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Graham Macdonald, MBE MBMG International Ltd.
Nominated for the Lorenzo Natali Prize

 

Banana Republic, is it a septic isle?

In a telephone interview on CNBC’s The Call, my business partner, Paul Gambles suggested that it would be wrong for the Bank of Thailand (BoT) to cut the benchmark interest rate. This was before the Monetary Policy Committee (MPC) convened on the 29th May. “A weaker Baht does not stimulate exports,” he said. “The Thai Baht is a pro-cyclical currency and tends to strengthen during periods of global growth, which is when the strongest Thai export growth occurs.” As we know, there was a 25 basis drop in the rate which, Paul, believe could be a mistake.
Paul believes that while everyone focuses on US Dollar/Thai Baht cross rate, it is also important to look at the Baht’s rate against the Japanese Yen, as well as the Chinese Renminbi (RMB) - especially as Asia is exporting within itself more and more so as to compensate for the drop in business with the West. “The Yen is being manipulated and the RMB seems undervalued too,” he explained. “One client recently returned from China remarking how cheap Big Macs are.”
This is significant as The Economist’s ‘Big Mac Index’ is an informal way of measuring purchasing power parity between currencies. So either the Chinese don’t like hamburgers or the RMB is cheaper than it should be. Fast food sales figures suggest that the Chinese do indeed like burgers, so the currency must be undervalued.
The Call’s presenter, Bernie Lo, suggested there was a consensus that rates would in fact be cut by 25 basis points, although Thai Finance Minister Kittiratt Na-Ranong has called for either a cut of 50 basis points or capital controls. Bernie asked if such explicit policy intervention by the Finance Minister was the definition of a banana republic.
“The Bank of Thailand isn’t doing the Ministry of Finance’s bidding,” Gambles replied. “It’s acting as a genuine counterbalance.”
Paul explained that the Ministry of Finance is pushing a growth mandate, whereas the BoT is going for sustainability and prudence. “The two are providing checks and balances in Thailand,” he added. “This is unlike the USA or the UK, where central banks are extensions of government policy.”
“I like bananas anyway!” retorted Lo.
Shortly after the show, the Joint Foreign Chambers of Commerce of Thailand scheduled a luncheon talk with Dr. Prasarn Trairatvorakul. However, Deputy Governor Pongpen Ruengvirayudh had to step in at the last minute as Dr. Prasarn was due to speak but he had been detained in a meeting with the Prime Minister and the cabinet. One can only speculate about that conversation!
When asked about Bernie’s banana republic comments, Pongpen suggested that we would have to monitor the MPC’s behaviour and its responses to economic situations and that the Governor was setting “A great example” - “The MPC is trying to be a good central banker in the BoT’s 70th anniversary year, by walking straight and walking tall; without paying attention to media commentary.”
Pongpen said that the high pace of credit growth raised the risk of the economy overheating. She added that the MPC had flagged this several times, was monitoring the situation closely but was also aware that growth was being affected by a compression in global demand.
Nevertheless, the Deputy Governor sees reversion to mean growth as healthy. She suggested that The Monetary Policy Committee must weigh up the objectives and that interest rates were not the only tools: macro-prudential tools were also available.
The BoT sees the Baht’s strength as a sign of better growth, strong external balances and good fundamentals with a catch-up effect. This situation can be compared favourably with the relative weakness around the region; such as the political uncertainty in Malaysia and Indonesia’s capital account deficit.
The Baht has deviated from its equilibrium, the Deputy Governor admitted, but she does not see foreign exchange as the main policy tool or even an intermediate target. She explained that she was more concerned with the impact of foreign exchange volume on SMEs. “The BoT, the Ministry of Finance and the National Economic and Social Development Board recognise that foreign exchange rates should not derail growth,” she said. “Policy measures will be designed to avoid unintended consequences.”
However, the Deputy Governor also commented that any pre-emptive policies should be used even if they cause short term impediments as long as they improve cause long term gain. So maybe Thailand isn’t a banana republic after all… which is more than we can say for USA, UK, et al.


Passive V Active - Which is healthy for you? Part 1 & 2

Part 1
Traditionally, investors have appointed investment managers to (actively) manage their exposure to asset classes - their asset allocation - and individual assets within each asset class - asset selection. Fund managers charge a fee for their service of constructing portfolios for their investors - either at the asset class or individual asset level, or both. In return for this they try to outperform their benchmarks. In the case of asset selection it would be something like the FTSE, MSCI or S&P500. They do this by identifying assets (shares in this case) that will outperform the combination of assets that make up the benchmark. Fund managers’ value proposition is that their skill in selecting assets (or asset classes) produces sufficient out-performance against the relevant benchmark to justify their fee.
Passive products differ from active products in two key ways. Firstly, individual assets are selected on a mechanical basis; and secondly their fees are significantly lower. The first generation of passive products was designed to replicate the returns of benchmarks such as the aforementioned. The range of these products has been broadened to include index tracking funds covering specialised indices that concentrate on a particular sector, e.g. commodities or technology, etc.
Other, more recent versions try to improve on this in systematic (i.e. mechanical) ways. Some use different measures to market capitalisation (the way the FTSE, etc., is constructed) to build their portfolios. The latest evolution in the passive space includes the so-called ‘Smart Beta’ products. They use pre-determined (i.e. mechanical) investment strategies to give investors consistent exposure to a particular investment style or outcome. Examples include value and momentum style portfolios and risk managed portfolios such as the minimum volatility (min-vol) product. These products all construct their portfolios using a fixed methodology or set of rules.
The ‘style’ funds such as value and momentum products systematically identify the presence of these ‘factors’ and construct portfolios of equities which embody them. In the case of the min-vol portfolios, they are constructed in such a way as to minimise the volatility of the returns of the portfolio using average historical returns and variance/co-variance matrices. As with all passive products the fees are low as the ‘recipe’ is fixed and the portfolio manager merely oversees its application.
Passive products have been around for a while in their various guises but it is only recently that they are getting more widely used in the many more markets. Why the delay? We believe that most investors tend to view them as direct alternatives, or substitutes, to the traditional active funds. If it is framed in this way, the debate immediately becomes one of ‘either/or’ - in other words: which approach is better than the other?
Comparisons are most often then made between the lower fees of the passive funds vs. the (often temporary) out-performance of the active managers. Somehow the idea of buying consistently average performance is not that exciting - even when it’s very cheap! However, as customers become more familiar with the concept of passive products and their relative advantages they are beginning to choose them more often. The relatively low returns environment offshore has also pushed investors there into using the cheaper passive investments to save on the negative impact of costs on their (already low) returns.
A more productive perspective is to view these two investment approaches as complementary to other - they can both play different, but equally important, roles in a portfolio. Passive products allow us to get very precisely targeted, consistent exposures to asset classes and investment strategies at a relatively cheap price.
We value this highly, given the importance of asset allocation in our investment process. The more recent developments in this field, such as the Smart-Beta products, allow us to get consistent exposure to investment strategies that were previously only available via active managers (e.g. value, momentum or high yielding equities). Furthermore we had to hope that active managers would implement these strategies consistently - in other words, there was no style drift. Now we can be certain of this outcome if we go the Smart-Beta route.
Part 2
When choosing active managers it is very important to distinguish between truly active managers and closet index tracker (active) managers. For example, any active manager that worries about tracking error (the extent to which their portfolio’s returns deviate from the benchmark) runs the risk of being a closet index tracker. Active managers are paid a fee to outperform a benchmark, not to hug it. Consequently, active managers who hold concentrated portfolios are more interesting than overly diversified managers.
It is possible in principle to construct a portfolio comprising of wholly passive products reflecting a particular asset allocation view. Given the importance of asset allocation in terms of investment performance and the relative cost savings of this approach this is not too bad an idea! However, there are areas where the skill and judgement of active managers is necessary. Passive investment strategies only work well when a specific strategy can be codified i.e. reduced to a set of rules that can be implemented consistently. Unfortunately there are some areas that don’t lend themselves to this. Asset allocation is one of them! This is where we believe active managers can earn their fees.
In conclusion, a multi-asset multi-manager’s role is to set the asset allocation for a desired return target and select the best way to implement this view. Where exposure to a particular asset class or investment theme is required looking for a passive alternative is a good starting point. They provide a consistent way to express an asset class or investment strategy view. However, active managers can add outperformance and diversification to this mix and so they should be viewed as a complement. The problem is thus not which approach is better than the other - it is rather one of how much of each an investor should have.
By redefining the concept of active versus passive, institutional investors can have a multi-strategy effect within their investment portfolio by implementing a core-satellite approach. Core strategies are typically those that are well diversified and provide broad exposure to an asset class, while satellite strategies complement a core strategy by providing the opportunity to generate alpha.
Traditional beta is typically best used as a core approach because it results in the lowest tracking error and provides the broadest exposure to an asset class. Conversely, concentrated active is used exclusively as a satellite approach because it has the highest amount of tracking error and typically results in the highest alpha as well. Therefore, a combination of the two should result in a market-like return from the traditional beta strategy complemented by the alpha generated by the concentrated active strategy. Smart beta and diversified active strategies can serve as either core or satellite approaches, depending upon the asset class; however, institutional investors should refrain from using traditional beta strategies as a satellite approach or concentrated active strategies as a core approach. This is because traditional beta strategies do not generate the alpha required of a satellite approach and concentrated active strategies do not provide broad exposure to an asset class because they result in too much tracking error.
Rather than broadly defining active and passive, investors would be better served by differentiating diversified from concentrated within the actively managed portion of their portfolio and traditional beta from smart beta within the passive portion. Doing so should allow investors to better understand the risk and return expectations of each strategy, as defined by tracking error and alpha, thereby allowing these different strategies to be used as complementary solutions within an investment portfolio. This should add value to the portfolio whilst minimising volatility.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]

 


 
HEADLINES [click on headline to view story]

Banana Republic, is it a septic isle?

Passive V Active - Which is healthy for you? Part 1 & 2