01l02.14 Protection against Inflation Risk - Credit …...| 3/32 Trends 01l02.14 Editorial Content Just as umbrellas and parasols give shelter from the rain and sun, inflation-linked

Protection against Inflation RiskDossier Inflation-Linked Bonds – Preserving Real PurchasingPower and Diversifying Risk

Macro Global Will "Helicopter Money" Bring Inflation?

Column Sustainability in Institutional Asset Management

01l02.14

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Trends 01l02.14

Editorial

Content

Just as umbrellas and parasols give shelter from the rain and sun, inflation-linked bonds provide protection against rising inflation.

Editorial

Dear Reader

Inflation is not headline news at the moment. But it is conceivable that continuing monetary accommodation from central banks could eventually lead to significant inflationary pressure. In this issue of Trends, we examine the question of what conditions could lead to higher inflation rates, and give our forecast.

We also place a focus on the only asset class that offers effective protection against inflation: inflation-linked bonds. And we explain why, contrary to popular opinion, real estate and gold do not really protect you against inflation.

In addition, we take a look at sustainable investments. These are becoming increasingly important, not least in institutional asset management. Amongst other things, we discuss which selection criteria come into play and give an overview of the different investment approaches. And, as usual, we also report on other markets and trends.

Incidentally, this is the last edition of Trends in this current format. Not only is the magazine being redesigned but, in the future, it will also be published monthly. The first edition of the new Trends will be out this spring.

We hope this edition makes for enjoyable and thought-provoking reading, and provides you with some investment ideas.

Yours sincerely

Robert Parker Senior Adviser: Investment Strategy and Research

Robert ParkerSenior Adviser: Investment Strategy and Research

Asset Allocation Driven by the Central Banks 4 Outlook 5

Macro GlobalWill "Helicopter Money" Bring Inflation? 6

Alternative InvestmentsImpact of Alternative Fixed Income Strategies in Response to Emerging Changes in Economic Conditions 9

Equity GlobalWell Invested with Security 12

DossierInflation-Linked Bonds – Preserving Real Purchasing Power and Diversifying Risk 16

ColumnSustainability in Institutional Asset Management 24

Real EstateForeign Real Estate – Smart Diversification is Half the Battle 28

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Trends 01l02.14 Trends 01l02.14

Asset Allocation | 5/32Asset Allocation

Investors are hanging on central bankers’ every word like never before. And the central bankers are in turn making every effort not to frighten the nervous investor community with their forward guidance. Investors’ fears are quite understandable, given that current central bank policy is in un-charted waters.

The monetary environment is undoubtedly one of the key drivers of prices on finan-cial markets. But investors’ current fo-cus on central banks is nevertheless unu-sual. With Tapering a term determines the headlines, which is not well understood. Even experts cannot agree whether a re-duction in bond purchases will impact the economy or whether the Fed’s ballooning balance sheet is in fact more important. We would point out in passing, though, that the ECB’s balance sheet has shrunk by 25% since summer 2012 and Euro-pean equities have still put in an outstand-ing performance during that time.

Whatever the direct effects of tapering may be, it is important to bear in mind that the normalization of central bank policy is ultimately a reflection of the ongoing re-covery in the economy. Our assumption is that the central banks will do their level

best not to put the upturn at risk. Infla-tion, which has actually been falling in re-cent months, shows no signs of posing a danger.

Rising interest rates a sign of recoveryThe markets now rightly believe that ta-pering is not the same thing as a hike in benchmark rates. That is still a long way off for the Fed, to say nothing of the ECB, SNB or BoJ. That does not mean that yields on longer-dated bonds cannot con-tinue to head north, so these instruments still hold little appeal. On the other hand, we do not see long yields skyrocketing. The public sector and private households are still too fragile to be able to cope with a sharp upward move in rates.

A scenario of moderate rate increases is a good starting point for the asset class that is our favorite on strategic grounds once again in 2014, namely equities. The biggest price driver in recent years – the correction of the undervaluation – has somewhat run out of steam. In fact, some indicators even suggest share valuations are neutral to high. But bull markets do not normally stop at fair value. The pres-sure to invest in equities, as a result of zero interest rates, suggests overvaluation is on the cards. On top of that, 2014 offers

further scope for earnings growth as the economy accelerates.

Temporary setbacksInvestors have to realize that the flip side of a higher valuation is more potential for a setback. After a long period when the news has been almost all good, any disap-pointments could see a sharp reaction. The Fed’s adroit announcement that it is to start measured tapering from January removed a major uncertainty. We have therefore in-creased our equity allocation again and are focusing in particular on the considerable catch-up potential for European and Jap-anese earnings. Given strained sentiment indicators, a temporary correction seems likely, but we would use it as an opportunity to further top up equity holdings.

Asset Allocation

Driven by the Central BanksPatrick Bucher, Head of Global Asset Allocation

Bold: tactical positioning. Normal type: long-term strategy/benchmark. Arrows show change compared with last issue of "Trends", 09|10.13.* This is an indicative asset allocation, which may change over time.

Historical performance indications and financial market scenarios are no guarantee of current or future performance.

Source: Credit Suisse.

Globally-oriented model portfolio for Swiss pension funds* CHF EUR GBP USD, JPY Em. Markets, Total CAD Commodities Liquidity 11.9% 0.0% 0.8% 0.1% 0.2% 0.0% 13.1% 9.8% 0.0% 0.0% 0.0% 0.0% 0.0% 9.8% Bonds 51.4% 3.4% 0.0% 2.0% 0.0% 56.9% 53.2% 3.0% 1.0% 2.0% 1.0% 60.2% Equities 9.7% 4.4% 1.6% 7.5% 2.5% 4.3% 30.0% 10.0% 4.0% 2.0% 8.0% 2.0% 4.0% 30.0% Total 73.0% 7.9% 2.4% 9.6% 2.8% 4.3% 100.0% 73.0% 7.0% 3.0% 10.0% 3.0% 4.0% 100.0%

Outlook Asset Allocation


Currencies against CHF

USD 0.88 0.97 – 9.6

CAD 0.83 0.92 – 9.7

AUD 0.79 0.87 – 10.9

JPY 0.86 0.92 – 7.2

EUR 1.22 1.25 – 2.3

GBP 1.45 1.48 – 2.2

Capital market (10-year government bonds)

USD 2.85 3.10 0.9 10.6

CAD 2.64 3.10 –0.9 8.7

AUD 4.23 4.30 3.7 15.0

JPY 0.67 0.90 –1.3 5.7

EUR 1.83 2.10 –0.4 1.9

GBP 2.91 3.20 0.7 2.9

CHF 1.02 1.40 –2.2 –2.2

Equity market

USA (S&P 500) 1,787 1,950 9.1 19.6

Germany (DAX) 9,085 10,000 10.1 12.6

Netherlands (AEX) 378 420 11.1 13.6

UK (FTSE 100) 6,486 7,300 12.5 15.0

France (CAC 40) 4,086 4,500 10.1 12.7

Italy (MIBTEL) 17,925 20,000 11.6 14.2

Spain (IBEX 35) 9,343 10,500 12.4 15.0

Switzerland (SMI) 7,831 8,800 12.4 12.4

Japan (TOPIX) 1,232 1,450 17.7 26.1

Money market (3-month LIBOR)

USD 0.24 0.30 0.3 9.9

CAD 1.27 1.20 1.2 11.1

AUD 2.60 2.60 2.6 13.7

JPY 0.15 0.20 0.2 7.4

EUR 0.27 0.20 0.2 2.6

GBP 0.53 0.60 0.6 2.7

CHF 0.02 0.10 0.1 0.1

Gold

USD/oz 1,231 1,150 –6.6 2.4

Estimated performance indications and financial market scenarios are no guarantee of current or future performance.

Estimate Expected return in Expected return 17.12.2013 12 months local currency (%) in CHF (%)

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Macro GlobalMacro Global

Macro Global

Will "Helicopter Money" Bring Inflation?Thomas Herrmann, Global Economic Research

Over the past years, central banks have reacted strongly and with un-conventional measures to counter the global financial crisis and the en-suing recession. Interest rates fell to zero and central banks bought large amounts of bonds, foreign curren-cies and even equities. While these policies were designed to counter deflation risks following the signifi-cant shocks to the financial system and steep declines in economic ac-tivity, the concern for investors and the wider public for several years has been that central banks' money print-ing efforts will ultimately cause sig-nificant inflation. We assess some channels that could lead to such a development, and discuss historical occurrences and the outlook for in-flation.

Some theory and some history From a longer-term historical perspective, persistent inflation is a phenomenon that only really emerged in the 20th century (see Figure 1). One key reason was the strong rise of "fiat money1" creation and the fact that – contrary to the current situation –central banks were not independent from political influences. With central banks now still explicitly or implicitly much more committed to medium-term price stability, three aspects are most crucial to assess when thinking about the medium-term outlook: economic slack, monetary, and in particular, credit developments, and in-flation expectations. All three suggest lim-ited risks at this point in most advanced economies. Over the past years, signif-icant short-term swings have resulted

from changes in commodity prices, ex-change rate adjustment or administered prices, but these short-term changes ap-pear to have limited lasting effects.

The real economy angle: economic slack and inflationAfter significant declines in economic ac-tivity, inflation usually takes a long time to increase meaningfully and has histor-ically been a "late-cycle" development. The reason for this is that after an eco-nomic shock, the amount of slack is great and price pressure from high capacity uti-lization or wages is unlikely. Despite im-provements in economic activity since the depths of the global recession, "slack" ap-

pears to remain high in many advanced economies, with a significant share of the labor force still unemployed. The longer high unemployment persists, the less likely it is that workers can easily be re-employed. In such a situation, the avail-able pool of idle workers might be smaller than unemployment rates suggest.

The monetarist angle: credit booms and busts and effects on inflation/deflationAs mentioned above, the rise of "fiat money" contributed to strong money growth in several episodes in the 20th century before monetarist assessment and inflation-focused policy making

gained importance. Credit expansion was strong in many countries before the lat-est financial crisis. This fueled credit and demand driven growth, which reduced economic slack and allowed wage growth to spill-over to inflationary developments. Many advanced economies currently face a "clean-up" phase with higher debt levels (partly now on the public balance sheet) as well as credit constraints both from a supply and a demand perspective. This remains a bigger issue than excess credit growth, especially in the eurozone pe- riphery. In contrast, several emerging markets, including China and Brazil, face the challenge of lowering credit depen-dence of the business cycle and of limit-ing the related upside risks for inflation.

The importance of central bank inde-pendence and inflation expectationsInflation appears to have generally be-come less sensitive to the business cy-cle and to short-term shocks like oil price swings over the past decades. One rea-son is probably an increased commitment on the part of central banks to prevent in-flation and improve their credibility. Apart from a more active management of the inflation risks, significantly improved sta-bility of inflation expectations has certainly been beneficial. As central banks’ cred-ibility anchors inflation expectations and shocks are viewed as temporary, workers are less likely to demand compensation (in the form of higher wages) or companies higher prices to limit the margin impact.

The 1970s US inflation surge: slack lower than estimated, oil price shock feed-throughOne more recent example of inflation get-ting out of control was in the 1970s in the US (see Figure 2) and several other countries. It was due to a combination of the effects described above. The sus-tainable, "inflation-neutral" growth rate was overestimated and the level of unem-ployment, at which wages would rise, un-derestimated. Monetary policy remained too supportive in light of tightening labor market conditions and once inflation in-creased as a result of this, it took a very strong and economically harmful mone-tary tightening to lower inflation expecta-tions and to control it. To some extent, the risk of overestimating the amount of slack is also present today, but at an unemploy-ment rate of 7% in the US, and measures of capacity utilization or the output relative to potential still indicating significant slack, these risks appear to be limited in most advanced economies for now. Importantly, central banks’ credibility appears to re-main high.

Outlook still for low inflation but mar-ket expectations already very lowContrary to many investors’ expecta-tions, inflation in most major economies has actually fallen substantially over the past months. Much of the decline was due to lower energy and food price pres-sure. In principle, this can be viewed as supportive for disposable income growth and corporate profitability. However, core inflation, (i.e. excluding the price of en-ergy and food), has also declined to low levels, perhaps indicating a more fun-

1 “Fiat money” has been defined as state-issued money which is neither convertible by law to any other thing, nor fixed in value in terms of any objective standard.

5-year moving average

-6

-4

-2

0

2

4

6

8

10

12

Sources: Reinhard & Rogoff, IMF, Credit Suisse.

Historical data compiled by Professors Reinhard and Rogoff show alternating inflation and deflation phases before "fiat mo-ney" gained importance. More credible and independent central banks, influenced by monetarist theory and in many cases with an explicit inflation goal are factors that contributed to a "Great Moderation" after the last big shocks in the 1970s.

Global inflation, median Deflation

2010

1990

1970

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1930

1910

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1870

1850

1830

1810

1790

1770

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1730

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157015501530

Figure 1: Persistent inflation is a 20th century phenomenon

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US inflation (headline CPI including food and energy)

1915 1935 1955 1975 1995

Sources: Bloomberg, Credit Suisse.

Year-on-year, %

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Figure 2: US inflation likely to remain very low

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Alternative InvestmentsMacro Global

Impact of Alternative Fixed-income Strategies in Response to Emerging Changes in Economic ConditionsDamaris Reiser, Alternative Investments Advisory

Alternative Investments

To correctly position the fixed-income portfolio in order to meet changing market conditions, a suitable solution should include fixed income relative value strategies. Their earnings drivers differ significantly from those of tradi-tional fixed-income investments and can therefore help diversify fixed-in-come risks, as the following article il-lustrates.

Current fixed-income market environ-mentThe fixed-income market has been marked by regulatory intervention in re-cent years. This has not only had an im-pact on pricing – which is now largely un-affected by supply and demand – but also on the behavior of market participants. In-vestor behavior is currently based primarily on expectations of central banks’ further regulatory invention. The central banks have been using quantitative easing to try to boost the credit markets and to stim-ulate aggregate demand. They achieve this by purchasing bonds. In the past few years, the US Treasury has bought hundreds of billions of dollars in Treasury bonds, while holding down interest rates at virtually 0%.

Implications for investorsGiven such conditions, fixed-income in-vestors, on their hunt for returns, no longer have many options open to them. As short-term rates produce almost no

returns, higher interest-rate and/or credit risks must be taken on to achieve even a modest return. Interest rates and credit spreads are at historically low levels. Gov-ernment intervention in the markets has made investors more willing to take on higher risks for a lower premium. In other words, investor appetite for risk has risen. As a result, bond prices are relatively sta-ble. A short-term widening in interest or credit spreads (on par with a fall in investor

risk appetite) could only be observed in the past if the wording used by central banks hinted that there would soon be a shift in monetary policy.

Long-term portfolio considerationsFor a long-term fixed income portfolio strategy, investors should price in an end to this monetary policy. A portfolio with high duration, but also elevated credit risk, could negatively affect the portfolio's re-

damental problem. With the Japanese experience of a protracted feedback loop from economic weakness to falling prices in mind, monetary policymakers are unwilling to tolerate inflation at very low levels. The combination of low infla-tion and moderate growth, especially in

the eurozone, raises the risk that a neg-ative economic shock might drive eco-nomic developments more towards "gen-uine" deflation.

Indicators to trackInflation is a "complex beast" with many

influencing factors whose importance varies over time. Given the channels de-scribed above, some indicators might give an earlier signal for inflation con-cerns. They include wage developments, credit dynamics and inflation expecta-tions. For the US, the picture is not clear-cut: some indicators, such as average weekly pay, have begun to show a pick-up in recent months, while others have changed little. In the eurozone, wage de-clines are still occurring in many periph-eral countries, weakening demand and creating pressure on the overall price level. Inflation expectations of both con-sumer and financial markets have so far been stable, both in the US and the eurozone. Most measures of economic slack, like output relative to potential or unemployment rates, remain high in ad-vanced economies. This should limit up-side risks for consumer price inflation, as opposed to asset price inflation. This suggests that major central banks can remain very expansionary in 2014. Nev-ertheless, market expectations for in-flation are currently very low and even slightly higher inflation could bring a sur-prise and could impact the pricing of rate expectations.

1

0.8

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0.2

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Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13

Global bonds Global equities Hedge funds

Figure 1: Rolling 12-month correlation of FI RV strategies with other asset classes, January 2011 – August 2013


To calculate the correlation, a Credit Suisse investment fund using this strategy was chosen as a proxy for FI RV strategies. The bonds are represented by the JPM Global Aggregate Bond Index, the equities by the MSCI Word Index and hedge funds by the HFRX Index.

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Alternative InvestmentsAlternative Investments

turn and risk. A widening of interest and credit spreads would mean falling bond prices, but also high volatility and, conse-quently, growing risks in the fixed-income portfolio. It is therefore advisable to con-sider strategies featuring a low beta to the fixed-income market, which generate stable returns under market conditions characterized by widening of interest and credit spreads or greater volatility.

Alternative fixed-income strategiesInterest rates have only a very limited ef-fect on beta-independent strategies. The market dynamics of demand and supply only have a marginal impact as well. Two examples of beta-independent strategies are residential mortgage-backed secu-rities (RMBS) and fixed income relative value (FI RV).

FI RV strategies generate returns by bet-ting that at some point there will be a cor-rection in inefficiencies in pricing on the yield curve or between different markets. The associated risks are mainly specific to the position and not systemic. Thus compared with long-only strategies, there is very little correlation between strate-gies and interest-rate or credit risks in the fixed-income market (see Figure 1 on the previous page).

Opportunities for relative-value man-agers in the event of a shift in current monetary policyFI RV managers have several strategies open to them, such as bond arbitrage,

yield curve arbitrage, volatility trading, inter-market spread trading, and money market spread trading.

Performance analyses show that these strategies can be very successful when market volatility is high. Currently, how-ever, volatility is being suppressed by cen-tral banks’ intervention (see Figure 2).

As mentioned, intervention artificially in-creases bond prices, creating a perma-nently bullish climate. In this environment, market participants mostly follow a buy and hold strategy, which results in low market activity. In the past, every time central banks announced they were in-tervening, volatility could be seen to drop markedly.

A further source of returns for FI RV strat-egies – structural price anomalies and ir-rational relative price differences – is not available in the current environment. This is because price differences are few and far between. Structural price anomalies are not being corrected through the mar-ket as they usually are, but are remaining intact due to external intervention.

Given the current market environment and potential earnings drivers, it is clear that FI RV managers can act only with the "foot on the brake" at present. A trend reversal is, however, on the horizon. In fact, the US Federal Reserve gave the first spe-cific indication regarding this shift when it announced that tapering would begin

in January 2014. Therefore, for tactical reasons, it makes sense now to "stock up" the fixed-income portfolio with beta-independent strategies to be in a stronger position when more turbulent market phases return.

Beta-independent fixed-income strate-gies at Credit SuisseCredit Suisse's AFS (Alternative Funds Solution) team has carried out detailed re-search on the impact of quantitative eas-ing and its implications for fixed income relative value strategies, and recently pub-lished a white paper (source: see pages 31 and 32 of this publication). The white paper shows that beta-independent strat-egies in a normal market environment (i.e.

one with no major government interven-tion) are characterized by stable returns, even under crisis conditions (see Figure 3).

Figure 3: Returns and volatility by asset class and strategy, 1.1.2005 – 31.8.2013

Annualized return

Annualized volatility

Sharpe Ratio

Fixed income arbitrage strategy1 11.3% 4.6% 2.5

Barclays US Aggregate Bond Index 4.7% 3.3% 1.4

Citigroup World Government Bond Index 3.2% 7.0% 0.5

MSCI World Index 4.2% 16.8% 0.2

S&P 500 Index 5.3% 14.1% 0.4

1 Based on a basket of 17 funds. Sources: Credit Suisse, Barclays, Bloomberg.

Historical performance data and financial market scenarios are no guarantee of current or future performance.

35 %Before quantitative easing Quantitative easing Tapering talks begin

30 %

25 %

20 %

15 %

10 %

5 %

0 %

Volatility of fixed-income arbitrage Volatility of US equities (S&P 500 Index)

Volatility of high-yield bonds (Barclays High Yield Index)

Volatility of US Treasuries (Barclays US Treasury Index)

Ann

ualiz

ed v

olat

ility,

rollin

g 12

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th a

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ge

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Sources: Credit Suisse, Barclays, Bloomberg.


Figure 2: Quantitative easing impacts the volatility of various investment segments

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Equity GlobalEquity Global

Equity Global

Well Invested with SecurityInterview with Dr. Patrick Kolb, Senior Portfolio Manager

Equities will remain the preferred asset class for many investors in 2014. With interest rates as low as they are this comes as no surprise since alternatives are few and far be-tween. But it can make sense to take a careful look at things. The equity universe offers interesting market niches in sectors such as security, protection and prevention. Global security industry is enjoying long-term structural trends and attractive growth rates. In the following inter-view, Patrick Kolb provides some in-sights into the industry and explains the key drivers behind this growth. With over seven years of investment experience, he is a proven expert in security stocks.

Patrick, why do people attach so much importance to security?

Security is an essential human need. This was recognized, for example, by the American psychologist Abraham Maslow. He put human needs into five categories in what is known as the Maslow’s Hierar-chy of Needs pyramid (see Figure 1). At the bottom of the hierarchy there are the physiological needs such as sleep, breath-ing and food. The next level up is the need for security. Maslow believes that these two lowest levels represent the needs that are vital to survival. Only then can a person live within regularized structures and turn their attention to higher needs, namely so-cial contact, esteem and self-actualization.

With security being a basic need, issues related to it have always been important. However, we only perceive this need se-lectively, generally when we are person-ally involved. Take a holiday flight as an example. What happens at the airport is always the same for all passengers; checking in, going through security con-trol, getting on the aircraft. But almost no one is aware of the many different levels of security involved. The only security- related factor we, as passengers, notice is when we go through the scanner. X-raying the baggage, the aircraft pre-flight safety tests and the air traffic control from takeoff to landing are all things we take for granted rather than notice directly.

"Security industry" is a very abstract term. What exactly does it mean and how do you define your investment universe?

We have deliberately chosen a broad defi-nition. For us, the industry covers all com-panies involved in security, protection and prevention. What these companies have in common is the overarching objective of offering products that help to make the world a safer, as well as a cleaner and healthier, place. We have identified five sub-themes we use as an investment focus: IT security, healthcare, environ-mental protection, transport safety and crime prevention. What matters for us is

that the companies have significant activi-ties in the security industry. So we have set a revenue criterion. The investment universe only includes companies that generate at least 50% of their revenues from security, protection or prevention. Defense companies are excluded auto-matically.

Experts particularly point out the structural growth trend in security. What factors are driving this?

Estimates assume the global security so-lutions market is growing at around 3% to 7%1 annually. This gives investors the chance to put their money in a sustain-able growth market. The industry growth is being driven by various factors, primarily technological innovation, increasing liber-alization in the movement of goods, capital and people, and tougher regulations. Let me explain this briefly.

In the last ten years, technological innova-tion has changed the world dramatically. At the same time, new security-related needs have emerged. For example, I think e-banking has been one of the most im-portant developments in the financial ser-vices industry. This innovation would have had little chance of being accepted if it had not been accompanied by protec-tion such as access authorization controls.

Or take the increasing liberalization in the movement of goods, capital and people as a result of globalization. One result is that manufacturers can source inputs globally, but they have to rely on certain quality standards such as certification.

For a cotton supplier, for example, cer-tification guarantees that production is organic and no environmentally harmful pesticides have been used. Providers of such certification are profiting from this structural trend.

The third key factor is ever tougher regu-lation. It is just under a year since a case emerged of horse meat being falsely de-clared as beef in ready meals. That ex-ample clearly shows how vulnerable our food chain is. I assume that in the future authorities will tighten up food controls, testing and hygiene standards. The ben-eficiaries will be companies providing such services to food manufacturers.

There are now a host of companies in the security industry. What should investors look out for?

The sustained high growth rates in the industry have attracted a large number of providers. There are now around 200 companies listed worldwide, covering a broad range of security solutions (see Figure 2 on the next page). In general, it is fair to say that there is a very large num-ber of small and medium-sized companies active in the security, protection and pre-vention sector. These are often small and mid caps, not well known to the general public and poorly covered by analysts, if at all. So pricing mechanisms are not al-ways efficient. For us, as active investors, this offers an opportunity to generate ad-ditional value for clients, which could be considerably higher than in the case of large caps. Security, protection and pre-vention companies are often leaders in

their particular niche market or technol-ogy. Anyone looking to invest directly in the segment needs to have the necessary market knowledge and take a hard look at the annual and quarterly financial state-ments. I think that a portfolio approach is the best solution, for reasons of risk.

Why are there so many small and mid cap security companies?

Innovative solutions and applications often begin in small start-ups. But as their busi-nesses develop, they desperately need capital. So many owners aim for an IPO to ensure they can continue to take their ideas and products forward. They are of-ten acquired by large companies, espe-cially if they have pioneering new busi-ness ideas.

Growth markets often see a great deal of consolidation. Is this the case for the security sector, and if so, what are the opportunities?

There have been many examples in the past of small niche companies from the security, protection and prevention busi-ness areas being taken over by conglom-erates at very high prices. For instance, Cisco has recently paid USD 2.7 billion for SourceFire, representing a takeover premium of 33%. As a matter of princi-ple, we recommend clients take a broad portfolio approach on risk/return grounds. This increases the likelihood of profiting from such events.

1 Source: Credit Suisse, estimate as of end-June 2013.

Physiological

Safety

Love/belonging

Esteem

Self-actualization

The hierarchy of needs is a theory that psychologist Abraham Maslow proposed in his "A Theory of Human Motivation" published in 1943 and subsequently expanded upon. Maslow argued that humans first fulfill their basic needs before gradually moving on to "higher" needs, which are satisfied according to a certain hierarchy.

Figure 1: Maslow’s Hierarchy of Needs pyramid

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Equity GlobalEquity Global

Many security companies are based in the US. Why is the industry so heav-ily represented there? What other countries are important?

Most security, protection and prevention firms are indeed based in Silicon Valley. The area south of San Francisco is one of a kind, with a unique environment for innovative companies. Israel is also impor-tant. The country is very advanced in IT

security, and has been underestimated by many investors and analysts. Here too, we have invested in promising smaller com-panies.

For which investors is investing in the security sector best suited?

The sector is an ideal addition to a broadly diversified overall portfolio. Investors should have an investment horizon of at least 7

to10 years. We are investing in long-term structural trends that are often not appar-ent on a short view and only emerge over the course of several years.

Let’s go back to e-banking by way of illus-tration. When it was launched, clients were identified simply with a log-in and pass-word. For security reasons very soon strike lists were added as an additional form of identification. A few years after that, multi-

factor authentication came in, and this is currently the standard. I can well imagine that in the future new and more sophisti-cated methods will become established, for example with biometric data such as finger prints, iris recognition and voice rec-ognition. Technological progress is crucial for user authentication. You need to invest in the companies at the cutting edge.

The sector has already performed very well in recent years. How do you think it will do from here?

As long-term investors, given the struc-tural growth opportunities we have been discussing, we feel the economic environ-ment for investing in the security, protec-tion and prevention sector will remain at-tractive. Until I see a slowdown, I remain optimistic. There may be short-term mar-ket volatility, but there is nothing you can do about that. You have to keep a cool head in such situations and grasp any opportu-nities that arise.

What criteria are used to select the stocks? Are there any areas you fa-vor right now?

Our stock selection uses a disciplined bottom-up approach. We analyze our global investment universe using qualita-tive, quantitative and growth criteria. The focus is on a company’s products and ser-

vices, the key financial data and manage-ment quality. We generally have a concen-trated portfolio of 40 to 60 stocks. Right now we are especially keen on IT secu-rity, so we have an overweight position in the segment. We only invest in companies

with strong market positions that are able to sustain or increase margins and boost profits.

Technology: 30%market capitalization

Healthcare: 20%market capitalization

Industry: 50%market capitalization

Examples:

Anti-virus software, network security systems

Firewalls Data loss prevention Compliance Intelligent access management systems

Electronic payment transactions

Airbags Aircraft collision avoidance systems Airport & port security Intelligent surveillance and monitoring systems

Hazardous goods disposal

Vaccinations Water and air analyses Sequencing Patient monitoring systems Medical robotics

Figure 2: The security sector is broadly diversified


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Inflation means that money gradually loses its purchasing power. It affects us not only as consumers, but also as savers and investors. Inflation-linked bonds are a means of preserving real purchasing power in periods of sub-stantial inflation. The following article looks at the characteristics of infla-tion-linked bonds and how they work. It also suggests ways for investors to use them to protect themselves from the undesirable consequences of an unexpected rise in inflation. In addi-tion, taking Switzerland as an exam-ple, it shows how protection against inflation can be created syntheti-cally for countries that do not have their own market for inflation-linked bonds.

A brief introductionInflation-linked bonds are securities whose coupons and/or nominal value are tied to a consumer price index. In the event of an unexpected spike in inflation, they protect investors by generating ad-ditional returns. In other words, they pre-serve real purchasing power.

Inflation-linked bonds are the only asset class to offer sustained protection against inflation, enabling investors to obtain a

real yield that protects purchasing power even when inflation is high. Since inflation-linked bonds have a low correlation with nominal bonds and stocks, they also help to enhance the diversification of a tradi-tional portfolio and thus improve the risk/return profile.

Real estate and precious metals: No true protection against inflationIn discussions about investments that

protect against inflation, real estate and precious metals are often mentioned be-cause these are "real assets." However, contrary to popular opinion, these two as-set classes seldom offer reliable protection against inflation.

In the case of real estate, rental income is fixed at a nominal value for the short to medium term, so rent cannot be adjusted immediately to the new general price level.

Inflation-Linked Bonds – Preserving Real Purchasing Power and Diversifying RiskDr. Samuel Huber, portfolio manager in the Overlay and Inflation-Linked Solutions team

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Protection against Inflation Risk

Moreover, a pickup in inflation increases borrowing costs, which counters a flight from cash to property and thus hinders real estate prices from rising. Given this two-fold effect, real estate offers only limited protection against inflation. The same ap-plies to precious metals and commodities in general. Rising inflation reduces con-sumers’ real purchasing power and erodes companies' revenues and profits. This in turn reduces demand for commodities and thus depresses their prices.

An asset class is deemed suitable for hedging purposes if the asset value keeps

pace with inflation. If inflation picks up, the asset value should increase accord-ingly. Conversely, after adjustments for inflation, the prices of asset classes suit-able for use as inflation protection should increase linearly. Figure 1 shows the evo-lution of the real value of gold between 1975 and 2013 (in Swiss francs). The volatile performance indicates that gold has not provided Swiss investors with good protection against inflation over the last four decades.

Evolution of the marketDating back more than 230 years, the

market for inflation-linked bonds is older than many people think. During the American War of Independence (1775 to 1783), the US’s fledgling government financed the war effort by substantially increasing the supply of Continental dol-lars in circulation, which had only just been introduced as the national currency in 1776. This quickly resulted in annual inflation rates of up to 30%. Against this backdrop, the state of Massachusetts issued the world’s first inflation-linked bond in 1780, with the cash flows of this bond linked to the prices for a represent-ative basket of consumer goods.

More recently, in 1981 the UK became the first industrialized nation to issue inflation- linked bonds (called index-linked gilts). The US followed suit in 1997 (with Treasury inflation-protected securities, or TIPS). Germany saw its first issues take place in 2006, after which the eurozone also developed into an important market-place for inflation-linked bonds. Today, 13 of the world’s 20 largest economies (based on gross domestic product) are active on the inflation-linked bond mar-ket. The total market value of all infla-tion-linked bonds issued worldwide cur-rently amounts to around USD 2.4 trillion (see Figure 2).

In terms of the market value of issued paper, the US leads the way, followed by the UK. Brazil is in third place, ac-counting for a market value equivalent to around USD 280 billion. The South American giant issued its first-ever infla-tion-linked bond back in 1964.

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Figure 2: How the market for inflation-linked bonds has grown

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Figure 1: Evolution of the real value of gold in Swiss francs

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The inflation-linked bond segment is dom-inated by sovereign issuers. But why do countries issue inflation-linked bonds? After all, doing so means that they are obliged to pay a real return that they can-not simply "inflate away." One of the rea-sons cited the most often is that the ab-sence of an inflation risk premium means lower costs (see also the section titled "Return differences between nominal and inflation-linked bonds" on this page). Inflation-linked bonds therefore reduce expected refinancing costs. Yet over the last nine years, the inflation risk premium has been extremely low at around just five basis points per year (or 0.05%)1. Another reason for issuing inflation-linked bonds is that it is a good way to tap into new in-vestor groups. In addition, central banks use conventional and inflation-linked bond yields to calculate expected inflation and set monetary policy. Furthermore, issuing inflation-linked bonds also helps to bol-

ster confidence because the state cannot inflate these debts away. This aspect is particularly important for emerging econ-omies, some of which are only able to ob-tain refinancing through the issuance of inflation-linked bonds in their respective national currency.

Companies, in contrast, only rarely issue inflation-linked bonds. Most inflation-linked bond investors are very risk-averse and therefore shy away from bonds that have no government backing. Conse-quently, demand for inflation-linked cor-porate bonds is low. Moreover, most of the few such bonds that exist on the mar-ket are very illiquid.

How inflation-linked bonds workInflation-linked bonds differ from nominal bonds in a number of key regards. Con-ventional bonds are issued with a fixed nominal coupon and a redemption pay-ment amount agreed in advance. These conditions take account of inflation ex-

pectations at the time of issuance, but are not subsequently adjusted. Inflation-linked bonds, in contrast, guarantee a fixed real return irrespective of inflation. The inflation realized during the life of the bond can be offset in two different ways:

the coupons are adjusted for the rea-lized inflation while the redemption value remains constant (see Figure 3);

the redemption value is adjusted to realized inflation on an ongoing basis, and the real coupons are calculated as a percent-age of this value.

Return differences between nominal and inflation-linked bonds A conventional bond’s nominal interest rate consists of three components: real interest, expected inflation, and the infla-tion risk premium that investors receive to offset the risk that the realized rate of inflation might exceed the expected rate and consequently reduce the real

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return (see Figure 4). Since this risk does not exist with inflation-linked bonds, they do not include this inflation risk premium, which has been extremely low anyway in recent years, as explained above.

How synthetic inflation protection worksInflation swaps make it possible to ob-tain synthetic inflation protection even for conventional bonds. A swap generally in-volves two parties exchanging future cash flows. An inflation swap involves one party (the payer) making fixed payments over the duration of the transaction in line with inflation expectations when the agree-ment was struck. The counterparty (the

receiver) makes payments corresponding to the actual realized rates of inflation (see Figure 5 on the next page).

Since a portfolio of nominal bonds prices in current inflation expectations, synthetic inflation protection can be achieved by combining such a portfolio with an infla-tion swap. The investor makes payments to the counterparty in line with the infla-tion expectations pertaining to the invest-or’s bond portfolio while the counterparty makes payments determined by the actual realized inflation. The investor thus ob-tains inflation protection that is equivalent to a direct investment in inflation linked bonds (see Figure 6 on the next page).

Inflation swaps offer the following advan-tages over direct investments in inflation-linked bonds:

the limited investment universe offered by inflation-linked bonds is enlarged to include the broad spectrum of nominal bonds;

protection is possible regardless of ma-turity and duration;

higher liquidity and resulting lower transaction costs.

Protection for countries without in-flation-linked bonds Inflation-linked bonds are not available in all countries. For instance, the government of Switzerland does not issue inflation-linked bonds. However, Swiss investors can still protect themselves against do-mestic inflation by using inflation-linkedbonds from foreign issuers.

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1 For the period from July 31, 2004 to July 31, 2013, the return on the Barclays World Inflation Linked Bonds TR hedged in US dollars was 4.69% p.a. while the return on the nominal benchmark index, the Barclays World Breakeven Inflation Linked Bonds TR hedged in US dollars, amounted to 4.74% p.a. This equates to an average inflation risk premium of 0.05% p.a.

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Source: Credit Suisse, for illustrative purposes only.

Figure 4: Composition of nominal interest rate

Fixed real coupon, adjusted for realized inflation

Fixed nominal coupon based on expected inflation

without adjust-ment for realized

inflation


Nominal bond Inflation-linked bond

Figure 3: Comparison of nominal and inflation-linked bond coupons

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Credit Suisse has developed an ideal con-cept for doing just that. In 2003, Credit Suisse became the first financial institu-tion to offer synthetic inflation protection for Swiss investors and today manages more than CHF 2 billion for private and institutional clients in this strategy. The model employed can be applied to other countries and can even be used, for ex-ample, to implement inflation protection for emerging-market investments.

The basic underlying concept is simple: the combination of foreign inflation indices that best replicates inflation in Switzer- land also provides the best basis for infla-tion protection for Swiss investors.

In this section we will examine the rela-tionship between inflation in Switzerland and inflation in Europe and the US. There are inflation-linked bonds for those two markets as well as a highly developed derivatives market. Figure 7 shows how the regression coefficients βEuro and βUS changed over the period between Janu-ary 1998 and July 2013, with βEuro representing the regression coefficient of the

log change in European inflation and βUS the corresponding coefficient for the US. It can be seen that both coefficients were largely stable throughout the period ex-amined.

The model enables Swiss inflation to be closely replicated and, by using an infla-tion swap overlay, enables synthetic infla-tion protection to be created for a portfolio invested in nominal Swiss franc bonds.

Synthetic implementation ensures that the portfolio is always invested in Switz-erland’s real interest rate curve and not

in a foreign curve, as would be the case with physical implementation using infla-tion-linked bonds from foreign issuers. In addition, the portfolio manager can invest in the much broader investment universe of nominal bonds, thus enhanc-ing portfolio diversification. Thirdly, the portfolio can be custom-adjusted to the investor's wishes with regard to dura-tion, credit rating allocation and market allocation. Fourthly, with a synthetic im-plementation, the foreign currency risk is limited to the cash flows of the infla-tion swaps and does not encompass the entire bond portfolio, as is the case with a physical implementation. This leads to lower currency hedging costs.

Return performance of inflation-linked bonds versus nominal bondsWhile the value of nominal bonds is determined by changes in real inter-est rates and inflation expectations, the value of inflation-linked bonds changes

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only when real interest rates fluctuate. If inflation expectations remain con-stant, the returns generated by nominal and inflation-linked bonds are therefore identical and depend only on the real in-terest-rate level. This means that any dif-ferences in the returns of the two bond classes are caused solely by changes in inflation expectations. If inflation expec-tations rise, inflation-linked bonds out-perform nominal bonds. Conversely, they perform less well when expected inflation falls (see Figure 8 on page 23).

Portfolio managementInflation-linked bonds can be actively

managed in a portfolio in various diffe-rent ways. Minimum-variance optimi-zation (MVO) seeks the same degree of protection against inflation risk in a nominal bond portfolio that retrospec-tively would have minimized the variance, or risk, of the portfolio. To illustrate the strategy, we have calculated the MVO of a portfolio of nominal US government bonds hedged with inflation swaps. Fig-ure 9 on page 23 displays the result-ing curve along the risk/return frontier, which shows that for the period exam-ined, a hedge ratio of around 45% would have improved the risk/return profile of a nominal government bond portfolio.

Why are inflation-linked bonds of in-terest right now?Inflation is not headline news at the mo-ment. Instead – in Europe in any case – it is deflationary risks that are the real hot topic. Consequently, protection against inflation is very inexpensive right now. As soon as signs of rising inflation emerge, the market will price these in, and hedging against inflation will become more expen-sive as a result. It is entirely conceivable that inflation will become an issue again sooner or later. In the US, for instance, the average rate of inflation over the past century has been 3.3%2. In November 2013, annualized inflation was running at just 1.2%. Taking the average for the last hundred years as a long-term guideline, there is certainly potential for an increase.

However, while it matters to get the timing right when protecting against inflation, the benefits for portfolio construction are even more important. Since inflation-linked se-curities have a low correlation with nomi-nal bonds, they can significantly reduce overall risk in a mixed portfolio. Moreo-ver, in recent years – in an environment of declining inflation expectations and fall-ing realized inflation – returns on inflation-linked bonds have only been marginally lower than those on normal bonds.

SummaryInflation-linked bonds are the only asset class to offer sustained protection against inflation. They enable a real return to be

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Beta Euro Beta US

Sources: Credit Suisse, Bloomberg.Period: January 31, 1998 to July 31, 2013.

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Figure 7: Evolution of regression coefficients for Europe and the US

Swap payments by the payer (yellow) and receiver (blue)


Coupons from nominal bond portfolio

Bond portfolio with synthetic inflation protection

Figure 6: How a bond portfolio with synthetic inflation protection works

ReceiverPayer

Pays fixed inflation expectations

Pays variable realized inflation


Figure 5: How an inflation swap works

2 Sources: Credit Suisse AG, FRED® database of the Federal Reserve Bank of St. Louis, Oregon State University.

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generated that preserves purchasing power, even when inflation rates are high. Inflation protection can be obtained either physically, via inflation-linked bonds, or synthetically via nominal bonds in com-bination with an inflation swap overlay.

Since inflation-linked bonds have a low cor-relation with traditional asset classes, they are a good means of lowering the overall volatility of a portfolio.

This article is an excerpt from the recent-

ly published white paper titled "Inflation-Linked Bonds – Preserving Real Purchas-ing Power and Diversifying Risk." If you are interested in this topic, you can request a copy. You will find the contact details on pages 31 and 32 of this publication.

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Sources: Credit Suisse, Bloomberg.Period: October 31, 2006 to July 31, 2013.


3.5%

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100% JPM GBI US

Minimum variance: 45% hedge ratio

Maximum Sharpe ratio: 20% hedge ratio

100% hedge ratio with IL Swap US ER

Figure 9: Inflation protection along the risk/return frontier

Figure 8: Possible scenarios for inflation-linked bonds

Real interest rates

Favorable scenario Unfavorable scenario

Rising inflation expectations Real interest rates

Falling inflation expectations


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The issue of sustainability has found its way into many aspects of our daily lives, and even into modern asset management, due to increased so-cial awareness. Over the last seven years, the sustainable investment market has grown by around 25% per year on average in Switzerland, Germany and Austria. Today there are thus many opportunities and ways to incorporate sustainability into institutional asset management. Investors are significantly helped here by solutions that do not require a complete change in investment philosophy, but are simply a prag-matic extension of investing from a sustainable angle.

What do we mean by sustainable in-vesting?Credit Suisse offers a wide range of sus-tainable investment solutions that, in ad-dition to providing a financial return, also take ecological and social issues into ac-count. The investment possibilities here are based on a three-pillar concept and include products and services in the areas of philanthropy, impact investments and sustainable investments (see Figure 1). For investors, the social objective is the focus of philanthropy, whereas in impact investments, the financial return, besides the social and environmental contribution, is important too. For institutional invest-ors, sustainable investing mainly comes into question because of their financial responsibilities toward third parties (pen-sion fund beneficiaries, trusts, etc.) who place achieving financial returns under

compliance with sustainability criteria at the forefront.

What criteria are normally used?Credit Suisse uses ESG criteria (see Fig-ure 2 on the next page) to assess the sustainability of an investment in securi-ties from a private- or public-sector issuer. These criteria cover environmental, social and corporate governance (ESG) issues and are currently standard criteria in sus-tainability research.

What sustainability approaches are there?Today there are a number of sustainability approaches that can be used, either indi-vidually or in combination with each other, to assess the investment universe. Based

on the definition by the European Sustain-able Investment Forum (Eurosif), sustain-ability strategies can be grouped as fol-lows (see Figure 3 on page 26).

Exclusion of companies with contro-versial business activitiesExclusion screening enables the targeted exclusion of companies with business practices or products that are considered to be immoral or unethical. It is primarily based on individual concepts of values. Business activities considered by most investors to be unsustainable include ar-maments, firearms and "sin securities" (tobacco, alcohol, pornography and gam-bling). Credit Suisse rules out all compa-nies that derive more than 5% of their rev-enue from one of those aforementioned

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Sustainability in Institutional Asset ManagementThomas Isenschmid, Head of Client Portfolio Managers iMACS, Gerda Pfeiffer and Andreas Schranz, Asset Management Switzerland & MACS

activities. This means, for example, that a food retailer that sells alcohol in its stores will remain in the investment universe if its sales of alcohol amount to less than 5% of its total revenue.

Norm-based screeningNorm-based screening means using ESG criteria to examine whether a company is involved in ongoing controversies (la-bor rights issues, involvement in sensitive countries, corporate scandals) that con-stitute material reputational risk. The re-sults of the screening are displayed using a "traffic light system" and a corresponding allocation of the companies into red, yellow, and green groups. Companies in-volved in serious controversies are excluded.

Best-in-class screeningBest-in-class screening identifies the companies in a specific sector with the best grades from an ESG perspective. An analysis is conducted to determine how well the company’s management deals with ESG issues. For instance, can the company lower emissions, retain tal-ented employees or ensure workplace safety? The individual factors can vary a lot from one industry to another. The best-in-class approach is based on a relative rating system that measures a compa-ny’s ESG risks and opportunities and as-signs grades ranging from AAA (the best) to CCC (the worst). This strategy aims to lower the financial risks that can arise from ESG reputational risks.

Thematic approachThematic investments seek to identify companies that provide ESG-upside in relation to a specific issue or challenge, such as resource efficiency, environmen-tal regulation, clean energy or corpo-rate governance. This approach concen-trates on certain sectors or themes. Now that the Swiss electorate has passed the Minder initiative into law, pension funds will be faced with compulsory voting, so this theme is likely to gain greater impor-tance even outside the realm of sustain-able investing.

Shareholder activismShareholder activism, also referred to as the "ESG engagement" approach, sees investors exert a direct influence on the management of a company by exercising voting rights or engaging in direct dialog with the company.

What is the impact on the investment universe?It is important for professional investors to understand how strong the impact on the investment universe is if explicit con-sideration is given to the aforementioned sustainability filters. Figure 4 on page 27 shows the impact based on the MSCI All Country Index. Best-in-class screen-ing (where a company’s rating must be at least BB) and norm-based screen-ing (where a company’s rating must be "green" or "yellow") significantly reduce the universe. If, in addition, all compa-nies engaged in controversial business areas (alcohol, tobacco, armaments, por-nography or gambling) are filtered out,

Figure 2: ESG criteria cover three subject areas

Environmental Environmental issues include:Climate changeToxic waste Resource scarcity

Social Social issues include:DiversityHuman rightsConsumer protectionAnimal protection

Governance Corporate governance issues include:Management structureLabor relationsManagement compensation


Philanthropy Impact investments Sustainable investments

Investments focused on achieving a philan-thropic objective.

An investment strategy that not only delivers a financial return, but also makes a social and/or environmental contribution.

Investments that focus on optimizing risk and return while taking envi-ronmental, social and corporate governance criteria into account.

Donations (social objective) Profit (financial objective)


Def

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Figure 1: Philanthropy, impact investments and sustainable investments

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the universe is even further reduced. The approach described will exclude a total of around one-third of the 2,400 companies composing the original universe. But in-vestors will still enjoy broad diversification across regions and sectors in the remain-ing equity universe. Sustainable investing can therefore be considered safe from a risk perspective.

Which asset classes are especially suitable?Unfortunately, sustainable investment im-plementation cannot be offered across all asset classes at present. Well-known research providers like MSCI ESG evalu-

ate companies in the MSCI All Country Index and some local stock indices and more than 90% of the issuers in the Bar-clays Global Aggregate bond index. The asset classes described above are es-pecially suited to sustainable investing. However, coverage of small and midsize enterprises is much sparser, so there are only limited opportunities to invest sus-tainably in SMEs through specialized in-vestment funds. Although opportunities exist for sustainable investing in real es-tate depending on the focus, sustaina-ble investments in other alternative asset classes like private equity, commodities or hedge funds cannot be implemented un-

der the scope of an asset management mandate yet.

What are the challenges of sustain-able investing?The issue of sustainability is playing an ever greater role in the investment rea-soning of institutional investors in Switzer-land, and pension funds in particular. A rather pragmatic approach is frequently adopted here, i.e. it is generally not dis-cussed whether assets that have pre-viously been managed using traditional methods should be managed using a pure sustainability approach, but rather in which form and to what extent sustain-ability considerations should be taken into account. Many institutional investors are faced with various challenges here:

Management of third-party fundsInstitutional investors manage other peo-ple’s money. They therefore bear greater responsibility than private investors. The institutional investor must answer to the asset owners. This also makes well-founded and transparent decisions on the investment strategy and on sustain-ability necessary.

Definition of sustainabilitySustainability criteria should derive from the client’s guiding principles. The crite-ria should be measurable and assessable so that their implementation is clear and comprehensible.

Investment strategyThe investment strategy should ensure that it is highly likely that the economic ob-

jectives will be achieved. The sustainability filter implemented should not adversely in-terfere with the defined risk/return profile.

Costs under the spotlightFor institutional investors, the costs of a mandate play an important role. The costs of an investment solution in the area of sustainability are comparable to those of a traditional mandate.

Legal frameworkThe legal framework (e.g. regulations governing pension assets pursuant to the Swiss Federal Law on Occupational Re-tirement, Survivors’ and Disability Pension Plans) must be adhered to.

How will this theme further develop?Sustainable investing is often based on moral and/or ethical considerations. In institutional asset management, how-ever, emphasis is still placed on earning an adequate financial return. It is there-

fore important to employ solutions that can achieve a competitive return. As is the case in the traditional investment en-vironment, each individual investor’s in-vestment strategy must be defined on the basis of the investor’s specific risk/ return profile, though a pragmatic ap-proach can definitely be chosen to imple-ment the strategy. This means that fre-quently only selected asset classes such as equities and bonds are implemented sustainably.

Environmental incidents such as the oil spill in the Gulf of Mexico have once again significantly increased public awareness of environmentally and socially responsi-ble conduct. Given this altered situation, it comes as no surprise that the product range for sustainable investment solu-tions has also undergone continual devel-opment in recent years. We believe that this trend toward greater market penetra-tion will continue. Institutional investors in

particular are increasingly seizing the op-portunity to enhance their current invest-ment strategies by adding in sustainabil-ity criteria.

Best-in-class rating

AAA – BB

ESG controversies ("red")

Controversial business activities*

Sustainable universe

* Controversial business activities: more than 5% of revenue derived from alcohol, tobacco, armaments, pornography or gambling.


Figure 4: Restricting the investment universe through sustainability criteria

Sources: Eurosif, Credit Suisse.

Figure 3: Overview of various sustainability approaches

Exclusion criteria/ Negative screening

Positive criteria/ Positive screening

Exclusion of business activities

Best-in-class

screening

Thematic approach

Shareholder activism

Norm-based screening

Exclusion of companies with controversial business activities

Selection of companies that outperform competitors as far as ESG criteria are concerned

Screening by investment themes such as clean water or environmentally friendly technology

Screening for certain minimum standards as defined by different institutions (OECD, World Bank, UN)

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Real EstateReal Estate

Real Estate

Foreign Real Estate – Smart Diversification is Half the Battle Ulrich Braun, Head of Real Estate Strategy and Advice, and Francisca Fariña Fischer, Fund Manager

Investors looking to optimize their investments have to ensure they are well diversified. International real es-tate can be an excellent way to im-prove a portfolio's risk/reward profile.

Investing in Swiss real estate has been very rewarding over the last 15 years. Swiss real estate funds have provided very stable returns and seen net asset values and prices rise over an extended

period. Adding some real estate to an equity and bond portfolio increases the risk only marginally, but boosts the over-all return significantly. That is why many insurance companies and pension funds have built up large positions in real es-tate - sometimes to as much as 20% of their portfolios. Attractive investments abroadSwiss real estate prices have been ris-ing, with minor interruptions, for 15 years now. Many foreign markets, by contrast, have not yet got over the sharp correction that followed the financial crisis, and of-fer attractive opportunities to get on board. Anyone looking for a solid cash flow from real estate over the next few years should be looking internationally. Geneva and Zurich might be pricy now, but what about Vancouver, New York, London and Syd-ney? International real estate is offering higher total returns than currently avail-able in Switzerland and other economi-cally important countries in Europe. This is mainly being driven by above-average economic growth, thanks to demographic trends and transformation in Asia and South America. Whenever a broad mid-dle class gets wealthier and GDP and productivity go up, demand for real es-tate - offices, retail space and residen-tial properties - rises. A large number of countries are seeing strong real estate markets, among them China, Brazil and Chile, but also New Zealand and Australia.

Edificio Ombú, Santiago de Chile

Demand for offices has also risen sharply in the US and parts of Canada recently.

Diversification – but how?One simple argument in favor of real es-tate is that net rental yields are currently above bond yields almost everywhere. In-vesting in foreign real estate offers not just the prospect of good cash flow, which is very attractive in the current period of low interest rates, but also a chance for capital gains, for instance if land values rise for prime sites.

One possible reason why there is not much international real estate in many Swiss investment portfolios may be that there are not many products that allow in-vestors to participate directly in the inter-national real estate markets. At present, there are two Swiss real estate funds ac-tive in this segment, and two consortia of investment foundations.

By contrast, even experienced experts who opt for a listed real estate company find it hard to keep track of the 3,800 or so individual stocks listed around the world. It is important to note that real es-tate stocks and real estate investment trusts (REITs) are exposed to both stan-dard real estate risk and also the risk of stock market movements. The volatility of international real estate investments is largely equivalent to that of equity in-vestments.

Generating stable cash flowsSeveral things need to be borne in mind if real estate investments are to provide the desired diversification:

It is worth investing in several coun-tries over longer periods to smooth out the different cycles and risks in the coun-tries concerned.

Directly owned properties are prefe-rable to listed investments to achieve the greatest diversification effect. In the US, for example, direct investments are offer-ing a total return of 7% p.a. This is only slightly less than the expectations from listed equities. The volatility of directly owned US property is only a fraction of that from exchange-traded instruments.

Real estate funds are an efficient so-lution for investing in foreign real estate markets.

Ultimately, Swiss investors are interest-ed in steady cash flow in Swiss francs. Two Credit Suisse real estate funds in-vest directly in attractive locations in vari-ous parts of the world and hedge most of their currency exposure.

ConclusionInvesting in foreign real estate is an ex-cellent way to generate stable and above-average returns while simultaneously im-proving a portfolio's risk/return profile.

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Rubrik

Trends 01l02.14

Contacts

Contacts

German-speaking Switzerland

Institutional ClientsStefan Gregor MeiliGiesshübelstrasse 30P.O. Box 800CH-8070 ZurichTel: +41 44 335 77 [email protected]

Sandro GschwendSt. Leonhardstrasse 3P.O. Box 564CH-9001 St. GallenTel: +41 71 226 36 [email protected] Daniel AmmonBundesplatz 2P.O. Box 5366CH-3011 BernTel: +41 31 358 54 [email protected] Hans StirnimannSchwanenplatz 8P.O. Box 2548CH-6002 LucerneTel: +41 41 419 15 [email protected] André WinklerSt. Alban-Graben 1–3P.O. Box 2553CH-4002 BaselTel: +41 61 266 73 [email protected]

Wholesale DistributionReto EisenhutSihlcity – Kalanderplatz 1CH-8070 ZurichTel: +41 44 333 29 [email protected]

French-speaking Switzerland

Institutional ClientsJean-Raymond WehrliRue de Lausanne 11–19CH-1201 GenevaTel: +41 22 392 21 [email protected]

Christian WaserP.O. Box 5705CH-1002 LausanneTel: +41 21 340 26 [email protected]

Wholesale DistributionMarkus StecherRue de Lausanne 11–19CH-1201 GenevaTel: +41 22 392 22 [email protected]

Ticino

Institutional ClientsAntonio MantarroVia G. Vegezzi 1P.O. Box 5900CH-6901 LuganoTel: +41 91 802 59 [email protected]

Wholesale DistributionReto EisenhutSihlcity – Kalanderplatz 1CH-8070 ZurichTel: +41 44 333 29 [email protected]

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Trends is a Credit Suisse Asset Management publication and contains information for professional investors.

Internethttps://www.credit-suisse.com/ch/ asset_management/en/ thought_leadership/index.jsp

Produced byMarketing Asset Management Core Investments

Responsible for this publicationPatrick Ide

EditorFranziska Liebich

Publication frequencyFour times a year

CirculationGerman 4,500English 400French 400Italian 1,000

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Data sourceCredit Suisse, unless otherwise specified

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