debt
market. The turnover ratio of the US debt market
has decreased on average by more than 30%
since 2007. Source: Credit Suisse, SIFMA
2007 2009 2011 2013
US Treasuries US total debt
US corporate debt
03_Outstanding US bond
US debt markets have increased 14-fold from
1980 to 2013. Source: Credit Suisse, SIFMA
1980 1990 2000 2013
Municipal Treasury Mortgage-related
Corporate debt Federal Agency securities
Money markets Asset-backed
GLOBAL INVESTOR 1.15 — 64
Head of Economic Research.........................................
+41 44 333 09 61.......................................................
Oliver Adler is Head of Economic Research at Credit
Suisse Private Banking and Wealth Management.
He has a Bachelor’s degree from the London School of
Economics and an MA in International Affairs and a PhD
in Economics from Columbia University in New York.
> Pages 10–12, 14, 26–29
Carla Antunes da Silva
Head of European Banks, Equity Research....................
+44 20 7883 0500.....................................................
Carla Antunes da Silva is Head of the European Banks
at Credit Suisse Investment Banking and has covered the
European banking sector for 15 years. Previously, she
was Associate Director of Research and lead analyst on
UK banks at JPM. She started at Deutsche Bank in 1996,
covering Iberian banks. She was consistently ranked a
top analyst in the space. She has an MA in PPE from the
University of Oxford and an MSc in Management from
the LSE. > Pages 58–61
José Antonio Blanco
Head of Global Multi Asset Class Solutions...................
+41 44 332 59 66.......................................................
José Antonio Blanco is Head of the Global Multi-Asset
Class Solutions unit and a voting member of the
Investment Committee. He holds a degree in economics
and a PhD in applied econometrics from the University
of Zurich. Mr. Blanco is a member of the Executive
Committee of the Swiss Financial Analysts Association
(SFAA) and the Swiss Society for Financial Market
Research. > Pages 10–12, 14, 26–29
+41 44 334 78 93.......................................................
Gregory Fleming joined Credit Suisse in 2006 as a senior
analyst for the Investment Decision Cockpit and Investment
Committee. Previously, he worked in portfolio strategy
for Westpac and Grosvenor Financial Services Group,
and for the International Textile Manufacturers Federation
as a global economist. He holds an MA with Distinction
in Economic History from the University of Canterbury,
New Zealand. > Pages 13, 38–39, 42–43
Fundamental Micro Themes Research...........................
+91 22 6607 3707......................................................
Nikhil Gupta joined Credit Suisse Private Banking and
Wealth Management in 2011, and is currently part of the
Fundamental Micro Research team. Before joining
Credit Suisse, he worked for a management consulting
firm for four years. He has an MBA from the Indian
School of Business, Hyderabad. > Page 15
Equity and Credit Research Analyst – European
and US banks..............................................................
+41 44 334 29 59.......................................................
Jan Hannappel is a Research Analyst in Global Equity and
Credit Research at Credit Suisse, focusing on European
and US banks. Before joining Credit Suisse in 2014,
he was a corporate finance analyst. Jan Hannappel holds
an MA in Accounting and Finance from the University of
St. Gallen. > Pages 62–63
Head of Mutual Funds & ETFs.......................................
+41 44 333 23 94.......................................................
Lars Kalbreier, CFA, is a Managing Director and global Head
of Mutual Funds & ETFs. In this role he is responsible for
the fund selection and advisory process. Before taking the
current role, Lars headed Global Equities & Alterna tives
Research and was a member of the bank’s Investment
Committee. He is a member of the investment committee
of Corpus Christi College, Cambridge. > Pages 24–25
Head of Global Real Estate Research............................
+41 44 334 32 89.......................................................
Philippe Kaufmann is Head of Global Real Estate Research
at Credit Suisse Private Banking and Wealth Manage -
ment, where he also worked for Swiss Real Estate Research
for six years. Before joining Credit Suisse in 2007,
he worked for a policy consulting firm and an economic
research company. He holds an MA in Economics from
the Univer sity of Fribourg, Switzerland. > Pages 44–47
Head of Research and Deputy Global Chief
+41 44 332 22 33.......................................................
Giles Keating is Global Head of Research for Private
Banking and Wealth Management, Deputy Global Chief
Investment Officer and the Investment Committee’s
Vice Chair. He joined Credit Suisse in 1986. He was a
Research Fellow at the London Business School and has
degrees from the London School of Economics and
Oxford where he is Honorary Fellow. He chairs Tech4All
and techfortrade, charities that use technology to reduce
poverty. > Pages 03, 24–25
Head of Private Equity Origination & Due Diligence.........
+41 44 334 53 88.......................................................
Sven-Christian Kindt is Head of Private Equity Origination
& Due Diligence at Credit Suisse Private Banking
and Wealth Management. Before joining Credit Suisse in
2008, he worked for Bain & Company and A.T. Kearney
in London. He holds degrees from ESCP Europe and the
University of Michigan’s Ross School of Business.
> Pages 16–17
Senior Advisor Credit Suisse.........................................
+44 20 7883 9864.....................................................
Robert Parker is a Senior Advisor to Credit Suisse in
Investment Strategy & Research. He has worked in the
asset management industry for 42 years and joined
Credit Suisse in 1982 as a founder of CSFB Investment
Management. He chairs the Asset Management and
Investors Council and is a board member of the International
Capital Markets Association. He has a BA and MA
in Economics from Cambridge University. > Pages 48–51
Head of Global Equity & Credit Research........................
+41 44 334 56 43.......................................................
Christine Schmid is Head of Global Equity & Credit
Research at Credit Suisse Private Banking and Wealth
Management. She has covered financials for 15 years
and coordinates the global financial view. She holds an
MA in Economics from the University of Zurich, and is
a CFA charterholder. > Pages 58–61
Head of Real Estate Investment Management Switzerland
+41 44 333 92 42.......................................................
Beat Schwab has been Head of Real Estate Investment
Management Switzerland since November 2012. From
2006 to 2012 he was CEO of the real estate services
group Wincasa AG. During his career he held various position
in the construction industry and real estate markets.
Mr. Schwab holds a PhD in Economics from the University
of Bern and an MBA from Columbia University. > Page 47
Head of Fundamental Micro Themes Research............
+41 44 334 88 57.......................................................
Markus Stierli is Head of Fundamental Micro Themes
Research at Credit Suisse Private Banking and Wealth
Management, based in Zurich. He holds a PhD in
International Relations from the University of Zurich
and is a Chartered Alternative Investment Analyst.
> Pages 04–08, 15
Cross Asset and Alternative Investments Strategist........
+41 44 334 60 47.......................................................
Marina Stoop is the Head of Risk and Flow Analysis
within the Cross Asset Strategy and Alternative
Investments team. She is responsible for providing input
to the Investment Committee on financial market risks,
liquidity and flow. Marina Stoop joined Credit Suisse
in 2010 after graduating from ETH Zurich with an MA
in Science. > Pages 21–23
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Credit Suisse AG, Investment Strategy & Research,
P.O. Box 300, CH-8070 Zurich
Oliver Adler, Markus Stierli, Gregory Fleming
30 April 2015
Markus Kleeb, Manuel Moser
Design and realization
Charis Arnold, Benno Delvai, Angélique El Morabit,
Monika Häfliger, Samira Moschettini, Nadia Bucher,
Rahel Schwarzentruber (project management)
Giselle Weiss, Robin Scott, Dorothée Enskog
GDZ print, Zurich
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No. 01-15-862140 – www.myclimate.org
© myclimate – The Climate Protection Partnership
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