Sovereign Wealth Funds; A Potential Force from Within For Emerging Nations

Posted in Emerging Markets, Financial Markets, Sovereign Wealth Funds with tags , , , , , , , , , , , , , , , , , , , on May 23, 2009 by evd101

By Erik L. van Dijk



A lot has been written in recent years about the so-called Sovereign Wealth Funds(SWF’s). Wealth Funds are large pools of money, created by governments or governmental institutions. The Western world is not totally unfamiliar with huge government pools of investments, but normally we associate them with state pension funds. Some wealth funds, like the Norwegian one for instance, do indeed have this form. In other cases the wealth funds resemble long-term investments funds or stabilization funds, used to ensure that one or a few dominant sources of income with volatile prices (e.g. oil and gas) don’t disrupt a country’s national income trends through spectacular ups and downs in GDP caused by large price and / or demand-supply fluctuations.

As so often with new trends, market analysts, journalists and governments have expressed fear that the SWF’s might become too big a force in the market. Are these concentrated portfolios really invested with pure investment motives in mind? Or are strategical and political factors incorporated in the investment philosophy as well? Quite a few pundits have expressed doubts concerning the pure investment activities and skills of SWF’s. They rather stressed the political danger of these institutions.

As if Western goverments do always apply pure investment motives when spending their budgets! SWF’s are extremely large and do invest a substantial percentage of their wealth abroad. Now, if they would have been political entities, investing abroad and going against the rules and regulations of the recipient country is risky. Recipient countries could take nasty countermeasures ranging all the way from court cases and penalties to nationalizations.

SWF’s; a powerful but relatively new phenomenon

In this blog entry we study the pool of existing wealth funds a bit more deeply using the database of the SWF Institute. The database contains some 55 wealth funds from developed and developing countries. The SWF’s from developing economies form the majority (41 out of 55, or 74.5%). This might seem strange, but it is not. When income distributions are relatively unequal, it is not uncommon that governments try to get a piece of the action. And especially the goverments of resource-rich nations have a nice opportunity to do so. However, the structuring of those investment pools into wealth funds implies a professionalization that is rather new. The average year of establishment of the 55 funds in our empirical study was 1995, albeit it that one of the most famous wealth funds – the Kuwait Investment Authority  with USD 202.8 billion under management- was founded in 1953.  And the Foreign Holdings portfolio of the Saudi Arabian Monetary Authority (SAMA)– with USD 431 billion assets under management – was created in 1952. But some of the real big ones aren’t old at all. Here are some of the most remarkable entries since 2005: China Investment Corporation (2007;AUM USD 207 billion), Libyan Investment Authority (2006;AUM USD 65 billion), the Russian National Welfare Fund  aka National Wealth Fund (2008;AUM USD 83.6 billion), and the Investment Corporation of Dubai (2006;AUM USD 82 billion)

The SWFs are an enormous force now and we should not underestimate their impact and influence. Total assets under management for the 55 SWFs in the database continue to show an upward long-term trend and the current level of AUM is USD 3,585 billion. When looking at the amounts needed to repair our financial industry and cope with the credit crisis, this implies that Wealth Funds might be able to play an important role in any recovery plan. It is therefore quite remarkable that Western leaders so far seemed to focus on a strategy based on ‘look to each other, and solve together’. Didn’t we basically make the SWFs in the Middle East and Asia richer by buying their oil and  gas or cheap products, thereby creating a moneyflow from West to East? Only Gordon Brown and Barack Obama seemed to be willing to concentrate efforts on the Middle East (Saudi Arabia and Gulf States). The opening up to Iran in recent periods can also be seen as an important step. Iran is probably one of the most secretive nations as far as its wealth fund(s) are concerned. The Oil Stabilization fund is well-known, but too small to be the whole story. Currently the US and its Western allies on the one hand, and Iran on the other are going through a serious political chess game with probably just one goal. To find some kind of common ground to get Iran back in the league of ”’acceptable” nations. The Roxana Saberi case illustrates how tensions are orchestrated and reduced in a purely political rhythm. In normal situations it would be unheard to see Ahmedinejad suggest things like this to judges within the Iranian judiciary system.

In terms of goals, we see that the bulk of SWFs start of as stabilization fund, and gradually but slowly moved to a role as state investment funds with long-term investment horizon. A next step is the transition into full-fledge pension system, at least with a substantial part of the assets involved. A growing number of nations understand that the creation of a pension system provides countries with a tremendous source of savings and investment potential that can help stabilize the political situation in a country and fight extremist tendencies while at the same time helping to stabilize the economy.

SWF’s; The New Capitalism?

When comparing the SWFs with other large institutional investors, there are some structural differences. One of the most important ones according to us, and that holds especially for the SWFs that are based on energy- and commodity-related wealth, is their ability to concentrate on (ultra) long-term growth. This will enable them to capture higher returns by locking in the higher risk premiums on riskier investments while working with an asset mix that is more tilted towards riskier asset classes. Obviously, with this type of SWFs often being from countries that did not establish themselves as major financial powerhouses yet, we need to place a caveat. The level of knowledge within the SWFs might be a constraint. In recent years we did indeed see some indications of suboptimal asset management in the SWFs. Some tended to link this to strategic motives, but a closer look at the asset allocation, holdings acquired et cetera indicated that this was not the whole story. Lousy ‘picking’ at the bottom-up level has played a far more important role. The sad investment story of Chinese insurer Ping An that bought a stake in Dutch-Belgian financial conglomerate Fortis at about the worst moment possible is indicative. This is not to say that there aren’t any ultra-professional, well-managed SWFs. But the difference in investment expertise is still striking and far bigger than it is within the institutional investor community in Europe or the US.

Now, with their long-term focus, enormous wealth, and huge size compared to the local economy (which automatically implies that the focus has to be to quite a large extent ‘international’) and top-down, hierarchical decision structure SWFs are definitely not pension plans like the ones we know in Western Europe or the US. Their relative lack of transparency concerning decision taking, performance analysis, compliance et cetera further strengthens the case that this is really a new category of investors entering the stage.

Sure, when looking at total assets under management Western institutional investors are – as a group – still far more important. However, also more fragmented with smaller average sizes and with a much larger focus on low risk, fixed income assets. The impact of SWFs on global stock markets will therefore most likely increase tremendously in the years that lie ahead of us. First of all, because the economic growth rates in the nation mix of SWFs are higher than those in nonSWF-dominated economies. Second, most of the traditional Western institutional investors don’t really grow that fast anymore with the inflow of pension premiums more or less offset by payments to pensioners, with demographic trends making it almost impossible that this will really change.

This implies that we need to take a closer look to what could happen in the future when taking these trends into account.

China will win, but energy-related SWF’s should not be underestimated in the next 10-15 years

Although the Asian SWF’s are gaining in importance, led by the Chinese Wealth Funds that benefit from the country’s growth record, the oil-related wealth funds will be a dominant force to reckon with for quite some time to come.

The energy-related wealth funds represent a bit more than half of the group of 55 when we look at the number of funds (31), and in terms of assets under management their total of USD 2259 billion represents 63 percent of total AUMs of the wealth funds.

So, unless the growth rates in China and some other Asian nations reach record highs, with oil prices remaining sluggish, the Middle Eastern SWFs – actually the group that most people fear because of their lack of transparency – will remain a very important category to take into account. We at Lodewijk Meijer believe that it is not just for this reason important to ensure a dialogue with this group of wealth funds. Also when looking at the political situation in the Middle East and the problems with global terrorism, an open and fair communication, trade and investment relationship with the countries in the Middle East will certainly be beneficial in these areas as well. The West should recognize that quite a bit of the tensions are directly related to flawed drawing of country borders in the Middle East by Western occupiers in the past in combination with giving Western oil companies too large a stake vis-a-vis the revenues left for the energy-rich countries itself. Add to that the fact that quite a few nations were or are led by leaders that do not have the support of the population to the same extent as they have Western support and an important part of  the terrorist story is explained.

Development and growth in general have always worked against terrorism. Terrorists thrive in climates with inequality, lack of chances, and poverty. The SWFs and their growth stories will definitely make it less likely that MENA countries themselves – as a group – will witness increased terrorist activity. Skepticists will add that they will have more funds available then to support terrorist activities elsewhere, but we tend to believe that this risk is far more greater when not allowing these nations a dialogue and place within the family world nations, while at the same time helping their SWFs to further professionalize and internationalize their portfolios. This is a win-win situation for all.

SWF’s and the local economy; catalysts for growth….

but local growth can only thrive when economies develop further and governance improves:

The Trinidad Case

SWFs are huge. Often too huge compared to the size of their local economy. They do therefore have to diversify internationally. This implies that their wealth that was often created through Western imports of oil, gas and relatively cheap products will in the end – to quite some extent – flow back to us and other nations via financial market transactions.

That is not to say that SWFs cannot play a fantastic role when developing the local economy of countries. Their potential to be a catalyst of growth is huge. A nice example is the situation in Trinidad and Tobago.In an earlier entry to this blogwe told a bit more about the country, one of the least know oil states in the world. Most people outside the region still believe that the whole Caribbean is about tourism and tropical products, but Trinidad and Tobago is definitely an important exception with attractive growth potential that makes it an interesting Frontier Market.

The country’s Heritage Fund has assets under management of USD 2.9 billion or about 12 percent of GDP. And that percentage will be growing assuming that oil and gas prices will at least stabilize. Trinidad wants to establish itself as a regional financial center and we believe that this strategy could work when undergoing a structured transformation of the economy and upgrading of the financial market system. When taking into account that Cuba will probably be an interesting new entry to CARICOM any time soon (we at Lodewijk Meijer think that it could take approximately 3-5 years for this to happen), that regional financial role could really be of tremendous importance. The ongoing growth in the trust/offshore business in the CARICOM region could also further improve things, with Port-of-Spain then becoming a logical on-shore financial center for the off-shore islands of the region.

When talking to local leaders and international investors, we believe that the opportunities are there.

However, one thing that worries us – and an area where change is needed – is the relatively low country score (3.6 on a scale of 1 to 10 with 10 being the highest) on the Transparency International Corruption Index (CPI). Activities undertaken by institutions like the Caribbean Procurement Institute, Trinidad and Tobago’s chapter of Transparency International and by politicians with large popular support and a willingness to change things could all help. Currently, developments in the ongoing proceedings of the Uff Commission of Enquiry into the Construction Sector of Trinidad and Tobago seem to indicate that – as so often in many nations, even developed ones, – construction and real estate are the areas where lacking corporate governance and fraud have led to a situation in which public funds were misused for personal gain by corrupt politicians/bureaucrats and/or entrepreneurs (e.g. within the construction industry)  and/or lost through incompetency, with a political chess game being played in the background. When analyzing the corruption proceedings, we believe that the nepotists seem to have decided to make former minister of Housing Dr Keith Rowley (one of the most popular politicians in the country, with a tremendous track record as far as new housing activity is concerned while he was in charge of that ministry, and one of the architects of the Vision 2020 report in which the transition into a more diversified economy was first introduced) their scapegoat over a negligble malperforming housing project after he left office. And not just that, too much decision power was and still is not in the hands of ministers in the first place, but is concentrated within UDECOTT;  the Urban Development Corporation of Trinidad that seems to act like a kind of state within the state.

 The Commission will present its final report in September 2009 and we are optimistic that it will unravel a smelly truth about what is a standard nepotism case so often seen in developing economies. Local newspapers help set the stage for a climate in which nepotists are forced into defensive positions. This is a tendency quite often seen in developing nations. When the country develops and corruption fighting grows into a serious countervailing power, the growing independence of the media is not just an important sign of this, but a tremendous catalyst as well. The country’s growth story and transition into a more diversified economy with expanded financial sector will further improve things. Smaller local nepotists will lose out when ‘big finance’ discovers the region. Huge financial institutions will – through the investment opportunities they provide andthrough their larger focus on procurement and ESG strategies (they have too much at stake to be caught in local scandals!)- basically provide the final blow to the nepotists even when the Uff Commission verdict doesn’t already do so in a legal setting.

Along the way the role of the Heritage Fundwill become more important; a) as the largest local investor; and b) as entity attracting the professional skillset of international investors, litigation lawyers, investment bankers, asset managers, investment analysts et cetera. Either directly (to work for the Fund) or indirectly (through provision of services by parties wanting to establish a position for themselves in the country).

This Trinidad example is illustrative for developments in many Emerging economies. And the trends we see developing here have so far shown that in successful growth stories external money and expertise went hand-in-hand with a local willingness to fight corruption from within. And from an investment point of view: it is actually this group of Emerging and Frontier markets where both components are visible, that actually have showed the most attractive return-risk profile.

SWF’s and the international economy; a growing role to play

With total assets under management of USD 3585 billion, it is clear that SWFs can be an important force when leading us out of the current credit crisis. The combined assets of the big Western institutional investors are still far larger, but SWFs are quickly catching up.

We foresee that their role and positive contribution will substantially increase during the next 6 to 12 months, with the beginning of a positive change already under way. Part of the 30+ percent stock market return generated during the first 5 months of 2009 was directly related to SWFs stepping in (finally!) looking for bargains.


SWFs are a relatively new phenomenon. Their large pools of funds are of tremendous importance to the domestic economy and are a great support for the world economic situation as well, because most of the SWFs are too big to concentrate on a home-alone policy. They have to diversify internationally to a larger extent than most other institutional investors a) because the local economy is not big enough; and b) because it is often not diversified enough.

Western nations have often complained that investment behavior by SWFs was to a large extent guided by strategic instead of economic principles. So far evidence in this direction has not been convincing at all. Sure sometimes strategic motives might have player a role, but wasn’t that the same for Western investments in our past?

The attraction that economic development and wealth funds have to international financial instutions that might want to provide services to them will trigger a climate of financial sector dynamics and growth. What could hurt the positive potential effect of this is often a local climate in which nepotism and corruption thrive. Once that threat is neutralized, the upside potential will be tremendous.

The Value of Virtue

Posted in Behavioral Finance, Emerging Markets, Financial Markets, Risk Management with tags , , , , , , , , , , , , on April 10, 2009 by evd101

By Erik L. van Dijk Introduction They are already working on it since 2002, but it is a fine academic paper on a topic that is getting an increasing amount of attention in recent years: corruption and fraud. Cornell scholars Charles Lee and David Ng studied corruption levels in 44 countries, using the Transparency International database. There have been numerous studies using this and other databases over the last decades, probably starting with work by Anne Krueger (later Chief Economist at the World Bank, together with the IMF and OECD also very active in this area)  in the 1970s. What makes the Lee-Ng study special is according to us at Lodewijk Meijer first of all the translation of country corruption scores into analyses of the impact of corruption at the firm level. By doing so, the authors are capable of answering the question if there is any ‘Value in Virtue’. This is a very important topic, because we see that the literature so far defended two positions. Up until 2003 we have seen various – mostly theoretical and deductive – studies that defended the view that corruption, defined as the misuse of public office for private gain, might actually be a kind of ‘bonus’ system in countries in which salary schemes and other remuneration for talented labour are inefficient. Empirical research presented over the years has indicated that this position is probably totally wrong. Theoretically fine, but the empirical evidence is overwhelming and contrarian. Various studies performed between 1995 (Mauro) and 2006 (Lee and Ng) led to the following conclusions: The Negative Impact of Corruption at the Macro Level, as presented in various academic studies

  1. A higher level of corruption translates into lower domestic investments and economic growth
  2. Higher levels of corruption hinder Foreign Direct Investments
  3. Higher corruption leads to lower tax revenues
  4. More corrupt environments stimulate negligence with respect to operations and maintenance in both firms and government institutions
  5. And point 4 even extends to health care: more corruption leads to higher infant mortality rates
  6. Higher corruption leads to higher student dropout levels in universities and high schools
  7. Higher corruption levels go hand in hand with a larger size of the grey economy, which is of course directly related to point 3

Jain (2007) analyzed what corruption actually is. When stating that corruption is about the misuse of public power for private gain, we basically translate it into an economic act. Why? Well, the cost-benefit analysis of corrupt persons involve three aspects:

  1. Someone must have the discretionary power to take decisions and consider a corrupt or fraudulent act
  2. There must be some kind of economic merit associated with that power
  3. The existing legal system provides a sufficiently low probability of detection and/or low penalty for the corrupt wrongdoing

Although it is clear that the legal part of the anti-corruption policy should play a leading role in fighting these crimes, it is also clear that social, cultural and economic aspects play an important role as well. Reason: in the end, corrupt acts are a cost-benefit decision case in which a probably talented individual or a group of talented individuals undertakes activities that are counterproductive from a macro- and microeconomic point of view. It would therefore be fantastic when it can be proven that economically, corruption destroys value at the micro- and firm level. If that can be shown, the likelihood that a well-defined remuneration system (positive stimulus) can help the negative stimulus derived from the improvements in the legal system will ensure a more effective anti-corruption policy. We are pleased to see that this philosophy of our firm, Lodewijk Meijer, has been translated into action by an Emerging Markets anti-corruption initiative: the CARICOM’s Caribbean Procurement Institute. Lodewijk Meijer managing director Erik van Dijk was appointed facutly member for ESG Finance and Investments. The abbreviation ESG was defined in the United Nations Principles for Responsible Investment, with E standing for Environmental, S for Socially-responsible and G for Governance. The idea is that a good ESG policy will help governments, firms and other economic actors in attracting capital and better conditions while at the same time ensuring better profitability and growth in the long-run at both the macro- and micro-level. In other words: we believe that there is Value in Virtue. With this being the case,  officials with the potential power to be corrupt might – when of course being confronted with a legal environment that makes fraudulous/corrupt freerider behavior too risky (i.e. the probability of getting caught and the negative incentive related to the penalty that follows make it more interesting to go for realization of a positive reward) – concentrate on realization of positive social and economic results. The Agency Theory work by Jensen and Meckling has of course indicated that this optimistic view is indeed only warranted when the legal and regulatory framework is sufficiently corruption-proof. This being said, initiatives like the Caribbean Procurement Institute are of the utmost importance in many countries. The latest ranking list of Transparency International indicates that the bulk of nations in the world still suffers from far too high – and therefore value-reducing – corruption levels. The list of countries which have a reasonable score is limited to about 22 with a score in excess of 7.0 on a scale from 10 (lowest or no corruption perceived by people surveyed) to 1 (highest level). This is approximately 15 percent of the number of nations in the world. So a lot needs to be done. The Transparency International 2008 Corruption Perception Index ranking The top (score in excess of 7.0) The top-22 consists of only two non-developed nations, namely Saint Lucia and Barbados. Both actually part of the CARICOM for which the Caribbean Procurement Institute defines its policy. The other 20 are mainly from Europe (13) with 3 Asian representatives (Singapore, Hong Kong and Japan), 2 from North-America (Canada and the USA) and 2 from Oceania (Australia and New Zealand).  Denmark, New Zealand and Sweden have the highest score (9.3) and my own country, The Netherlands, shows a good score (8.9) as well. The rest of the list The rest of the list is mainly filled with Emerging Markets nations, although there are certain developed nations were corruption levels have remained remarkably high. To some extent low places in the list are directly correlated with flaws in the legal system. But we do have the impression that ‘social’ and ‘cultural’ factors play a role as well, including religious factors. Treisman (2000) has done some interesting research in this area. He found that low corruption levels are positively correlated with the following factors:

  • Protestantism;
  • Former British Colonies;
  • Higher GDP;
  • Common Law versus Civil Law-based legal systems;
  • Higher ratios of imports to GDP (i.e. openness/integration of a country in the world economy);
  • Longer exposure to democracy;
  • Unitary forms of government.

Remarkably, Treisman’s study showed that the following factors are not significant.

  • Relative salaries in the public sector;
  • Degree of political stability in a country;
  • Endowment with natural resources;
  • Degree of state intervention in the economy;
  • Level of ethnical diversity.

The need for a multi-factor approach at the micro level As you can see, the bulk of these analyses is focused on the macro level. However, acts of corruption are undertaken by individuals or groups of individuals at various levels of society with the bulk of course being at the lower levels (simply because of the law of large numbers). Sure, at the lower levels the relative amounts at stake are often smaller or marginal, but added up they have just as much of a disruptive impact on society as the few occasions of big fraud and corruption that catch the attention of the media. We do believe however that it is important that procurement lawyers keep a good balance between the bulk of smaller cases with in the end the largest aggregated impact and the few media cases that catch the public eye. The latter play an important role in showing people that the high level hot shots are not getting away with their fraud. This has an extremely important effect on the cost-benefit analysis at the lower levels. At the lower levels, it is not just corruption that is at stake. Corrupt acts can easily be examples for employees working in firms. The recently published report on fraud by PriceWaterhouseCoopers under some 5400 firms in 40 countries shows the following results:

  • Men are responsible for 85 percent of fraudulous acts. To some extent this is related to their dominance in the labour force, especially in emerging markets, but it is also directly related to what we already indicated in our blog entry on investment styles. Basically, the cost-benefit analysis that is at stake when commiting fraud or corruption is an investment decision. The risk to get caught is probably seen as less of a barrier for men – who normally opt for higher risk strategies – than for women. Machoism in cultures is also important. A men who gets away a few times with fraud and then gets caught might be considered a ‘tough, cool guy’, contrary to the sissy whimp that just listens to his superior. Women are not so sensitive to this kind of reasoning.
  • About 70 percent of fraud cases is commited by men in the age class 35-55. In other words, the age class in which men get a bit more confident concerning their societal status, with their built-up experience giving them the feeling that even after being caught they might find employment elsewhere. Younger men suffer more from machoism, but probably tend to translate that into other acts (harrassment; or fighting in bars in the weekend etc.) than their older gender colleagues.
  • Social control – also in the work place – is important. The PwC study indicates that 68 percent of frauds worked as a loner.
  • Contrary to standard beliefs the main frauds were not temporary workers that switch from one employer to the other quickly. One third of frauds worked 2-5 years for the firm, with the bulk of the others working longer for a specific firm!
  • And just like what we see in the government corruption case, it is definitely not true that it is about peanut crimes at the lower levels only: about 25 percent of fraud cases was directly related to top management, with industries known for their complex valuation and risk management structures like real estate, construction and banking/insurance/investments being well-known for large fraud cases in recent years.

It is impossible to create a corruption- and fraud-free world. Everybody makes his or her own cost-benefit analysis. Moral decay is a reality and so is the deterioration of social control structures. This implies that there is a growing need for strong procurement initiatives and improvements in law, just as much as there is a need for attractive, smart salary and wage structures that reward acts of good-doing. In both areas a lot needs to be done. Recent discussions in the financial industry about excessive greed and horrible bonuses for top managers were just as much indicative of the moral decay and mentality of the people accepting these bonuses as they were of incapable human resource professionals and corporate lawyers helping top management and their controlling bodies (governments, labour unions, board of directors) to create smart bonus structures that award tremendous performance and penalize bad performance. When analyzing the Value of Virtue, it is important to check things at the micro level as well. Firms are still the economic drivers of most developed and developing societies. It would be fantastic if we can prove that firms acting in a more corrupt environment (and therefore probably being direcly or indirectly part of this system) are actually valued lower than their less corrupt counterparts. That is exactly what Lee and Ng tried to achieve in their study. There are a few problems when translating the macro results into micro-level conclusions. First, the available ratings are often at the country level. It is only recently that specialist ESG asset managers have started to use analysts or special bureaus to rank and rate individual firms. And unfortunately – due to a lack of data and maybe even interest (after all Emerging Markets investments are still just 5-10 percent of the institutional equity portfolios of institutional investors in developed nations) – they have started this trend in the developed nations. I.e. in the group of nations where the need for firm-level analysis is probably a bit smaller due to good control and legal systems. This is another reason why Lodewijk Meijer supported the Caribbean Procurement Institute initiative. It is a) from a mainly Emerging Markets region (CARICOM) and b) a region that has shown the willingness to act; with c) the presence of 2 CARICOM nations (Saint Lucia and Barbados) in the world top-22 indicating that it is not just willingness, but also actual success that can be shown. When analyzing the valuation effect of corruption at the firm level, we have to deal with a few problems. Firm valuation is dependent on a large number of variables, not just corruption. We do therefore have to create multi-factor models that unravel the valuation of individual firms in various nations while at the same time ensuring that differences in industry distribution between countries are taken into account. Lee and Ng regressed two valuation variables, the Price / Book ratio in which the market price of a stock is divided by the book value of common equity, and Tobin’s Q, defined as the market value of debt plus equity divided by the book value of debt plus equity, on a set of firm and country variables. The firm variables that they looked at where:

  • Return on Equity (for the P/B analysis)
  • Return on Assets (for the Tobin’s Q analysis)
  • Profit Margin (net)
  • Research and Development Expense / Sales
  • Dividend Payout
  • Beta (systemic risk factor measuring the firm’s stock market return sensitivity to changes in the MSCI World index)
  • Currency Beta (measuring the sensitivity of the stock market return of the firm to changes in the value of the US Dollar vis-a-vis a basked of major currencies)
  • Earnings growth (5 years)
  • Credit Rating of the firm from Institutional Investor Magazine

At the country level, the researchers looked at:

  • Country level average Return on Equity (for the P/B regression)
  • Country level average Return on Assets (for the Tobin’s Q regression)
  • Inflation
  • GDP growth
  • And of course, the Transparency International Corruption Perception Index

For a 10 year research period (1994-2003) the researchers were left with almost 60,000 valid observations. More than enough for a good statistical analysis. If Virtue would add Value, the result should be that in both the P/B and Tobin’s Q regressions higher levels of corruption would translate into lower valuations. I.e. Corruption should have a negative and significant sign in the regressions. This was indeed the case. The Cornell scholars found that – ceteris paribus (all other things being equal) – firms in the high corruption tertile had a 15-20 percent lower valuation than firms in the low corruption tertile. There was not much difference when looking at P/B compared to Tobin’s Q, with the latter being a firm-level analysis and the former looking more at the equity level. Value in Virtue: where does the value loss for firms in a corrupt system come from? When looking at the theoretical discount models, value loss could come from reduction in expected future cash flow and dividend levels, reduction in earnings growth or increases in the required rate of return that a firm would have to offer its shareholders and debt providers. Common belief was that the increase in the required rate of return is the dominant factor. However, Ng and Lee show that this is not true. In a corrupt system firms suffer mainly because the expected future cash flow levels will be lower. Partly because of the corruption (extraction of cash via bribes etc.) itself and partly because of loosing customers and/or translation of the corrupt climate into direct internal fraud (people at all levels in society start to believe that if greed and immoral theft is the standard, then let’s do it ourselves as well). Especially international clients and/or investors might be very weary to do business. The tremendous growth of ESG Investing in recent years is indicative of this trend. Both employers and employees (via their labour unions) on the one hand, and the government on the other, stimulate this trend. Good examples are the large Swedish state pension plans AP1 to AP7, who have a combined ESG investment policy, and the Dutch mega investor ABP, one of the largest pension plans in the world. However, ESG is growing but not so big yet as to guide investment decisions of institutional investors completely. But it is indicative that even private investors are getting more enthousiastic about the idea. Not surprisingly as our analysis shows. There is Value in Virtue for long term investors and firms following an ESG policy. We believe that this can be of special importance in Emerging Markets. It will increase value and enable firms and countries following a good ESG policy to attract more foreign capital which in turn can lead to further growth. CLICK THE LINK BELOW FOR THE FULL NG-LEE STUDY corruption-virtue

Smaller Frontier Markets: Hidden Opportunity or Totally Uninteresting? The Trinidad Case

Posted in Asset Allocation, Emerging Markets, Portfolio Optimization, Risk Management, Uncategorized with tags , , , , , , , , , , , on April 2, 2009 by evd101

By Erik L. van Dijk


In the first entry to this blog we presented one of Goldman Sachs’s Next-11 countries, Iran, as an interesting ‘neglected country’ for speculative investors. On the one hand, we saw an economy built on huge oil and gas reserves (which provide a kind of collateral or put option to your investment strategy in the country) and on the other we saw growing signs of structural talks between the US and other Western nations with Iran in the political arena. The fact that Frontier economies like Iran and others (Kazakhstan, Vietnam, Saudi Arabia are also well-known representatives in this category) have a relatively low correlation with the MSCI World index and even with the MSCI Emerging Markets index are of interest to large investors that want to diversify their portfolio. But we also know that smaller economies are more sensitive to the potential risk of growing protectionism in a world that is struggling with the credit crisis. We did therefore decide that it might be good to look at a smaller Frontier Market as well, to see how things are going there.

Our Emerging Markets unit decided on Trinidad and Tobago. On the one hand (see also below) the country is not a tourism-dominated, one-dimensional banana republic, but one of the richest Caribbean nations with an economy built on strong oil and gas reserves. On the other, we see a relatively stable political situation, a leading role within the CARICOM (the regional cooperative entity between some 15 Caribbean states) and an English-speaking population. When we add to that a legal system that has tight links with British rules, it makes for a Frontier market that is definitely ‘unknown’ and ‘neglected’, but also not ”scary” like so many other exotic nations in this group.

In our databases we have daily stock market information about Trinidad and Tobago (TT) starting from May 2005. Almost 4 years of data split up in a good period for world exchanges (2005-2006-beginning 2007) and a disastrous one (second half 2007 and especially 2008-09). A relatively short period, but definitely an interesting one when trying to get a feel for Frontier Market investing, its opportunities and its dangers.

When we look at the index information (in USD) over this period, it is not surprising that the net result for the period is not a good one for global equities. The effect of the credit crisis is clearly visible in the numbers. The MSCI World index generated an annualized return of minus 7.82% for the period. When we compare that with the plus 8-10% positive return normally expected for global equities, it is clear that we are dealing with a dramatic  outlier here. Everybody states that when the rich, developed world is sneezing, smaller Emerging nations are catching a cold. Now, when we look at the annualized return over the period for the MSCI Emerging Markets index we derive a figure of 2.58% positive (!). So notwithstanding the fact that Emerging Markets did indeed drop a bit more than developed ones in the  2008-09 (until March 27)  period (-58.87% compared to -51.81%), their positive net result indicates that the value gain in the May 2005 – Dec 2007 period compensated for that. It was the period when the BRIC nations gave the leading Emerging Markets economies their new catalyst role. Obviously, some (e.g. Russia) suffered more than others, but all in all the correlation with developed nations was quite high, and return differentials not that big and there wasn’t really a big cold. When we look at the MSCI Frontier Markets index we see where the old adage about sneezing and catching a cold comes from: the smaller developing economies in this index were the ones struggling. The MSCI Frontier Markets index lost on average minus 14.65% on an annualized basis during the period May 2005 – End of March 2009! Trinidad and Tobago (TT in the remainder of the entry) was actually a big outperformer with an annualized return of minus 7.65% for their equally-weighted First tier stock market index and minus 8.03% for the marketvalue-weighted one. Lodewijk Meijer decided to look at both equal-weighting and value-weighting due to the fact that the TT stock market index is to quite some extent bank/other financials-dominated. But analysis made clear that although the banks and other financials did indeed suffer quite a bit, their story wasn’t as bad as that of many of their huge US and European colleagues that ended up at the brink of bankruptcy.

So, in and of itself the performance of the TT exchange wasn’t good. Relatively speaking the7 percent outperformance compared to the Frontier index was interesting, and so was the countries solid oil- and gas-based economic basis. If we add to that government initiatives to play a larger role within CARICOM on the one hand and ideas about setting up a regional International Financial Centre (IFC) on the other, we found it interesting enough to present TT as our representative small frontier market. And besides: don’t forget that the main stock market wisdom says that you have to buy low and sell high. So one could also present the bad performance of the Frontier Markets as an opportunity to step in if you believe with us that mean-reversion of global markets will indeed set in in 2009 (6-12 months before seeing the first signs of the economic recovery that normally follows the stock markets).

But it is not just that: we also looked at volatility (measured as the standard deviation of return) as absolute risk indicator and beta (indicator of systematic risk, measured as percentage average return when the world index changes 1%). High volatilities and high betas are then indicative of risky markets and low volatilities and betas of less risky markets. Since we compare things with the MSCI World index when calculating betas, the MSCI World has – by definition – a beta of 1. The MSCI World had a volatility of 20.53% annualized for the whole period and 32.76% for the 2008-09 period. That is a huge number. The 32.76% translates into an almost 35 percent likelihood that the actual realized return will fall outside an interval ranging from -22.76% to +42.76% when you expect a 10% return on stocks. I am sure that none of us will mind a more than +42.76% return with a probability of almost 17.5%, but there is a similar chance of ending up with another terrible year of more than a 22.76% loss! This is indicative of the turbulence in the global economy, with especially larger countries now being very nervous due to enormous tension of their financial systems, the unwinding of struggling hedge funds et cetera. In normal situations the Emerging Markets would have both higher betas and higher volatilities. But the beta for the period was actually 0.972, i.e. the Emerging Markets reacted more or less the same to bad or good news as the developed ones. Their normal excess country and firm risk  (in general) was compensated by the fact that our financial system in the West was under enormous pressure. The volatility was still higher in Emerging Markets, but actually not that much: 26.60% in EMs for the overall 2005(May)-2009(March) period (versus 20.53% for the MSCI World). And in the 2008-09(March) period the EMs went up to a volatility of 39.27% versus 32.76% for the MSCI World. It is indicative of a changing world in which the New World Order (with bigger role for China, India, Brazil and Russia) is gradually but slowly happening. And that will make Frontier investing more interesting as well. The BRIC nations are known to be more active with investments in the Frontier markets, see for instance how the Chinese and some Sovereign Wealth Funds are increasing their influence in Africa.

Frontier Markets are amazing when looking at their risk profile. They are the least risky ones when taking a first look at volatility and beta. The beta was relatively stable for the period (0.178 for the overall period and 0.188 for 2008-09). Far lower than the beta for Emerging Markets or the MSCI World. And the volatility was only 17.74% and 24.15% respectively!

How is that possible? Where is the investment risk when opting for a Frontier Markets strategy? Are they really less risky? Yes and no. They are less risky in that these numbers are correct. They do move less when analyzing day-to-day or week-to-week price movements. But what is going on here is to quite some extent related to illiquidity and thin trading. You can compare investing in Frontier Market public equities quite a bit with private equity in Western nations. Share trading is thin and that suggests a peacefulness that is only there as long as new news items aren’t too big or investor-induced portfolio trades (for non-firm or non-country related factors) not too dramatic.

Lesson 1 for the investors:

Never forget about illiquidity of Frontier Markets

When you go there, be sure to have a longer-term strategy based on fundamental (i.e. not speculative, trading-oriented) factors, especially when you are big.

When you are too big: forget about it.

And that brings us automatically to lesson 1 for the frontier country.

Lesson 1 for the country:

Make sure you create trust in your exchange.

And also ensure sufficient liquidity!

 And that is where TT has its main problem. Volatility levels during the period for the average firm in the market were so low that you might almost think that TT stocks were bonds. When looking to daily data the volatility was 4.78% over the period as a whole and 5.47% for the 2008-09 period. Academics have written tons of papers about the adjustments that are necessary to correct for thin trading, with the work of Scholes and Williams in the second half of the 1970s basically being the start. Without going into detail in this direction, we would like to compare the low volatility and systematic risk with what you could see in private equity strategies. In private equity we do not have daily price quotes as a result of which annualized return and risk levels are based on far less data points with a larger interval between them. To some extent the situation here is similar. Abou 3-3.5% is the turnover (as percentage of market capitalization of stocks) at the TT stock exchange. Compare that to the 50-100% rate seen on most Western developed exchanges! It is much closer to the 0 percent liquidity of private equity.

Question then: is the ultra-low liquidity enough reason to forget about a country? The answer is no. Frontier Market investors should know that the characteristics of investments in these markets do have quite some similarity with private equity. In and of itself that is not necessarily bad. Especially now, low correlations and low betas (TT has a beta of about 0 with the MSCI World) are qualities that can be of interest when creating diversfied portfolios. However, the investor should at all times be aware of this aspect of Frontier Market investing. Don’t do it when you don’t have the time to wait and/or the advisor with fundamental knowledge of the markets to support you.

Trinidad: The Country

Columbus arrived in Trinidad in 1498. The Island state has an overall size of just 2000 square miles, neatly situated outside the famous Caribbean hurricane belt. Initially the Spaniards occupied the country, but they never took the colonization very serious. In 1797 the territory became a British colony, a situation that lasted until its independence in 1962. Ever since the linkage with the UK has been prominent, with the British Privy Council for instance being the highest Court of Appeal, with the Caribbean Court of Justice (2005) – an institution of the regional cooperative body CARICOM – now being prepared to replace it. Politically this strong linkage with the UK has ensured relative stability in a democratic system in which not more than 2-3 political parties seemed to play an important role. It was only in 1990 that a Muslim movement led by Yasin Abu Bakr (Lennox Phillips) created some turmoil through a 6 day coup effort. But even in this case, the TT definition of turmoil turned out to be nothing like what we have seen elsewhere in Emerging and Frontier economies. Helped by large oil and gas reserves, the increase in oil prices in the 1970s and again in the period 2003-2007 has led to a tremendous increase in average wealth with now an income per capita in USD of $ 18,600. As is normally the case, political stability and wealth increase were highly correlated.

The small Island state (1.2 million people, of which 96 percent lives at Trinidad and only 4 percent at Tobago) has a remarkably mixed population, with 80% being of Indo-TT or Afro-TT descent. The Indian group is the larger of the two by a small margin. The other 20 percent is made up of Europeans (whites), Chinese, Syrians and Lebanese and mixed people. With political parties to some extent catering to the needs of ethnical and to some extent also religious groups, it is quite remarkable that the political situation is as stable as it is. And there isn’t really any reason to believe that this will not continue.

The only worry seems to be that the population is not growing at all with the relatively small (for Frontier Markets standards) net population growth rate due to births minus deaths being compensated by net emigration to (mainly) the UK, US and Canada. That could create problems for an economy with ambitious growth targets.

Trinidad: The Economy

TT has a GDP of US $ 24.2 billion. The GDP growth rate dropped recently from 8% to 5% and we foresee a further drop to about 3-3.5% due to the strong linkage with oil and gas. But it is still a growth rate and that is something that a lot of countries cannot show anymore in this period of crisis and turmoil that we are in. Governnment debt is low at 28% of GDP. The proven oil reserves are some 728.3 million barrel and gas reserves are at 481.3 billion cu m. Nothing like the huge reserve numbers we showed earlier for Iran, but still in general with a bit fantasy you could say that it is like a smaller version of Iran. Neglected, but with a nice collateral and in this case (to compensate for the smaller collateral) a situation where no one in the world has any problem with this sympathetic Island of steel drums, soca, calypso and limbo (contrary to what people think about the Islamic Republic).

Gas is recently getting more important than oil, with the country now being responsible for some 70% of the US imports of LNG. Oil and gas are responsible for 40% of GDP and 80% of total exports. But only 5 percent of employment is related to these industries and that helps explain the emigration trends.

But the government is trying to create a diversified economy, which looks like anything but a tropical island resort. Sure, Tobago is to a large extent tourism-oriented, but Trinidad has expanded in the following sectors: petrochemicals and plastics, manufacturing (steel, aluminum), cement and food and beverages. And even the old agricultural sector (a very important part of the economy before oil and gas prices started to rise in the 1970s) is not insignificant, with citrus, coffee, cocoa, rice and poultry being important crops.

The country posted a US $ 5.7 billion current account surplus over 2008, which is about 22.5% of GDP with the US being the most important trading partner (57.5% of exports and 20.2% of imports). For more detailed information we refer the reader to the CIA Factbook.

Not surprisingly with the US being so important and with economic results being relatively OK, the country had no difficulty to maintain a more-or-less stable exchange rate vis-a-vis the US Dollar. The TT dollar sells for about 6.2-6.3 to the US dollar ever since 2004.

The ambitious government of Patrick Manning, the prime minister, has indicated that its target is to become a developed nation by 2020. From frontier to developed in 15 years. Not impossible (look at Singapore), but a lot has still to be done. Especially in the financial system, and a government white paper, written in 2004, shows that the government is aware of this. The ambitious goal is to transform TT into an International Financial Centre (IFC) for the region. This regional approach of the government does also show a sense of realism (TT as stand-alone entity is probably too small to achieve very ambitious goals). But creating this IFC is easier said than done, knowing that we come from a low base in the financial sector and that regional cooperation through CARICOM implies that some 15 nations one way or another have to cooperate.

But there are a few factors that might help the government. First, due to the economic development in South America (mainly Brazil of course) and its strategic location between South America and the US, the interest in the region is indeed growing. Not just from regional parties, but also from Europe. The latter is also helped by actions from various European governments against tax havens like Luxemburg, Switzerland, Monaco, Liechtenstein et cetera. The region is already known for having a few alternative tax havens here (Cayman Islands, Virgin Islands, Barbados, Turks and Caicos et cetera) and TT will not copy their effort, but when international money flows will lead to a net inflow into the Caribbean area, the better developed nations will benefit if-and-only-if they do provide the financial infrastructure for the regional money inflow. Something similar happened to Singapore in Asia and Dubai in the Middle East. And that is the two examples that the TT government probably has in mind. What are the odds?

Trinidad: The Exchange

When comparing Dubai with Singapore as the two main examples we would like to use for TT, there are a few differences and they are important. Singapore has been successful because it was capable of not just transitioning the economy (with a huge role as regional transportation hub via the harbour and its prestigious Singapore Airlines), but also as financial center with a well-respected, developed stock exchange.  The creation of strong Sovereign Wealth Funds like GSIC and Temasek played an important role as well.

The Dubai story is younger of course, but we are not convinced yet that this ”walking on two legs” (economy and exchange) is successfully implemented here already. There is still a long way to go.

The same holds for TT. The first tier of the TT stock exchange lists some 30 stocks with a total market capitalization of TT $ 73.5 billion as of March 27, 2009. That translates into some US $ 12 billion, i.e. about 50 percent of GDP. A stock market size of 50 percent of GDP is reasonably OK for Emerging or Frontier Markets standards, but still low compared to levels in developed nations. And the reason is immediately clear when analyzing the group of 30 Tier 1 firms. With oil and gas being the main drivers of the economy, they are more or less absent from the exchange. A lot of economic activity is done by affiliates of foreign oil/gas companies and the main exception is Neal and Massy Holdings (NML). The NML conglomerate (with activities in other industries as well) is in market cap only 6.7% of the exchange, but holds an 18.4% stake of total annualized turnover. What is needed are more listed proxies for these two most important sectors of the economy.

In this respect, TT resembles Iran a bit. The Tehran Stock Exchange is also dominated by firms outside the oil and gas sector (with Iran Telecom since its IPO in 2008 being dominant). But countries that want to grow their economy and financial sector should be aware of the fact that international investors do not really like exchanges that are not a good proxy for the underlying economy.

Lesson 2 for the Country:

Do what is needed to increase the percentage of oil and gas related listings and trading at the Exchange

In terms of market capitalization the following 5 firms are the most important ones:

  1. Republic Bank TT $ 13.8 billion (=18.8%)
  2. First Caribbean International Bank TT $ 13.7 billion (= 18.6%)
  3. ANSA McAl TT $ 7.7 billion (= 10.4%)
  4. Scotiabank Trinidad and Tobago TT $ 4.9 billion (= 6.7%)
  5. Neal and Massy Holdings TT$ 4.9 billion (= 6.7%)

And in terms of stock market turnover, the top-5 is as follows:

  1. Republic Bank TT $ 604.1 million (= 31.2%)
  2. Neal and Massy Holdings TT $ 357.0 million (= 18.4%)
  3. Sagicor Financial Corporation TT $ 197.2 million (= 10.2%)
  4. Guardian Holdings TT $ 175.2 million (= 9.0%)
  5. Trinidad Cement TT $ 78.8 million (= 4.1%)

The much lower numbers of the turnover are illustrative of the illiquidity problem. In line with the government plans to stimulate the financial industry, both the market value and turnover lists show 3 financial firms: Republic Bank, First Caribbean International Bank and Scotiabank TT in the market value list; and Republic Bank, Sagicor and Guardian in the turnover-based list.

When looking at stock market performance over the period 2005(May)-2009(March), the top 5 performers were:

  1. Readymix West Indies (0.51% of the mv weight and 0.75% of the turnover weight) +37.67% annualized
  2. Trinidad Publishing Company (1.24% of mv and 0.28% of turnover) + 19.24% annualized
  3. Williams LJ B (0.05% of mv and 0.03% of turnover) + 11.34% annualized
  4. ANSA Merchant Bank (3.32% of mv and 0.69% of turnover) + 10.19% annualized
  5. Angostura Holdings (1.82% of mv and 0.68% of turnover) +8.60% annualized

In other words: the five best performing stocks were all relatively small (or less tradeable part of a bigger entity). Readymix is a cement producer, Trinidad Publishing Company is itself part of the also listed ANSA McAl conglomerate with the bulk of shares still being owned by the latter. LJ Williams is a trading / manufacturing conglomerate. ANSA Merchant Bank is just like Trinidad Publishing Company also part of ANSA McAl. Angostura is one of the main producers in the beverage sector.

The worst performers were mainly in the financial industry, albeit not necessarily the general banks.

Challenges for the Country

The big challenge for the country, when embarking on this route towards developed status by 2020, is how to attract foreign capital. Foreign – if possible institutional – capital will not only boost the economy, it will also provide it with the necesary seal of approval when moving towards International Financial Centre status within the region. Foreign ‘neglect’ by portfolio investors will automatically be interpreted as a logical confirmation of the ‘neglected country’ status.

But, to attract foreign capital, the stock market infrastructure needs to be improved. The 2008 survey by Transparency International from Berlin (Germany) gave the country a score of 3.6 on a scale from 10 (perfect) to 1 (totally corrupt). With that number the country ranks at place 72 in the world. The score is equal to that of China and Mexico. It is not dramatic, spot 72 in a list with 180 countries, but it is definitely not good enough if your ambition is to become a regional financial center.  

But there are good initiatives on its way or they have already been started. One of them is the creation of a Caribbean Procurement Institute in close cooperation with specialists from abroad. Assuming that TT can be successful in creating an improved regulatory framework, the next step is to ensure that there is enough to invest in for the foreigners.

Something that makes sense also when comparing it with the structure of the underlying economy. Some kind of (semi-)government vehicle could do the trick for the oil and gas sector, i.e. through some energy fund. An IPO of (part of) the telecom provider TSTT would also be an interesting idea, basically copying the example of Iran.

Fears about the outflow of capital are not valid in a country with such a huge current account surplus and a relatively small public debt service. The improvements in regulatory framework and liquidity of the exchange will translate in a reduced corporate cost of capital as well, thereby stimulating the economic growth further.

The expansion of the exchange and improvement of average liquidity of the available listings will also help in strengthening the case for the IFC when having to negotiate about it with the other CARICOM nations. In and of itself we do believe that TT does have the potential to become an important factor in the region. But to get from potential to realization in what has to be political lobbying with about a dozen of other nations will only work when the first seeds are sown. The economy is interesting for Frontier standards, but we at Lodewijk Meijer are less convinced that the financial system is as interesting yet.

That is not to say that knowledgeable investors should avoid investment in the country, if they want to allocate to Frontier Markets. But, only if you really have expertise in the country and a long term outlook (because of the illiquid trading) a direct investment in the stock exchange could be considered. There are some investment fund opportunities available. But they are illiquid as well. The alternative is to buy a stake in a mix of Neal and Massy (proxying the oil / gas industry next to some other industries where they are active), ANSA McAL (itself also a diversfied portfolio) and one of the banks (Republic Bank) as reasonable portfolio following the fate of TT in its quest for regional economic leadership. 

Challenges for Frontier Investors

TT is not different from any other Frontier economy in this respect. Thin trading, unclarity about rules and regulations and a developing financial industry with probably on average still quite a bit to learn compared to standards at home are all factors that Western investors willing to invest in the country will have to deal with. But for a long term investor, carefully following the macroeconomic story and politics while closely working together with a local/regional specialist it might be worth the effort.

The world is changing. Emerging Markets are here to stay in the New World Order and selected Frontier Markets are definitely gemstones in the years to come. Those with a solid economic base or commodity reserves might be the first to benefit from the globalization of investment portfolios of Western pension plans and Sovereign Wealth Funds from other places on the globe. Although of course relatively small, TT’s role in the Caribbean might make it a valid building block within a Caribbean Frontier portfolio. We at Lodewijk Meijer will carefully watch developments for you.

2009; The Year to add More Convertibles to your Portfolio?

Posted in Financial Markets, Manager Selection, Portfolio Optimization, Risk Management, Uncategorized with tags , , , , , , , , , , , on March 27, 2009 by evd101

By Erik L. van Dijk

The credit crisis was the period of disasters with structured products. Even the normally relatively quiet convertible  bond market ended up being bashed in the illiquid, panicky arena that financial markets seemed to be all through 2008 and especially since Sep/Oct 2008. Convertibles are basically hybrid securities with a risk profile somewhere between that of straight bonds and equities. On average, their expected return will lie between that of bonds and equities as well. Convertibles are hybrid in that they contain a debt component and a call or warrant component directly linked to the underlying price movement of equity. This implies that the holder can benefit from the upside potential of stocks, while at the same time having the debt value as a cushion.

Contrary to the situation in 2002, convertibles didn’t seem to provide investors the relatively soft-landing scenario they expected. On February 11, 2008 DJ Financial News Online stated that it would be an interesting year for convertibles, ”because they should benefit from the increased volatility”. Yes, it is true – and we know that from option models like Black and Scholes – that the call option or warrant component of this hybrid security will benefit from an increase in volatility. However, and that is the difference with regular options, the cushion component provided by the underlying bond might get hurt in that a period of increased volatility can often go hand-in-hand with economic debacle. When this became reality in 2008, the high correlation between volatility increases on the one hand and increased probabilities of default on the other led to a higher credit spread. This in turn triggered an increase in the relevant discount rate for the calculation of the net present value of the bond component of the convertible as a result of which the positive option valuation impact caused by volatility increases was more than offset.

And that is why convertibles are difficult securities. Only the true champions like for instance Nick Calamos of  Calamos Investments or Kris Deblander of Ed Rotschild Asset Management know how to add up the various valuation components that play a role in convertible pricing in the right way. In and of itself the pricing of convertibles is straightforward when looking at the individual variables that play a role in their valuation. Unfortunately adding them up is difficult because the relative importance of the various individual factors changes not just over time, but also when comparing one issue with another.

Emmanuel Derman’s 1994 note on Convertible Valuation, written with some colleagues at Goldman Sachs Asset Management provides a nice overview of the important valuation components. Not surprisingly, the model presented is an elaboration of work by the late Fisher Black (together with Huang). For the full note of Derman, click on the link below:


But to summarize the note, the important valuation factors are:

Convertible-related Factors

  1. Principal / Redemption Value of the Bond (+); quite obvious, the higher the amount the investor will receive at maturity for the bond component, the more valuable the convertible
  2. Coupon (+); a higher coupon improves the value of the debt cushion, which also translates into a more valuable convertible
  3. Coupon Frequency (+); also logical, if I get 2 times a coupon of $10, I am happier than when I receive that same coupon just one time per year
  4. Conversion Ratio (+); this measures how many stocks I will receive in exchange for giving up my convertible debt instrument. Obviously, the more the better.
  5. Conversion Price (-); the conversion price = Principal/Conversion Ratio. The negative relationship is logical: the lower the conversion price, the quicker the call option component of the convertible will end up being in the money.
  6. Parity / Conversion Value (+); is equal to the conversation ratio multiplied by the current stock price. The higher the stock price, the more valuable the convertible is (see also Market-related factor number 1 below).
  7. First Conversion Date (-); the longer the period during which I can convert, the more valuable the conversion right is. Longer periods imply earlier first conversion dates.
  8. Call Provision for Issuer (-); in quite a few cases, issuers give themselves a call right. It is clear that issuers will use this right once the call option for the investor becomes too valuable. The call for the issuer is therefore a negative value component for the investor.
  9. Call Price of the Call Provision (+); the higher the call price at which the issuer can use his/her call right, the less bad it is for the investor.
  10. Put Provisions for Investor (+); this type of provision is like an extra cushion for the investor. It gives hem the right to demand a certain amount of cash through early redemption (before maturity date) of the convertible bond.

So there are quite a few convertible-related valuation factors that in-and-of-themselves aren’t rocket science in terms of finding the right sign for the relationship between factor and convertible market price.

There are also a couple of market-related factors that should be taken into account:

Market-related Factors

  1. Current Stock Price (+); the higher the current stock price, the higher the value of the option
  2. Volatility of the Stock (+/-); see link with 5 below as well; volatility is one of the most complicating factors in convertible valuation. When looking at the option component, it has a positive relationship with valuation. The upside potential is infinite when looking at stock prices, whereas the minimum price is 0. But this positive ‘vega‘ can be offset by the negative impact on default risk (see 5 below) with in some cases a negative vega as end result.
  3. Dividend Yield (-); since the convertible holder is not holding the underlying stock, but the bond plus call option high dividend payments by the firm are not to his advantage. On the contrary, they will reduce the potential for share price increases. The convertible bond holder would rather see the firm opt for reinvestment of realized profits so as to trigger further growth and increases in share price.
  4. Riskless Rate (-); Convertible bonds are entitling the holder to a potential stream of future cash flows, either directly (coupons plus principal), or indirectly (to the underlying cash flows related to the stock via the option component). Net present value calculation is based on a discount rate, with the riskless rate being the basic component of this rate. The higher the discount rate, the lower the net present value.
  5. Issuer’s Credit Spread (-); convertibles are hybrid instruments in which the default risk of the issuing firm is of importance as well. The debt cushion is just as strong as the credit rating of the underlying firm. The larger the likelihood of the firm going into default, the less valuable the cushion. Default risk levels can be measured through the credit spread, i.e. the additional interest rate premium on top of the risk-free rate that has to be added to the cost of capital/discount rate by the firm. High default risk firms have higher net discount rates, because of the increased credit spread. Therefore this negative linkage.

Factor 5 and its linkage with the earlier mentioned volatility factor (market-related factor number 2) is one of the most complicating aspects of convertible valuation. Markets go through trends as far as volatility is concerned. However, when in periods of fear or panic, this is often directly related to the underlying fundamentals be it at the firm level (high volatility for the firm, with normal volatility for the rest of the market) or at the economy level (high volatility across the board). In both cases the increased default risk – be it real or sensed – translates into a lower valuation of the debt cushion. And that reduces the convertible value that is normally positively related to volatility (via the option component).


The year 2008 was terrible for convertibles, because the cushion value of the debt component seemed to work less well than investors and their advisors expected. The UBS Global Focus Convertible Bond Index lost 31.7 percent in Euro’s over 2008, a disastrous performance that was only hardly better than the -46% lost by the MSCI World index. There are four reasons for the lousy 2008 performance:

  1. Forced sales by hedge fund managers. Hedge funds were holding 70 percent of the convertible market in 2008. A huge number, that can be asigned mainly to so-called convertible arbitrage hedge fund managers. Excess leverage led to problems for these managers. As a result, they had to delever and sell their assets. This translated into an increased supply of convertibles to the market.
  2. Low number of buyers due to flight into quality/safe-havens. The excess supply could not be sold to buyers, because they were less active or even left the market due to a flight for quality in 2008. Cash was king. The convertible market suffered from the same problems as equity markets did, with liquidity drying up.
  3. The highly pressurized market environment, that hurt all asset classes (credit crisis). The period of the credit crisis was equally stressful for investors in many different asset classes and that was not different in the convertible market. There was fear, and buying and selling behavior was often irrational. This has led to a situation in which – compared to models like the one presented in the Derman/GSAM note presented above – undervaluation went as high as 10-15 percent. Investors simply did not want to step in and this was a unique feature in the normally not that volatile convertible market.
  4. The collapse of Lehman Brothers. Lehman was a big player on the convertible market, both as an investor as well as market maker. Its collapse in October 2008 has hurt the market substantially.

Now, what does that mean for the outlook of Convertible Markets in 2009? We believe that convertible bonds have good potential. First, the average bond yields of convertibles are quite attractive. Yield levels of 9-10 percent are common and that is of course amazing during a period in which yields on regular fixed income instruments have fallen to relatively low levels due to the coordinated actions by Bernanke, Trichet and other central bank presidents. If we add to this the existing undervaluation of convertibles (see above) which normally will be traded away relatively quickly, we do believe that the underlying return related to the debt component of the convertible is actually quite high already. We do not really believe in a quick and sudden increase in risk-free interest rates and even if that would happen due to inflationary pressures, the current credit spreads are full of overreaction by investors in fear-torn 2008. So with a potential reduction in credit spreads, we have some cushion in case interest rates creep up. Added to this, we know that stock prices at the moment are relatively low. With March already showing the first signs of mean-reversion (it was so-far actually one of the best stock market months since 1974), the option component of the convertible has high potential.

Rothschild’s Kris Deblander tells a bit more about how he would construct his convertible portfolio at the moment in this interview:


His Saint-Honore Convertibles Fund won the Lipper Fund Award in his category for the years 2005, 2006, 2007 and 2008. So this guy surely knows what he is talking about. Lodewijk Meijer’s manager selection unit considers this fund one of the best to go for if you want to exploit the potential for a stock price rebound without taking all the risk that comes with stock market investments. Deblander suggests a normal weight of 10 percent convertibles in your portfolio, with probably even an overweight of 5-10 percent right now. We do subscribe to a larger convertible component in the portfolio, albeit that the non-specialist can better outsource the decisions to a specialized fund manager. As we showed above, convertibles look simpler than they actually are. It is a hybrid security with a lot of valuation factors within it and their relative weight is not always clear.

Therefore, if you believe that 2008 was not indicative of the end-of-the-world being there, shares will rebound. Now, the rebound could come quickly or still take some time because we have to go through a period of uncertainty in the economy first. The insurance aspect of the debt component of a convertible is then ideal. We do therefore recommend investors to take a closer look and buy convertibles. US investors are referred to firms like Calamos, Europeans can opt for Deblander’s Saint Honore Convertible Fund.

How International is the Internet?

Posted in A word from the author with tags , , on March 26, 2009 by evd101

By Erik L. van Dijk

How international is the internet? One of the better Dutch international news reporters, Bert van Dijk (same name, but no family as far as I know) who is based in Shanghai, China, wrote a nice column for our local financial newspaper. He showed quite convincingly that internet is actually not international at all. In every country, especially so when language is still a barrier, people seem to concentrate on home-made providers that bring them internet services or products. This is actually strange, because if there is one area in the world where location should be less of a factor, it should be the internet world of course.

After adding a flagcounter to our site some 10 days ago, we do of course have the opportunity now to do similar type of research with our website. Where do people come from and to what extent is this is inline with expectation?

Well, the bulk of our readers come from the US. Still the biggest market for finance-related blogs. Also the market with the largest amount of online people. The percentage of 59.7 percent is not strange either. We can imagine that size of the country is a factor when writing a financial blog. However, relative size of the exchange and interest of people in the stock market, is somewhat above average too here in the US.

If we use the US market weight as a proxy for its importance, there is still an overweight because the US is in terms of marketweight not more than 40-45 percent. That the Netherlands are in a good second place is less remarkable than it might seem to some outside observers. We are Netherlands-based and have our big network here. With a percentage of 16.1 percent Holland is a clear number 2. Great Britain 4.8 percent, Canada 4.8 percent and France 3.2 percent did also score noticeable sores.

There were 12 nations in total interested in what we do. New Zealand, Trinidad and Tobago and India represent the English-language market that has a total weight of around 75 percent. In other words: writing in English is indeed international. But for three quarters of your effort the crowd will be local, AngloSaxon.


Of course, our blog is highly technical and it could be that the country factor is less important when dealing with other topics. But it does remain true that  – when markekts are somewhat stressed and weird – a blog like ours still triggers first and foremest the interested readers in UK-US related markets. It will be interesting to see how that percentage will develop now that we also added Twigger to our repertoire of instruments.


Talk to you tomorrow after finishing my next contribution to this blog.


Tomorrow a big story again. Today I wanted to just confirm Bert van Dijk’s story. The INTERnet is more of a LOCALnet. International providers that feel that they have to send their clients something, are better advised to think globally but provide reports etc locally.


All the best, with tomorrow a big story again. English is a lingua franca for sure, but it is not yet so that the internet crowd reads heavy stuff like our stories full-fledge online.

That might be the case with one-liner stuff like at the Twitter. but that is not what we are doing here.

Professional Money Managers Admit: Risk Management Can and Should Improve

Posted in Manager Selection, Portfolio Optimization, Risk Management with tags , , , , , , , , , , , on March 23, 2009 by evd101

By Erik L. van Dijk

The EDHEC Risk and Asset Management Research Centre  has done a lot of good work during recent years. Especially in the area of hedge fund research, where it tried to bridge the gap between sophisticated academic work on the one hand, and the use of these concepts in practice on the other.  Lately, their work in the area of Asset Allocation has drawn attention as well. In 2008/09 researcher Felix Goltz of the French institute first surveyed a group of almost 300 high level European money managers, and then – based on the outcomes of the survey – contacted them again to discuss the results. The study led to some remarkable conclusions that shed new light on both the quality of players in the industry AND risk management quality during the credit crisis. We can therefore say that the study corroborated findings discussed earlier in this blog.

You can find the full EDHEC paper in the link below (at the end of this entry), but first we will provide you with a summary of the main results.

The main conclusion of the study is a harsh one:

practical applications of portfolio construction/optimization techniques and risk management in the institutional investment world fall short of what has been described in the academic literature as ‘state-of-the art’.

To some extent your author should feel guilty about this, because our Markowitz-Van Dijk framework for risk management and optimization/rebalancing is one of the more advanced systems that are available to practitioners when trying to better manage risk. Actually, MIT professor Mark Kritzman and State Street Scholars Seb Page and Myrgren, wrote a nice paper in 2007 indicating that our methodology was actually superior to other available methodologies. But there are more good systems. What is important is that risk management is not about doing things right whenever we feel like ‘doing another risk assessment’. No, what it is all about is that we apply the technique chosen ALL-THE-TIME and USING THE RIGHT ASSUMPTIONS.

The EDHEC study indicates that there is still a long way to go. Professional money managers do – as a group – apply optimization and risk management tools, but often not the right ones. Or they use the right ones, but use the wrong assumptions, or they do things right, but forget to continuously apply them.

A few of the major mistakes:

How to measure risk? Absolute versus Relative, and What About Outliers?

Optimization of an investment portfolio is about trying to achieve the maximum amount of return for a specific level of risk during a specific investment period. Or, the minimum amount of risk for a specific level of return. With respect to the calculation of returns there isn’t much of a problem. We all know that it is equal to the price return plus percentage dividend (in the case of stocks) or coupon interest (in the case of bonds).  More problematic is the derivation of the right risk definition. It turns out that by far the largest group of professionals uses an absolute risk definition, be it the so-called Value-at-Risk (VAR) or the volatility. Absolute risk factors are good when analyzing a portfolio decision, without comparing it to some kind of benchmark. However, professional investors are by definion always invested in something. They could for instance hire our friend King Kong with the darts to manage portfolios or flip coins. The market average of such a strategy would then provide a good benchmark, with the difference compared to this benchmark being the quality/skill (or lack thereof!) of the professional money manager. Strange therefore that only a minority of professionals is thinking first and foremost in relative terms, notwithstanding the fact that folkore (?) within professional circles always explains that wealth management for private investors is about absolute risk and return indicators, with the real institutional professionals focusing on relative return and risk indicators. It is true that professionals do pay special attention to alpha as a measure of excess return (= Return strategy minus Return benchmark) and tracking error (= standard deviation or volatility of the excess return), but somehow they do not integrate this in the optimization or risk framework. They seem to use excess return for the calculation of variable fee (bonus!!!!) levels and tracking error as a kind of constraint (‘avoid tracking errors in excess of x percent’).

VAR and the Normal Distribution of Returns

Another mistake made is that – when applying absolute analysis – the majority is using a Value-at-Risk (VAR) framework while assuming a normal distribution of returns. However, we all know that – during extreme periods like the one at hand – the likelihood of extreme events happening is far larger than what the normal distribution tells us. Normal distribution theory assumes that events that are 3 standard deviations away from the average have a chance of occurence of 1 percent maximum. Events 2 standard deviations away from the average have a chance of occurence of 5 percent maximum and events 1 standard deviation away from the average  about one-third. Result: dozens of chief risk or investment officers of even big firms (e.g. Bob Littermann at Goldman) had to tell journalists last year that things that initially were supposed to happen just once every 10,000 years happend two times within a year. In other words: due to the normality assumption there was an underestimation of the ‘fat tails’ in return distributions caused by the fact that people either exaggerate when in panic (excess pessimism) or when too enthousiastic (irrational exuberrance). As a result of the fat tails the value-at-risk is much larger than what can be derived based on the mean and variance. Actually: what is the use of applying VAR when assuming that distributions are normal? In that case the whole distribution is already defined by the mean return and the variance of return!

‘Too complicated for the clients’

Some managers even suggest that they do not apply top-level risk management and optimization techniques because clients don’t ask for them, or would actually not understand them. That is an insane line of reasoning when you would for a second see the investment specialist as a kind of medical doctor trying to cure the financial health of his patient, a.k.a. the client. The average patient in a hospital doesn’t understand anything about Medicine or all the complicated machinery and/or pharmaceuticals used by the doctor. But be sure that patients wouldn’t be too happy if their doctor thinks like this! Thank God it was just a minority of specialists putting forth this line of reasoning. But the fact that alleged professionals dare to think like this is outrageous and indicative of the necessity for increased professionalism within the industry.

The Not-Invented-Here Syndrome

Academic risk and optmization techniques do have a large quantitative component at a level considered difficult by most graduate students or professionals that went for an MBA. It is Ph.D kind of stuff. As so often things that are considered difficult are surrounded with a feel of them being ‘magic’ (at best!) or even ‘pure theory’ (very often!). Result: to the extent that senior management in an investment organization is willing to apply these methods it is too often the case that the one’s that have to decide are not themselves specialists. This creates a feeling of not being totally in control as a result of which there is a preference to use these techniques only when the knowledge is available internally. Why? Well, external specialists cannot be that easily controlled and they are also more expensive. ‘Prudent’ thinking implies that you do not spend too much on things that you don’t totally understand, right? But after some time in this inward-looking culture within the machoist financial industry something else happens. People start to actually believe that they are good internally, not hearing the real specialists (who work outside the firm) anymore and being surrounded within the firm by youngsters that won’t dare to be too critical because that might hurt their career. A so-called Not-Invented-Here syndrome can then set in easily.

The Age- or Vintage-related Knowledge Gap

As long as it is true that senior managers are on average by definition older, with knowledge developments in the young investment science going relatively quick, we will notice that the average younger graduate – still working at lower levels within the organization – is more knowledgeable than the older, senior people. Sure, the older ones have more experience and qualitative knowledge. But risk management and optimization are first an foremost about quantitative skills. And that leads to an age- or vintage-year-related knowledge gap with the ones that probably understand less about risk management and optimization being the ones that have to decide. This is dangerous, and we do strongly believe that to some extent the credit crisis is directly related to this problem. Not to the least, because men have a tendency to be overconfident, as we already indicated in an earlier contribution.

What is New! Sign of Changing Times: Mea Culpa

Not much good news, it seems. However, in one area there was a remarkable difference between the reaction of the top-level professionals to the EDHEC researchers when asked about the survey results now, compared to similar reactions before. Before it was almost standard that – whenever something was academically-oriented or mathematical – practitioners would discard it as being ‘theory’, ‘impractical’ and/or ‘irrelevant’. They would never ever confess that it was too complicated and that they actually did not really understand what it was about. Maybe also due to the credit crisis, and the resulting first indications of some modesty, do we now see that there was something of a ‘mea culpa’ with professionals admitting that they were the ones that were to blame most. There was according to them a big need for additional education. Something that we at Lodewijk Meijer would be pleased to be involved with. But as a kind of mea culpa on behalf of all academics or semi-academics with strong professional roots, we also admit that too often university- or business-school-organized courses were indeed to theoretical. The top scholars never had the responsibility over big multi-asset portfolios that had to be managed on behalf of an end-client represented by a board who applied complex goal functions concerning the way in which the portfolio should be taken care of. And that was difficult, because traditional optimization techniques suffer from the existence of too many constraints. Constraints that are the standard reality of life for practitioners. That is why Harry Markowitz and I myself worked on our new ‘near’ optimization technique, later labeled Markowitz-van Dijk by Kritzman c.s. Scientists with at least some knowledge of hands-on asset management should also try to explain things in a clearer way. But the majority of the professionals with self-criticism made it clear that this was only a secundary reason.

What about the US?

The EDHEC study was primarily about asset management within the European institutional community. What about the US? We said at many occasions that the level of asset management in the US was on average higher than in Europe, and we still believe it is. But even there, the situation is not good but at best mediocre. The focus on stock picking and return is too high, which leads to overconfidence. Results can be improved by better incorporation of risk management and portfolio optimization. It is illustrative how Kritzman’s study indicates that something as simple as efficient rebalancing using Markowitz-van Dijk can easily improve net results by 0.5 percent or more per annum. And that is a lot of money for institutional investors who often have assets under management in excess of USD 500 million. A simple statistical tool can in that case already improve net results by USD 2.5 million per annum! It is therefore not surprising that almost none of the participants in the survey listed ‘costs’ as a prime factor for not applying these modern, state-of-the-art techniques.


Professional money management is an industry under construction. Knowledge levels can and should be improved in a few areas, with risk management and portfolio construction certainly being one of them. Based on the findings in the EDHEC survey it is not surprising that something like the credit crisis could happen. When you are not in the driver’s seat in a risky and changing market, how can you expect to be able to avoid major pitfalls and panics?

It is good to see that the prime actors are at least modest in this respect, something that we did not see sufficiently yet when it comes to bonuses. We are convinced that – with the guidance of the regulators and the interest of the main actors in ongoing education in these areas – improvements are possible. Increased competition between providers, better manager selection by specialized parties who help distinguish between the good and the bad, and interesting opportunities for implemented consultants willing to organize courses will collectively help improve things. But in the meantime end-clients have to make sure that they select professionals that do pay attention to portfolio construction and risk management in a sophisticated manner. Something easier said than done, because of the high abstraction and math levels involved in these applications. Whenever you feel that our support could be of help to you in taking the right decisions in this area, do not hesitate to contact us.





Posted in A word from the author, Twitter with tags , , , , , , , on March 21, 2009 by evd101

By Erik L. van Dijk

Whoever pretends to be something of a modern cosmopolitan will have to add Twitter to his online presence. Well, so be it. Today I linked my Twitter page to this blog (see also the widget in the right hand column of this page).

Whenever online and doing or hearing something that might be of interest to you, I will share my views. Would be great to hear yours as well, albeit that I hope to be able to limit the topics to those that are either directly or indirectly related to the tags in this Blog!

Well, looks like fun, and I chose a good first Twitter hour, because I immediately was informed that the Hungarian prime minister has resigned. I consider this – in combination with the French move to provide funding to Renault for increased production of the Clio in France, instead of Slovakia – the first signs that Europe is probably heading for a period of increased protectionism.

With the US at the same time gradually but slowly starting serious talking to Iran. Although the clash of two Navy vessels (one a nuclear submarine) in the Street of Hormuz close to Iranian territorial waters wasn’t helping that much. The more so because it led to the waste of 90,000 liters of diesel fuel. I am sure that the Iranians aren’t amused. The more so because it was the time of the Persian New Year, Nowruz.

With Mir Hussein Mousavi, the popular former Prime Minister who led Iran in the period of the Iran-Iraq war now being the candidate in the so-called reformist camp – with Khatami withdrawing earlier this week – the outcome of the Iranian elections mid-June 2009 is very important and directly of influence to a potential new spring in the Iran-US relationships.

That is the kind of news we need in the world. Not the negative stories related to bankruptcy, unemployment, prime ministers stepping down et cetera. I do believe that we will still get our share of the negative stuff in the coming months, but somehow I have the impression that the balance of power is shifting towards at least some positive surprises. Initially the positive surprises will be more of the type implying that negative results are a bit less negative than expected, but around the summer this might be replaced with the first signs of good news. I wouldn’t be surprised if talks between Iran and the US will be the first real good news stories. I belief that the Iranians are ready for it, so let’s see what Obama and his assistants Clinton and Mitchell will come up with.

Let’s sit and wait, and in the mean time enjoy a nice weekend (at least here in the Netherlands, with for our standards spring-like temperatures).