1. How a global investment approach can add to the risk/reward characteristics of a portfolio
2. How a global approach opens up a broader range of asset classes to investors
3. Why larger funds are capable of offering broader diversification than smaller portfolios
DIPANJAN ROY: Well when I think about globalisation there are two things which I consider for any multi-asset investment portfolio. Firstly there is the risk aspect to it and secondly there is the returns aspect to it. So when we are considering risk, any geographical location, whether it be in the developed market for a jurisdiction like the UK or whether it be emerging markets, there are country specific and jurisdiction specific risks; for example Brexit. So there are advantages to diversifying away that country specific risk by going global. That’s on the risk side of it. On the return side what we are really trying to see is where our returns going to come from in the long term, sort of 10, 20 years from now, because that is the typical investment horizon of most of our clients.
Now, when we’re looking at long-term returns of asset classes, the starting point is the economic growth which we expect from different economies from different countries. And this is a theme which we have been working a lot on, and what we see is that the demographic headwinds to economic growth in most of the developed world is such that it will be a significant factor constraining economic growth in these economies. This is less a concern for perhaps the US, but it is becoming a concern for the UK. It is definitely a concern for Europe and Japan. So where are the demographics supporting long-term economic growth. These are in the emerging markets, in Asia, in Latin America, in Africa.
So the returns which we expect in the long term are going to come from an increasingly global portfolio rather than a portfolio which is concentrated on the UK. So both from a risk as well as a return perspective is makes sense to go global.
PRESENTER: So we’ll discuss demographics later on in greater detail, but currently I’d like to know why it’s so important to go global, given that in terms of financial markets themselves they are correlated on there. We’ve got central banks behaving and acting more or less at the same time; commodity prices when they change obviously this affects absolutely everyone across the globe; and in terms of international money flows as well, they are effective at pricing assets and closing out arbitrage opportunities. So in this context where do you go?
DIPANJAN ROY: Sure. So you’re very right in noting that correlations internationally have gone up in recently times. And this is largely determined by monetary policy, which as you have remarked is being synchronised across most central banks. But there are still divergences if you like. For example, the US is in a state of its monetary cycle where it’s looking to raise rates, which is in contrast to Europe and Japan and the UK. So there are these divergences. Despite the increased correlations, despite the fact that a large part of the financial cycle is being synchronised across geographies, there is still a benefit to investing in different geographies, just because they are in different phases of economic growth. They are in different phases of the monetary policy cycle.
So there are still economies which are raising rates, whereas there are economies which are lowering rates. There are economies in the middle of QE; there are economies which have exited QE. If we’re looking at the commodity cycle, for example, there are commodity producers and commodity consumers who get impacted in radically different ways from whether oil prices are rising or falling for example. So there are all these differences which we try and harness and harvest by looking in different geographies, in different economies.
PRESENTER: And in the QE context, which assets would you favour? Because we are seeing both securities and equities rising up at the same time because of QE, so what do you do in this context?
DIPANJAN ROY: So in terms of QE I think it’s very important to realise that what QE has done is it has lowered the risk premium for all assets. So because government bonds have been artificially constrained in terms of their yield by central bank action, what has happened is investors like ourselves have been forced to go into riskier assets. Now this is a double-edged sword, because what has happened is because investors have moved further along the risk curve, we have seen risk premiums in all these assets go down, which means that prices have gone up in corporate bond, in equities, in property across the asset spectrum.
Now that is good if you’re holding these assets. The danger lies in the fact that these returns if you like are being borrowed from the future. So you are taking future returns and you’re realising them right now. So the classic example is for example bond yield. The bond yields are low, but bond prices are quite robust. Bonds have returned excellent returns over the past couple of years because of QE. But that comes at a cost. The cost is the fact that your future returns are going to be lower, just because yields are lower. So it’s almost like an arms race where you have people constantly searching for yield and moving further and further into riskier assets.
Now the danger lies in the fact that you take on risks which are not adequately compensated. So, as global investors investing across different asset classes, our concern is always the fact that are we being adequately compensated for the risk which we are taking on? So every asset has its risks. Now the question is that given the array of choices which you have, do you really want to take that risk, or do you want to say that OK this is not for me, I’m getting too little returns for the amount of risk which I am taking. That is a decision which you need to take for each asset class, for each geography and indeed for each individual investment.
PRESENTER: And do you get access to new asset classes when you choose emerging economies, for instance, or when you decide to go global? Can you give us some examples?
DIPANJAN ROY: So when we’re talking about new asset classes, I think what we need to consider are the asset classes which were new a couple of years ago, and the asset classes which are currently new. The reason why I make this distinction is that because of QE, because of risk premiums being compressed in traditional asset classes, most large institutional investors have moved into these so called alternate asset classes, new investment opportunities. Now what has happened is classic demand/supply economics, because there are so many investors chasing yield in these new asset classes, in a lot of these classes valuations have become insanely high and the returns which you get for taking that risk are not justified. So what we’re really looking for are asset classes which other investors aren’t looking at, or are looking at but are not able to get into because of different constraints, or investment asset classes which have fallen out of favour which investors do not want to get into.
The other context to that is that in each of these asset classes there might be cases where the risk is not fully understood. So the two things which any investor needs to watch out for are firstly do you understand the risks in a new asset class, in a new investment opportunity? And secondly are you getting enough returns to compensate you for that risk? And to be frank with you there are a lot of investment opportunities where one or both those criteria are not being met. There are cases where because there are so many institutional investors going after the same investment opportunities, the returns are actually worse than the traditional asset classes on the risk-adjusted basis.
PRESENTER: And can you be a bit more specific about the new assets you’re referring to? Are we talking about property, infrastructure or funds; what type of alternative assets are out there when you take a more global perspective?
DIPANJAN ROY: So in terms of new asset classes as I said they are not really new but they are being increasingly brought into focus by investors looking for yield. So obviously there is property which is I would say is almost a traditional asset class. There are infrastructure projects. There are lending opportunities in the market, whether it be bridge loans, whether it be leveraged loans. There are opportunities in renewable energy for example, large projects. Now when we consider these opportunities we need to make sure that we have the expertise to understand both the idiosyncratic risk which is peculiar to that particular asset class and that particular investment. And also the systemic risk, which is how do these investments behave in a broader market context? So if for example there is a liquidity squeeze or there is general risk aversion in the market, are these asset classes affected and to what extent are they affected?
PRESENTER: So how do you do your homework? How do you find out about the risk when you are not on the ground and you don’t know the jurisdiction, you’ve never been to that country, how do you do it?
DIPANJAN ROY: Well in my company at PPMG it’s quite simple. We have the experts on the ground who are able to give us their views. But going back to your broader question, I think it’s important that investors realise that there are different ways of accessing the same market, and there are different ways of looking at the same market. And both these are very important. Because if you’re looking at these new investment opportunities, there is a real danger as I earlier said that you might not be appreciating all the risks. So do you really have the expertise to understand those risks? And then the second thing is do you have the infrastructure on the ground to access those investment opportunities in a cost effective manner?
Because as the financial markets have broadened and deepened, it has become increasingly easy for investors to access new investment opportunities. The crux of the problem is more the cost of accessing those investment opportunities: the fees which you’re paying to the manager or your in-house experts to access those. So do you have the returns expectations from those asset classes to adequately compensate you for the increased costs of accessing those investment opportunities?
PRESENTER: And are we seeing a shift currently in the traditional centres of power? We know that obviously China is such a large economy, and is also using self-diplomacy to establish its power even further. So, in terms of what’s happening in this power shift across the planet, how do you play that and how do you account for it in your strategy?
DIPANJAN ROY: Well that’s a very interesting question, because when you talk about the traditional power centres, if we take a long enough timeframe, those traditional power centres weren’t there say a century ago. So if you look at say a century ago the traditional power centres were the United Kingdom and the US was an emerging power centre if you like. So it’s important to get that into perspective, that when we’re talking about long-term investment strategy power centres always shift – and that is the nature of economies, that is the nature of countries. So we will have the traditional power centres gradually reduce in their dominance of the economy, and we will have new power centres emerge.
So Japan for example, which is now considered one of the power centres, at least from an economic sense, came into prominence just after the Second World War for example. So if you were asking someone in the 1960s or 1970s they would consider Japan to be an emerging power centre. So we have similar dynamics playing out now for example with China or even with the developed economies in Asia. So there are many economies which started out from an emerging market status, and are now moving into a developed market status. There are economies which are starting out with frontier market status and gradually becoming emerging markets.
So these are constant shifts which happen. And you’re very right in pointing out that they have a huge impact on the investment returns which you get. So if you are able to correctly predict these shifts which happen in the economic balance, the returns are potentially huge. The trick or, I won’t say trick, the strategy is to really diversify so that you’re not putting all your eggs in one basket. So we can say that generally the economic status will change and new economic centres will emerge, but that doesn’t mean that I have 100% certainty that for example one particular economy, say China, is going to grow and become huge. So you want to invest in sufficient new emerging economies with the expectation that ultimately the returns which you get from one will counteract against loss of returns from another.
PRESENTER: Since you’ve mentioned Japan I think it’s interesting to notice that obviously it was considered to be a very powerful country when it was at the forefront of technological innovation wasn’t it?
DIPANJAN ROY: Yes.
PRESENTER: Does the same apply today?
DIPANJAN ROY: Well Japan is a curious case. It started out if you like in the place where China is currently. So you had years of positive growth, years of very good growth actually, and you’ve had a curious mix of conditions which led to its current status and its current economic predicament almost. I think the biggest problem with Japan is twofold. One is its ageing demographics and secondly its deflationary mindset which has become so entrenched that despite monetary policy, despite fiscal stimulus, despite the political will, it’s very difficult for people to shift their inflation expectations, and this has been brought on by decades of low growth, low inflation. And to get out of that is going to take a long time. So you cannot counteract decades of low growth and low inflation by a few years of monetary policy.
So the Bank of Japan has been at the forefront of quantitative easing. So long before the US Federal Reserve and the ECB and indeed the Bank of England tried quantitative easing, it was originally tried in Japan. And yet the problem was so severe that even that was not sufficient to overcome the low growth and the low inflation expectations. Is the Bank of Japan going to succeed now? It’s difficult to tell. As with these things there is always an uncertainty. But I think the bigger problem is the ageing demographics, which mean that even with a supportive monetary policy, even with Abenomics and the supportive fiscal policy, the long-term prospects for Japan are having these headwinds.
PRESENTER: And isn’t it the same here in Europe? The same applies doesn’t it? We’ve got an ageing economy, deflation not quite but almost let’s face it, and fairly low interest rates, low growth as well apart from here in the UK are doing a bit better obviously, but what about this demographic trend here in Europe?
DIPANJAN ROY: Yes. So when we’re talking about Europe I think it’s crucial to separate the UK and Europe. So in the UK the demographic trends are not very supportive, but they’re still better than what we’re seeing in Europe. So in Europe the ageing demographics, the high dependency ratio, which is the ratio of the people who are too old to work or too young to work, vis-à-vis the working population, all of these are showing structural signs of degradation. And these are changes which do not reverse very easily. Some would say that they’re even irreversible. So once you have low fertility rates within the population it’s very difficult to get rid of that except through external stimulus like migration for example. But then that has its own political ramifications.
So the demographics in Europe are definitely a headwind to long-term economic growth prospects. And the other part or the other side of the coin is the political risk. So what we’re seeing is increasingly the political risk in the entire economic union of Europe is becoming sufficiently large for us to demand an extra risk premium for investing in Europe.
PRESENTER: And talking about big political shifts, you’ve just mentioned obviously the Brexit vote here in the UK, more recently the US elections and Trump. Is this just political news or something more fundamental happening currently? What about potentially the new trend for more protectionism as well, how will that affect your strategy going forward?
DIPANJAN ROY: Well that’s a very interesting question, because this is a long-term trend which is coming about. And the manifestation has been recent in terms of Brexit, in terms of the Trump presidency. But what we’re seeing is that globalisation has brought an enormous labour pool if you like into the global labour force. So we have had the population of emerging markets like China, or even the population of the Russian Bloc after the collapse of the Soviet Union, coming into the global labour force. And what this has done is this has compressed wages for a lot of the activities which are transferrable. So stuff like manufacturing, stuff like services which can be outsourced. These are activities where a worker in Europe or a worker in the UK is no longer competing with themselves; they are competing with workers in the emerging markets who are willing to do it for a lot less.
Now keeping apart the normative argument about whether this is right or wrong, we need to accept the fact that this is happening. And this will be increasingly manifesting itself in terms of disaffection amongst those who have lost out. Now this political risk is going to be elevated because what has happened is the people who have lost out, or the part of the labour force which has lost out in the developed world haven’t really been given an alternative by their government. Now what form that alternative takes in terms of the welfare state, in terms of re-education and training of the workforce, those are long-term solutions. But what we’re seeing is right now the problem is being brought into focus. From the time the problem occurs to the time the problem is being brought into focus has taken something like 10-20 years. Because if you like the globalisation started around 20 years ago, and it’s only now that those who have seen their wages compressed are making their voices heard.
So from now to the time a sustainable policy solution is found for these issues is going to take time. And until such time as a sustainable policy solution is found we are going to see sustained political risk, and this sustained political risk is going to affect investment choices. Obviously, there is no two ways about it. And that is another reason why we think that to invest in the developed world which has already an ageing demographic and headwinds to economic growth is also going to face heightened political uncertainty in the future.
PRESENTER: An ageing population is obviously a problem in many developed economies, and emerging economies quite often have the benefit of a young and large population as well. But there’s also a risk, and the risk is rapid automation and robotisation which could create a situation of mass unemployment, I suppose, not just in the West and in developed economies but also elsewhere across the globe. And that’s a long-term trend that could dramatically affect investors and how we live our lives really. So how do you take this into account?
DIPANJAN ROY: Well that’s a very interesting question, and the simple answer is I do not know but I can make some educated guesses if you like. So automation is something which we are already seeing the effects of. And if you have a look over the past couple of decades you are seeing that increasingly. The economic growth and the returns which you get from economic growth are being captured by capital more than by labour. Now one factor contributing to this is obviously globalisation, as in if I run an industry I can get a part of the work done very cheaply in emerging markets. That is one factor. The other factor is automation which you referred to. That if there is something which I can do via a machine, often times it is cheaper and more effective to do it that way rather than via a workforce. That doesn’t mean of course that humans are going to be obsolete and robots are going to take over. That is certainly not my prediction. But what we will see is a large part of the mechanised workforce which is doing things which are repetitive in nature and can be done by machines, are going to be done by machines as machines become cheaper and cheaper.
Where does this leave emerging markets and developed markets? I think that this is going to be a headwind certainly for emerging markets whose sole competitive advantage is cheap labour. Because as the cost of labour in countries like China increase because of their success in globalisation, you will see that the cost of machines are going to come down to a point where the cost of outsourcing your operations to China are going to be more than the cost of buying a machine and doing it in the UK or Europe or the US. So that is one factor. But more generally the prospects of automation are I think overall going to change the nature of the economy. So the production of goods and services is one aspect of the economy. And then there are the human interactions if you like, whether it be entertainment, media or indeed social media, and that is already something which we are seeing, whereby large parts of the production of goods and services are being done by machines. And human beings are moving over to more value added services which involve human interaction, which involve human judgement, human skill; things which machines cannot do.
PRESENTER: There’s one thing we haven’t mentioned yet, and yet it’s probably the most important thing to consider when you invest globally, and it’s currencies. I’ve mentioned obviously the political risk and political news and the impact it’s had on currencies lately, so how do you manage this currency and are there benefits to it as well, to being exposed to various currencies?
DIPANJAN ROY: I think that’s a very good point that when we’re talking about investing in different markets, there is obviously the investment itself, whether you’re buying equities or bonds or infrastructure projects or different other assets, and there is the currency aspect to it. Now the way we think of it currency and these other asset classes are interlinked in a way, whereby is it often beneficial to not hedge your currency risk. And this is something which investors need to consider very carefully. That if you are for example investing in Russian equities or Indian equities or Brazilian equities, if the overall economic condition of Russia or Brazil or India or China is expected to improve over time, is it really possible for you to say that what percentage is going to come via currency appreciation and what percentage is going to come via the appreciation in your stock or bond or property?
In a lot of the cases it doesn’t matter. In a lot of the cases the interactions are so complex that we think that you are indeed concentrating your risk by hedging your currency back 100% into your local currency, whether it be pounds or euros or US dollars. So it often makes sense for you to keep your international exposure unhedged or partly hedged at least from a currency aspect, because you want to get the returns from the currency as well as your foreign asset.
PRESENTER: And when looking to diversify globally, how important is the concept of scale or scalability?
DIPANJAN ROY: I think that’s very important to understand. Because when we’re looking at different asset classes across the globe, what we’re really trying to do is we’re trying to diversify away the part of the risk which is idiosyncratic, which is diversifiable, and we want to keep the systemic risk which cannot be diversified and be compensated for that systemic risk. So how do we diversify the idiosyncratic risk which is particular to a particular company, to a particular stock, a bond, a property? The only way you can do it is by having enough assets within your overall basket so that the individual risk from a particular company or a particular property or a particular project in infrastructure is small enough that it doesn’t affect your portfolio returns overall.
The problem comes with the fact that in a lot of these asset classes like property, like alternatives, like infrastructure or private equity, the ticket sizes are quite large. And when I mean ticket sizes I mean the minimum you can invest. So if you’re looking to buy for example a shopping mall in the UK, there is a minimum investment which you have to make. Now the only way you can diversify that risk and not be exposed just to one particular shopping mall is by buying a multitude of shopping malls across the UK. Now to do that you obviously need a portfolio which is large enough so that you’re not exposed to the idiosyncratic risk, and yet you’re able to get the returns from these asset classes which are not available to smaller retail investors, because you as a larger institutional investor have the sufficient skill to do these investments, and not just do them, to do them in a cost effective way.
So you are able to for example hire a team of property specialists, and you’re able to hire a team who for example work in Asia looking specifically at Asian fixed income or Asian equities. So they are able to give you exposure to that asset class in a way which is cost effective from your overall portfolio context. So the cost of maintaining these teams is small enough that your compensation for investing in these asset classes is not being eating up just by the cost of maintaining this team alone. So scale is very important when we’re looking at any illiquid large investment which have a minimum ticket size, but which you still want to invest in from a multi asset perspective simply because they have good uncorrelated or lowly correlated returns to other asset classes.
PRESENTER: You’ve mentioned liquidity, it’s obviously very important for investors who may be concerned that investing in emerging markets, they may be investing in less liquid assets. So how do they deal with that risk?
DIPANJAN ROY: Well when we’re considering illiquidity I think that is a term which has become the focus of a lot of investors, particularly in the context of volatile markets. So it’s very essential to understand that every illiquid investment or every illiquid asset class should have an illiquidity premium associated with it. What do I mean by an illiquidity premium? It’s very simple. The returns which you get from an illiquid investment should be more than the returns which you get from a liquid investment with the same amount of risk. Now that doesn’t always happen, and that again goes back to my earlier point that because of QE there have been many investors who have been looking to capture this illiquidity premium and going into illiquid asset classes.
So what you need to consider in every decision is are your risk-adjusted returns adequate for the illiquidity which you’re taking on? Because let’s face it, no one wants their money to be tied up in a particular project for five, 10 years, unless the returns are sufficient to justify it. But that doesn’t mean that you give up illiquidity altogether, because essentially you need to ask yourself what is the advantage which you have as a long term investor vis-à-vis other short-term plays in the market? And the biggest advantage which you have is your ability to have an illiquid portfolio, or a part of your portfolio which is illiquid. This is a crucial advantage which if properly utilised can ensure that you get higher returns than short term investors, simply because you’re willing to stay the course and you’re willing to invest for the long term.
PRESENTER: So to wrap up, when looking at diversifying globally what are the main three things investors should look at?
DIPANJAN ROY: Well the main three things are quite simply returns, risks and correlations. If I were to expand on each one of these when you’re looking at a global portfolio, you need to look at the returns which you get obviously from the different economies, but also the risks which you have from different economies, different asset classes. Firstly do you understand the risks? And secondly are you getting adequate returns to compensate you for those risks? What we refer to as risk-adjusted returns. And the third part which is usually more difficult to do, and certainly more difficult to quantify, is correlations. So what this means very simply is if for example there were to be a slowdown in a particular part of the world, how will it affect your asset classes and your investments in other parts of the world, in other asset classes?
Now this is a huge topic in itself which I won’t do justice to in a few minutes, but it’s very important to realise that your correlations in a market liquidity event when there is a sharp downturn are going to be quite different from your correlations in normal market conditions, because in the worst case all asset classes would tend to go down together. Now I’m not saying they will but it’s certainly not going to be the same correlation as in normal market conditions.
PRESENTER: Dipanjan Roy, thank you very much.
DIPANJAN ROY: Thank you.