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Euro ‘crisis’ now part of portfolio strategy

Firms using array of tools to incorporate currency's uncertainty

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Protecting: Stuart Fiertz said his firm is using call options as a hedge.

Even as global leaders are joining forces to prevent the eurozone debt problems from spreading further, investment managers are deploying new measures to better protect their portfolios against a deepening crisis.

Two years after the initial bailout of Greece was announced in May 2010 and following a crucial election this month in which Greeks effectively decided to stay in the eurozone, the crisis is morphing from a short-term factor into a long-term consideration for portfolio managers.

“It's hard to continue to describe this as a crisis, it's beginning to become status quo,” said Dan Morris, executive director and global strategist at J.P. Morgan Asset Management (JPM), London.

Peter Halligan, co-head of multiasset research at Aon Hewitt, London, said managers “certainly have had to consider issues they haven't been presented in quite this way before.”

Initially, many investors took a short-term opportunistic approach to investing in the eurozone, following a pattern of buying cheap assets with the expectation that government intervention is around the corner, then exiting shortly after the policy announcement.

“There's now a migration away from this opportunistic approach,” Mr. Halligan added.

With each phase of intervention, “clearly, the medicine is getting less and less effective,” said Simon Savage, co-portfolio manager and head of risk in the $1.7 billion European Long Short Fund at GLG Partners LP, London, which is part of Man Group. Following an announcement June 9 of the e100 billion ($126 billion) bailout for Spanish banks, the market rally lasted about three hours, Mr. Savage said. “After the Greek election (on June 17), the euphoria lasted about three minutes.”

“Tactically, portfolio managers have to be aware of that and change ... techniques for managing money accordingly,” Mr. Savage said. GLG had $28.6 billion in total AUM as of March 31.

All managers interviewed firmly believe that a breakup of the euro is unlikely, but the chance — however small — is rising. As a result, more safeguards are being put in place as “the muddling-through environment will go on for a while, perhaps years,” said Christophe Caspar, chief investment officer for multiasset solutions at Russell Investments, London.

In some cases, managers are tweaking the investment process itself to better reflect the current investment environment. At Aberdeen Asset Management PLC, an adamantly bottom-up fundamentally driven manager, top-down factors are playing a bigger role in portfolio strategies.

'No quick solution'

Wolfgang Kuhn, Aberdeen's head of euro fixed income based in London, said: “The issues are very difficult, and there is no quick solution to the problem. It will take quite some time for things to be repaired, and a long time before we are back to a purely fundamentally driven investment environment.” Aberdeen AM manages $295 billion in global AUM as of March 31, about e5 billion of which is invested in the euro fixed-income strategy.

One top-down factor that is increasingly important throughout the eurozone crisis is the concentration limits to any individual country, Mr. Kuhn said. “We might like companies from a bottom-up perspective, but if there's too much concentration in one country, the risk might be too high,” he added. “Company ratings in the eurozone are now linked to the country in which they're domiciled very explicitly, which is one reason why (the country factor) is currently the most significant driver of spreads.”

Investors also are finding new ways of implementing derivatives to tailor exposures.

“We haven't felt the need to hedge against a breakup of the euro until now,” said Stuart Fiertz, president and director of research at Cheyne Capital, a London-based hedge fund with about $6.3 billion in assets under management. Within the past several months, Cheyne Capital began buying call options on the Danish krone, which is pegged to the euro and is a cheaper hedge than some other euro-pegged currencies such as the Swiss franc.

“If the euro deteriorates, we've got some protection,” Mr. Fiertz said.

More institutional investors are using zero-premium swaption collars to protect pension fund portfolios against further drops in interest rates.

Phil Page, London-based client manager at consultant Cardano Risk Management BV, said swaptions can be more efficient because investors essentially sell the upside in the event interest rates rise above a certain level to pay for the downside protection. (A swaption is an option to enter into a swap agreement.)

“Clients are protected just in case the eurozone crisis does deepen, but they're not locked into the current low interest rate level” that exists in using swaps, Mr. Page said. Swaption contracts are usually implemented over a period of one or two years.

Tail-risk hedging

Andrew Balls, managing director and head of European portfolio management at Pacific Investment Management Co. LLC based in London, said: “For a long time, we would only sell options. ... Now it makes sense to buy options” as tail-risk hedging has become a bigger consideration to protect investment portfolios. PIMCO managed $1.77 trillion in global AUM as of March 31, about e390 billion of which is from Europe.

At a recent media round table, Mr. Balls likened the situation to getting into an elevator knowing there is an 85% chance the elevator will safely reach the bottom. “Do you want to take that very high percentage chance of success, or guard against a much lower chance for failure?” he asked.

David Blake, director of global fixed income at Northern Trust Global Investments, London, said a “euro breakup remains unlikely in our scenario analysis, but the magnitude of such an event — if it does happen — requires careful portfolio construction. More fiscal and political integration will eventually emerge, via a continuation of "just enough, just in time' policy, and with no foreseeable end to the crisis.” NTGI had $293.3 billion in global fixed income AUM as of March 31.

Managers are looking for safer routes to gain certain asset exposures. For example, instead of investing in peripheral bonds issued domestically, some managers are purchasing sterling-denominated bonds issued in the U.K., which can have higher levels of legal protection.

“Contracts in London will have different terms and conditions than those issued in local debt markets,” said Aon Hewitt's Mr. Halligan. “With Greece's (debt) restructuring, for example, Greek debt issued in Greece took a larger haircut than those issued in London.”

Reconsidering strategies

Emerging market managers also have reconsidered their investment strategies as a result of the turmoil emanating from Greece. Jana Velebova, London-based portfolio manager of emerging markets bonds at Rogge Global Partners PLC, said more consideration is being placed on any securities with relatively high exposure to the eurozone. For example, emerging European countries such as the Czech Republic, Hungary and Romania are “very exposed” and are underweight in the Rogge's investment portfolio, she said. Rogge is a global fixed income manager with about $50 billion in AUM.

Yet the crisis also has had positive impacts on emerging markets strategies. “As the situation in the eurozone deteriorates, (investors) are willing to explore new opportunities within emerging and frontier markets,” Ms. Velebova said. “We're seeing more African and Caribbean countries, for example, entering our investment universe. All that is possible because of the extra liquidity in the financial system and as investors look for idiosyncratic growth stories removed from the eurozone.”