Alas, as we all know now, the subprime crisis revealed a new risk created by the uncertainty of not knowing who was exposed to what type of debt and by much.
“A lot of investors threw caution to the wind, looking for the proverbial free lunch and have been burned quite badly in some cases,” reflects Mr Sauter, who oversees nearly $1000bn (€658bn) of assets managed by Vanguard’s fixed income and quantitative equity groups.
“It stands to reason that if you thought you were investing in a triple-A quality bond that was providing a premium yield over other triple-A securities, that there really was more risk there than you realised. And as it turned out, the correlations of the securities held within many of these underlying tranches went very high under crisis conditions and consequently these securities were repriced.
“In the end, there really is no alchemy and when you think you can turn a package of triple B securities into a triple A security, you have to step back and ask if that is really
possible.”
He reckons investors will be extremely wary about going back into CDOs and that special investment vehicles will disappear altogether. The current pull-back from risk is, he notes, just a normal function of the “greed and fear” cycles that propel the investment industry globally. Simply put: investors search for yield in low return environments, taking on more risk than is prudent, and ultimately they get burned. Then they become conservative investors for a time.
But of course, it is not as simple as that. The ratings agencies have come under fire and in response have quickly downgraded many securities, calling into question whether they had assigned the appropriate ratings to begin with.
“I think the model whereby the ratings agencies negotiate with the various packagers of these securities to put certain ratings on them will be reviewed.
Clearly there is a conflict of interest when the ratings agencies secure a significant percentage of their revenue from negotiating the ratings on these securities,” says Mr Sauter.
With the subprime crisis and the on-going credit crunch still claiming victims in the banking world, the final outcome is uncertain.
As investors recoil from CDOs, it is hard at this time to see what will renew confidence to invest in newer types of structured products. Risk managers, warns Mr Sauter, are going to be concerned about the potential risks in a new product so making it very difficult to launch new types of structured products in an uncertain market environment.
“We can estimate the impact of known risks affecting products, but it is the risks that we don’t know that we need to be wary of.”
Selectivity
So what advice for bond investors? “Keep a higher quality orientation. While diversification is prudent, we would not diversify into the lower credit qualities. It is still time for upgrading portfolios.”
But the watchword is selectivity. With the widening of spreads, he maintains there are good opportunities among high quality financials “which have really taken a beating in current market conditions”.
At the total portfolio level, Mr Sauter says alternative assets offer good diversification benefits as long as investors find good managers.
“You have to be aware of the difficulties of capturing excess return and you have to make sure you are controlling the costs because most alternative or hedge fund-type
investments do not end up beating the market but the best managers do.”
He adds that even if alternative asset managers only succeed in earning the market rate of return, that can be appealing if in doing so, they also diversify away from the market’s exposure. So if by investing in alternative assets, you can moderate your overall portfolio volatility, it is a huge benefit.
Since it is so difficult to know where the market is going, Mr Sauter believes investors should pursue a long-term strategy and be prepare to ride the ups and downs.
“Institutional investors should fight that behavioural tendency to react to what has happened in the market place. Focus on the total portfolio and not the individual pieces of the portfolio.”
Absorbing the crunch
He is cautiously optimistic about the ability of the global economy to withstand the credit crunch and current market volatility if it can just “muddle along” for 12 months without a significant blow-up.
“The US economy is reeling from the subprime debt crisis. As long as there is not a major blow-up, the financial institutions will be able to absorb many of these write-offs. They have taken about $150bn worth of write-offs to date and we think before all is said and done that it will be $300-400bn in total.
“But the good news is that these investment banks have tremendous earning power and if they are just given time to work their way out of this without being forced into a corner, they will be able to earn enough to pay for these write-offs,” he adds.
Market volatility presents but one investment headache for institutional investors. The volatility of future liabilities has equally worrying implications for the investment policies of pension schemes and insurance companies.
Gus Sauter observes that while pension funds in Europe are currently ahead of their US counterparts in implementing liability-driven investment (LDI) strategies, changes in US law will drive demand for risk-immunised portfolios across the Atlantic.
“Our experience has revealed that European institutional investors are quite sophisticated and have been focused on the volatility of the residual in their pension plans,” he notes.
Vanguard has responded by creating a long-duration bond fund (22.5 years) in the US. The firm also recently launched two new long-duration bond funds in Europe – the 20+Year Euro Treasury Index Fund and the 30-40
Year Duration Euro Index Fund. These Ireland-domiciled Ucits funds are benchmarked respectively to the Lehman Euro Aggregate Treasury 20+ Year Index (AA- and Above) Index and the Lehman Euro 30-40 Year Zero Coupon Equal Notional Swap Index.
“The advantage of long-duration bond funds is that they can match the duration of a pension fund’s liabilities with a relatively small investment,” says Mr Sauter.
“If you have a very long duration fund, you do not necessarily need to devote a tremendous percentage of your assets to that investment, which enables you then to pursue higher returning strategies with the remainder of your plan assets. We think a very long duration portfolio can be used to complement an investment in equities, freeing you up to go for higher-returning strategies. It probably means you don’t need as many investments in shorter duration fixed income funds.”
Vanguard has $41bn of assets under management in exchange-traded funds and is hailed as offering some of the cheapest ETFs on the market, something which undoubtedly helped the company to record $18bn in ETF sales last year. At the present time, the products are not available to European-based investors, although the firm is currently looking at offering them in Europe at some point in the future.
Fundamental indices
Despite managing nearly $1,300bn in assets, including more than $100bn in non-US assets, Vanguard seems to feel threatened by the advent of products based on fundamental as opposed to market cap-weighted indices.
Fundamental indices use factors such as cash flow, dividend yield and earnings to calculate how much of a stock to buy. Mr Sauter contends that they are taking bets against the market as a whole and questions whether such bets are capable of producing alpha.
He maintains that investors are rather getting pure beta.
“Fundamental weighting factors produce a bias towards mid-cap value stocks and small-cap stocks. Now we know that throughout the world, value investments and smaller cap investments have outperformed over the last 30 or 40 years. So it is not surprising that if you take a bet which places you in that segment of the market, that it has outperformed. But we are concerned that investors just don’t realize that they are taking a value bet.”
He claims that investors can gain a more efficient and cost-effective exposure to, say, the mid-cap value market by investing in a mid-cap value index fund that’s market cap weighted. This is because fundamental indices need to be constantly rebalanced, thereby incurring costs and potentially realising capital gains.
Mr Sauter presides over $25bn of assets under management worldwide in active quantitative strategies, a figure he says had reached $30bn before the markets started falling last year. So how do these active quantitative equity strategies differ from a fundamental index fund? The difference he says, is the pursuit of alpha.
“We can apply active quantitative strategies to any segment of the market. For instance, we don’t have a mid-cap value enhanced fund but our process could be applied to that segment of the market and if we are successful, we would not only provide that mid-cap value exposure which is what these fundamental indices tend to do but we would provide consistent outperformance above and beyond that,” explains Mr Sauter.
“We are really distinguishing between that factor exposure you are getting with fundamental indices versus an additional alpha or incremental manager skill return on top of that return. So the real distinction is adding an incremental return above and beyond what any given segment of the market is going to provide,” he adds.
THE MAKING OF A CIO: GEORGE U “GUS” SAUTER
1997: Appointed chief investment officer of Vanguard
1987: Joins the Vanguard Group
Trust Investment Officer, First National Bank of Ohio
MBA in Finance from the University of Chicago
BA in Economics from Dartmouth College
