Archive for the Uncategorized Category

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.

The World is Changing: Also in Asset Management

Posted in Emerging Markets, Financial Markets, Manager Selection, Uncategorized with tags , , , , , on March 20, 2009 by evd101

By Erik L. van Dijk

The world is changing. On the one hand, we see that the relative importance of Emerging Markets is growing. When looking at the relative market value of stock markets of these nations, we see that the percentage went up to some 10-15 percent in 2006-07. True, due to the credit crisis this percentage dropped back to about 7-8 percent recently. And although that number is more or less in line with percentages seen in the decade before, one thing is totally different since 2003. Market values of stocks represent the price of economic activity in a country (albeit as a rude proxy). But the gross domestic product (GDP) of a country is an indicator of the underlying asset base / fair value of that economy. Robert Shiller’s excellent book on Market Volatility contains a few papers that clearly indicate that prices are far more volatile than fair value. Result: we move from periods in which prices are far too high to periods when they are more or less in line with fair value to periods when prices are way too low, et cetera. With the GDP weight of the Emerging Markets now being close to 30-35 percent of world GDP, it is obvious that the market value weight underestimates their current importance. More than ever so. We do therefore believe that the bulk of conclusions drawn by Jim O’Neil and his Goldman Sachs economic research team in their book ‘Brics and Beyond’ do still hold. This is going to be the era of Emerging Markets. Sooner or later China and maybe India will be bigger economies than the US one.

But it is not just the economic world that is changing geographically. A similar phenomenon is going on in the asset management world. As an asset manager selection specialist, I would say that up until the beginning of this century the bulk of real best-of-breed asset managers was Anglo-Saxon. Within that group, the US asset managers got the lion’s share. This was especially true when looking at so-called quantitative asset managers. In the fundamental zone there were some good British asset managers active as well. Local parties in other nations were mainly of interest to local end-investors to the extent that the local factors were of importance. Be it legally, or because of the local presence. In terms of performance track record they couldn’t keep up with the best-of-breed specialists from the UK and US.

Now, with the world getting smaller due to globalization, the number of products growing and international complexities increasing, something has happened. The dominance of the Anglo-Saxons in the best-of-breed major league is far less prominent than it used to be. In the case of the Americans part of this is understandable. The Americans were always best in domestic products, and I would still be more than surprised to see a top-notch US equities or bonds manager not being from the States. It can be done, but it is hard. But their attitude to label products elsewhere as ‘International’ and put them alltogether in one mandate/fund was illustrative of how the US saw the world: us, the US, versus the rest. In terms of a world divided by market cap this was actually quite understandable. The US’s relative weight in terms of market cap was indeed about 40-50 percent for many years. If you add to that the fact that the Wall Street stock markets were the best-regulated and most-liquid ones, this approach was more than OK.

But with the shift in economic activity, and with the world becoming a more equally-weighted place with the US now being approximately 30-35 percent of the total pie, Europe and other developed nations (JAP, CAN, AUS, NZL, SING, HKG) representing a similar percentage and the Emerging Markets also, things are changing. And not just that, it is also clear that with this shift in economic power two important trends have helped to change the balance of power in asset management:

  1. The increasing role of London as center for international asset management. With Americans being less internationally-oriented than the Brits, major banks, insurance firms and asset managers from all over the world realized that London was an excellent alternative as world hub for international mandates. Not just in terms of available knowledge, but also in terms of time zone, being neatly placed between Asian time zones and the US time zones. The UK also followed an active strategy to grow the London Stock Exchange and attract as much as it could this type of new business. And with it came the shift of knowledge to this market. Even big American institutional investors and financial services firms accepted it and the growth in the City of London was to a large extent caused by American institutions understanding that ‘London was the place to be’ for non-US asset management. It was not surprising that the brightest talents in the asset management community followed this trend. Sure, when thinking in terms of academic study in Finance or Investments the US was still the hottest place to be, although levels in European schools like the London Business School, London School of Economics, INSEAD or even Asian ones like the Indian Institutes of Technology, top universities in Israel, Hong Kong and Singapore are definitely not considered much lower by recruiters anymore.
  2. And not just that. With the economic balance of power shifting, it became clear that there were areas of the market in which foreigners could do at least as good a job as their American colleagues. The ‘investment game’ is not the same in every asset class. Equities, Fixed Income, Hedge Funds are different games. And that is definitely true when looking at running portfolios of securities in these markets in different countries. This has led to the rise of excellent asset managers in other nations as well, also on a performance basis.

Examples: the top-level French asset managers are true specialists in Fixed Income. Somehow the French specialists, often relatively quant-oriented play a ‘game’ in Fixed Income that makes it very hard for the big Americans to compete. Germans also are strong in Fixed Income. Good quantitative managers are now also not a rare thing in the UK anymore, albeit that it is mainly in boutiques (with the exception of large powerhouse Barclays Global Investors, albeit that BGI is especially strong in index products). Average knowledge levels in the Netherlands and Scandinavia have gone up spectacularly.

This increased competition between a growing number of international players with far more knowledge dissemination than before has led to:

a) growing numbers of strong asset management boutiques, that exploit a specific, specialized skill set on a relatively narrow market segment;

b) finally (!), some downward price pressure on asset management fees, with unfortunately brokerage fees still not following quickly enough

c) the demise of parties that didn’t really add value, but simply leveraged their ‘brand name’ image / ‘size’

d) a growing interest in manager selection, because – with the non-existence of reliable ratings similar to what we described about rating systems in the Chess World in a previous entry – a larger number of providers in a growing number of sub-categories of asset management made things less overseeable for the average investor.

That is where we stand. An industry getting more mature at a time when the financial world seems to be burning. Investors do not just have to analyze carefully which asset manager has products in a specific category that are truly outperforming on the basis of skill, no, he/she also has to make sure that the provider itself will be there one year from now. Especially asset managers that are part of large banks or insurance firms have to be analyzed carefully. Before you know the asset management operation is sold as part of the restructuring operation, with all the turmoil that goes with it. What will that do to the team of specialists that you think you are hiring when opting for a specific product that you like? Will they stay with the entity? Leave to another one? Start their own?

Asset management in a grown-up financial world is more important than ever, but separating the good guys from the bad ones will itself prove to be a new, specialized quality as well. A quality that can make or break overall portfolio results. Those of you that were hurt by investments in the Madoffs of this world, or in asset management products that underperformed indices by 100s of basis points know what I talk about.

The end result of this new development is of course good: they are all signs of maturing. But as long as end-investors do not realize what is going on and think that the old world is still there, it will take quite some time before end-users – be they pension plans or private investors – will be provided with a full opportunity set of good products, with bad products having no chance at all. In the mean time the grey zone will continue to make victims, because penny-wise, pound-foolish market participants might continue to follow a DIY strategy of selection without realizing that it is really true that results in the past are not necessarily in-and-of-itself indicators of success in the future.

Investments 101; What we can learn from Chess Grandmasters

Posted in Behavioral Finance, Manager Selection, Uncategorized with tags , , , , , on March 17, 2009 by evd101

By Erik L. van Dijk


Two years ago I had the pleasure to sponsor of a chess team. Not just that: the pleasure even extended to becoming Dutch champion with the team. Even some of the big teams in Russia saw us as serious contestant for the European Club title. Unfortunately we didn’t get the funding right so as to compete with the Russians in that competition. But that we made it to Dutch champion was nice. And to a certain extent not so complicated: analyzing my budget (the cost side), I explored what good grandmasters would cost per game. And then we hired some of the strongest players in the world, using the FIDE (= World Chess Federation) rating list. This rating list was based on a methodology developed by the Hungarian professor Arpad Elo. Basically what that rating system does is giving players points for victories and penalties for losses, while at the same time incorporating differences in playing strength based on earlier achievements. The latter is important: if I join a chess club as a new youngster, and happen to be in the same club as a famous grandmaster, obviously my draw against that guy is not really a draw when trying to calculate my rating score. It is a sensation that should be rewarded with an increase in number of rating points. The same token, the grandmaster should be penalized for this unexpected lousy draw. Et cetera. If you then continue with that performance calculation system for many years, rating all the players in the game, you get a very nice system that will give you quite some accuracy with respect to expected  tournament results. Result: Grandmasters are really Grandmasters! The nice thing was that – both as a sponsor and representative of the board of the Dutch Chess Federation – I met with quite a few of those geniuses. And geniuses they are. Nothing like King Kong beating the professionals here. Top grandmasters can play blindfold chess against you as an amateur having a board, seeing the pieces, in not just one game, but dozens of them! Yep…the incredible quality of a top specialist.

Now back to investments. It looks so simple. All investments are about return (the positive variable), stability of returns (also positive), risk (negative to the extent that it is bigger than what an investor is willing to take), risk preference (who is the investor, what can he afford, what is his investment style, et cetera), investment type, correlation with the rest of the investments in portfolio (the lower the better), sensitivity to outliers, et cetera. Yep, everything in there can be measured to quite some extent.

Now, how come we find it so difficult to distinguish between good and bad investors or investment opportunities? If you talk to the average professional investor and tell him about the chess grandmaster, his first thought is that chess is a far simpler activity than investments and that it is being played by nerdish, mono-focused guys. Most of the time they tell you so, without even really knowing the game. And in the end, it cannot really be true. Take the following example: if we simply ignore the factors in the ”model” that you are using (either an implicit model when you are a fundamental style investor, or explicit when you are a quant), then at the end of the year you either beat the benchmark (be it some kind of index, or your required rate of return if you want to define the game in absolute space instead of relative space), are about equal (i.e. a draw), or you lost (underperformance).

The averave chessplayer, when talking to him about investing, never assumes that his game is more complicated, but it is striking that brilliand amateur investors (read: chess players) do often have very smart things to say about the problems facing investors. Reason: they recognize it as another kind of game. And chess grandmasters are game specialists. But investments defined the way we did before are a kind of game too. It is you out there against the competition, i.e. the other investors / the market. There are certain rules, there is a (hopefully level) playing field, there are various competitions (Dutch equities, US bonds, Asian Real Estate and so further), so play if you wanna play.

The main difference is also not the decision models used. Sure, there are a lot of important factors to take into consideration when analyzing your investments. But top-level chess is multi-factor as well. It is just that the factors are different ones. And the number of opportunities in investing is not necessarily bigger than that in chess. Equity strategies, or hedge fund strategies can be compared with playing ‘open’ positions with either not too many pieces on the board anymore and/or pawn structures where nothing or not too much is blocked. Blocked, closed structures are more like fixed income strategies, et cetera.

No, the real difference is that somehow big investors can make far more money than top grandmasters. And investors work in firms/structures led by shrewd managers that are all about indeed making a lot of money, not just for the investor, but for themselves as well. The average chess grandmaster is far less money savvy, and often more interested in playing a nice game, enjoying a nice location when playing a tournament, et cetera. How does that translate into differences between investing and chess? There is more at stake when being ‘bad’. Clients will withdraw money from your portfolio, bad returns translate into lower fees on existing client money, your boss might fire you, et cetera. So basically, whereas chess players didn’t really mind Professor Elo and the FIDE to develop that nice rating system, there is some kind of tendency among the average player (and that is the majority, just like in chess) to avoid becoming the bad guy. Result: smoke screening and a lack of performance measurement in a robust way.

Parties like Morningstar, Lipper and some of the better institutional manager selectors like Bfinance, Russell and ourselves (albeit all with slightly different decision models and goals) try to change that. But, professional investors are most often dealing with money from third party clients. Chess players on the other hand play for themselves. Sure, sometimes they do participate in team matches, but even there you can see that this ‘collectivity’ aspect doesn’t really change things, because it is in the end about the impact on the rating. And rating in turn decides on your position in the World Rankings.

The confusion about performance in investments has been further articulated by the fact, that clients and their advisors are sometimes not really certain of what they want and how they want it. Indeed, that is related to what we said earlier about ”Good Reasons”. They often assume that naive simple performance graphs over the last 2-5 years tell the story about how good or bad a manager is. And the traditional overconfidence aspect is also there: when we ourselves as investor go through a nice series of good performance, we often assume that we are a great investor. But as we saw in an earlier presentation, you need 8 years before 100 naive King King investors flipping coins might be de-masked as charlatans.

So we truly need more objective, Elo-like analysts of markets. A role that we at Lodewijk Meijer try to fulfil. Not to be the standard criticaster standing at the sideline, blaming the professional asset managers for doing a bad thing. It is a fantastic, difficult, impressive thing to outperform the market. So we are full of admiration for the truly strong ones, but only if they do have the investment philosophy and detailed analysis to show that it was skill and not luck. In other words: just like it was in chess, the strong guys like me, the not-so-strong guys that want to learn might still like me (maybe I know some place where they can improve skills in the area that led to the defeat they just experienced!) and some of the sincere bad guys might for the same reason still like me.

But….who really won’t like me, is the big investor trying to look bigger and better than he is. We will do all we can to de-mask him, warn potential clients. Not just in the interest of the client, but also in the interest of the asset manager. If ther is one thing to be learned from markets, then it is that being in there for the quick buck will in the end always hurt you. Tulipomania in the Middle Ages, Daytrading without having either a structured model to exploit small inefficiences and/or a position as broker so that your costs are lower, Insider Trading, Stock Market Fraud, short-term decisions based on short-term factors whereas you are a long-term investor…they all have led to disaster for the investors following that kind of strategy.

And even if you work hard, avoid overconfidence and specialize, you still need to make sure that you do not put all your eggs in one basket. Diversification – one of our core themes as incorporated in the Markowitz-Van Dijk approach to asset allocation – is part of the story as well. Even the strongest of grandmasters, be they Fisher, Karpov, Kasparov, Kramnik or Anand, they all have a so-called repertoire in which they play more than one opening so as to be sure that a) they are less predictable; and b) in case one or the other opening is somehow not functioning, that at least the results in the other opening might probably be uncorrelated.

From the grandmasters mentioned Russian Anatoli Karpov was probably the ”laziest” with the narrowest reportoire. So why was he world champion for such a long time? Was it luck, because the rest was bad? No, I do not think so. He was very much aware of the fact that he was not the hardest worker on new ideas at home. But he also knew that his endgame strength was fantastic. So even if the position during opening and middle game was somewhat inferior, he might still turn the tide in the endgame. Knowing that, he in a way optimized his strategy by focusing on a simple game plan, exchanging pieces relatively quickly, avoidance of hectic turbulent positions with potential for dangerous attacks and sacrifices, all to just get to the endgame quickly. Isn’t that like top specialists in low-beta, low-volatility asset classes? E.g. Fixed Income or Money Markets. On the other hand guys like Kasparov who play every game for a spectacular attacking win, have to work harder at home so as to know much more by heart before the game. Similar to what we can expect from an equity or hedge fund manager, for instance. Or a specialist in Emerging Markets, where often the data set available is still too short.

So, as long as we do not have a rating system like the Elo system in investments, it pays to compare asset managers (either at the firm level or at the level of individual products/lead portfolio managers) with chess players. If they like that or not, we don’t care. It will help us avoid all kind of pitfalls in what is in the end a similar type of game.

From to Chess to Credit Crisis

So why then the credit crisis? Can we still use the metaphor of chess when looking at the crisis? The answer is yes. When alleged specialists turn out not to be specialists, i.e. the players in our championship weren’t the best, there is a big chance that organizers and owners/sponsors (us as end-investors) might freak out and put pressure on our non-delivering ‘stars’ that weren’t stars after all. OK, there are excellent specialists out there that couldn’t help us avoid the crisis, but at least they will ex-post know that the basis for their giant status was laid in periods like the one at hand. When the going gets tough, the tough gets going.

In the mean time we have to go through the motions and make sure that we filter out the bad guys. As long as the ideal rating system is not there, we might use ”bonus” and ”fee levels” as a proxy. Research has indicated that the best money managers are not the ones charging the highest fees. On the contrary, true specialists want to attract a large portfolio so that they can earn their excess return fee over a larger Assets Under Management base. Attracting a large portfolio is easier when fees are not too high. Lousy players pretending to be good know that the likelihood of earning that performance bonus is small. Therefore it is better to charge a high ex-ante fee.

And about performance bonuses in banks. Nothing wrong with it if the bonus is related to TRUE outperformance. But too often do we see that bonus structures in big financial institutions are not related to a definition of performance that is in the end in the best interest of their clientele. Not even is it in many cases based on benchmark levels that are really difficult to beat. And in some cases there are no high watermarks assuring that lousy performance in the past will have to be compensated for in the future, before being entitled to a new bonus.

Obama was right to be angry to many bankers and to investigate what he could do. What we can do in the mean time is use eagerness to score bonuses or fees as a negative proxy with respect to future performance.

I hope that this chess-based reflection gives you some basic ideas concerning what you could look for if you do not have a full-fledge rating system.


Within the chess world there is a lot of discussions going on, indicating that even there people are not fully satisfied with the Elo rating system. However, it is far better than nothing, and far better than what we have in the financial world. There is still a long way to go. And it is good to see that there are a lot of intiatives going on that will help you to distinguish good from bad much better than you could in the past. I will be more than pleased to brainstorm about this more, if you desire.

In our next entries we will of course go from metaphor back to daily market movements and hands-on analysis of products and markets.