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Dr. Stefan Tilch

“The classical target conflict between preserving foundation assets and

optimizing returns is a continuous challenge for foundation investors.”

(Interview – Dr. Stefan Tilch, Deutsche Oppenheim Family Office AG, 23. July 2013)

Given the current phase of low interest rates, foundations and other institutional investors are

looking for investment alternatives. Markus Hill* spoke for IPE Institutional Investment with

portfolio manager Dr. Stefan Tilch, Deutsche Oppenheim Family Office AG, about the current

conditions of the capital market and possible investment approaches.

HILL: Many institutional investors are anxious. Bonds are

seen as “safe” investments. What did lead to the significant

price losses across the bond sector during the months of May

and June?

TILCH: Until the end of May, the first half of this year

actually went relatively well for the bond segment. Certainly,

negative political news such as the Cyprus crisis or the

turmoil surrounding the Italian elections rocked the boat a

little, but for the most part, the bond environment kept pretty

steady.

At the end of May, however, things changed drastically. Chairman of the Federal Reserve (Fed),

Ben Bernanke, announced an unexpected paradigmatic change in monetary policy: starting this

year, and continuing until the middle of 2014, the Fed will gradually discontinue its securities’

purchases. Nevertheless, a fact that many market participants overlooked was that this

announcement was dependant on a number of economic requirements which are not necessarily

going to come true. Yet, it did lead to far-reaching consequences for the global bond markets. An

unexpected, strong sellout across all bond classes happened. For instance, within a few weeks, the

return rate of ten-year US treasuries increased quickly from 1.6% to 2.6%. The return rate of ten-

year government bond reached a new annual high of 1.81% at the end of June.

HILL: These circumstances, for example, lead to the ten-year government bonds top loss of 3.5%.

For foundations in particular, which base their plans on annual payouts, this was a bad surprise.

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TILCH: I believe most market participants were caught off guard by the extent of the rate hike. At

the end of June, the situation had calmed down so that most bond portfolios closed the first half of

the year with a “red zero.” Even the Fed seemed to have been caught by surprise by the intense

market reaction, and they scaled back their rhetoric. Obviously, a quick rate hike can’t be in the best

interest of the Federal Reserve because it may threaten or offset the real estate market recovery.

Nevertheless, this event also had an advantage, since bond investors had become a little too self-

satisfied. Institutional investors in particular focused on new issues and most bonds received partly

unreasonable gains. Issuer or liquidity risks were largely ignored.

HILL: What is going to happen next for the bond markets?

TILCH: We expect a slight recovery of the bond markets in the weeks to come. From our

perspective, a number of reasons suggest a decrease in return rates. Initially, the US economy faces

its own challenges. Results of the budget sequestration on the national level have only taken full

economic affect since the second quarter. Unemployed people who have resigned and given up on

the labor market make up a quiet reserve; these people are beginning to look for work due to an

improved economic outlook. The world economy develops slower than anticipated this year.

Especially China’s growth is below expectations. In Europe, most indicators point toward a base

formation so that the coming months may bring slight economical revival. Average growth rates for

Europe, however, continue to be out of reach for now. These circumstances have caused the

European Central Bank (Europäische Zentralbank, EZB) to announce that interest rates in the Euro

zone will remain at their current levels for some time to come. These factors suggest decreasing

bond rates and recovery of most segments. Yet, this does not change the fact that the Federal

Reserve has set a rate change in motion that likely leads to an increase in rates about 6 to 12 months

from now.

HILL: But doesn’t this mean that corporate bonds have an even higher risk than government

bonds? After all, corporate bonds have had even greater losses over these past weeks…

TILCH: The announcement of the Federal Reserve has also lead to significant global market

declines of corporate bonds. Corporate bonds were hit twice as hard: For one, market prices

decreased due to the general rate increase; secondly, extension of the credit risk premiums resulted

of additional losses. This development is concerning because in the years 1987, 1994, 1999, and

2005, a strong rate increase lead to a decline of credit risk premiums, which in turn resulted in a

relative outperformance of corporate bonds. In the past, it was crucial how quickly the rate increase

occurred. A sudden rate increase like this year’s hits corporate bonds twice has hard. If one assumes

a moderate rate increase for the second half of the year, corporate bonds will become attractive once

again.

HILL: In the current market environment, are Exchange Traded Funds (ETF) for corporate bonds

an alternative to individual securities for institutional investors?

TILCH: Basically, ETFs offer a broad, diversified bond portfolio with a low cost structure. Yet,

they do have disadvantages. Most ETFs continue to be synthesized copies of the reference index.

From the point of investors, this means that in addition to credit and market risks of the ETF, they’ll

have to consider a counterparty risk, since the index reproduction generally happens through third

party swaps. Their financial standing remains unknown to the ETF buyer; he or she therefore can’t

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assess the associated risk. ETFs with physical replication/sampling method of the reference index

are thus preferable from our point of view.

Another risk factor is the so-called “survivorship bias.” It suggests that insolvent titles are removed

from the reference index and that the index’s return rate is overwritten. Next to this, another

phenomenon exists, increasing the risk of ETFs in comparison to individual securities. A new study

conducted by the EDHEC-Risk Institute on the topic of “Corporate Bond Indices” indicates that

there is a conflict of interest between issuers and investors during the composition of indices.

Issuers are likely to use low rate bonds with longer duration and vice versa. Therefore, a respective

ETF in a low rate environment will exhibit a significant longer duration and vice versa. This greatly

increased the duration risk from the point of view of the investor; duration control will thus be

offset. Thus study furthermore suggests that there is an opposition between market liquidity of an

index and its duration stability. This means, a broad, diversified corporate bond index is generally

illiquid and vice versa. Investors should be aware of these risks, if he or she plans on using ETFs to

supplement their bond portfolio.

HILL: How should foundations react to the current low interest environment?

TILCH: The classical target conflict between preserving foundation assets and optimizing returns

is a continuous challenge for foundation investors. Beginning with the return rate goal of “3% after

cost plus real capital preservation” exceeds the return rate potential of most bond segments in the

current market environment. Next to the use of bonds for asset investments, additional return rate

sources need to be developed. Stock shares are an important part of asset allocation, even though

their share is limited by the risk tolerance of most foundations. Next to stock investments, active

asset management is a key factor to reach a suitable target return rate.

HILL: Shouldn’t foundations focus on passive strategies when it comes to their asset management?

TILCH: Passive strategies can be an alternative if the foundation management has relatively free

reign in terms of their investment decisions and if they have the necessary experience to implement

passive strategies. Many foundations are managed based on individual sustainability criteria. If the

foundation’s assets are invested in an index, there is always a risk that the index includes titles that

do not meet the set sustainability criteria. Numerous foundations have additional limitations in light

of issuers, valid minimum ratings, or duration. Based on experience, most indices include individual

securities that violate investment regulations. In such a case, the foundation board members must

consider whether the chosen investment strategy meets regulations. So-called foundation funds

offer a good alternative because they are managed based on sustainability criteria.

HILL: What expertise do you have in foundation management?

TILCH: Since the beginning of the 1990s, we provide services for foundations in terms of asset

investment and strategic planning. In addition, we counsel foundations and other non-profit oriented

investors in the area of asset strategy, management, and controlling/reporting. At this point in time,

we care for the asset investment needs of over 20 foundations. Total volume equals about 500

million Euros. We offer individualized asset management for foundations starting at 5 million and

going up to 10 million Euros. Besides, we direct two mutual funds as standardized asset

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management which are a good fit for small to midsized foundations and are also managed based on

clearly defined sustainability criteria.

HILL: Many thanks for the detailed information. Obviously, there is healthy competition going on

here, even in the area of family offices. In terms of mutual funds, there are numerous interesting

offers for foundation funds or “asset managing approaches.” In the meantime, a small fund advisor

and fund selector industry is developing. Interestingly enough, you also offer solutions for “small”

foundation assets. Talking to different family offices, one notices an increasing flexibility towards

target groups and investment volume. Many small to midsized foundations may be able to find new

partners, both nationally and internationally.

Feedback, additional thoughts, experience or any kind of dialogue on such context is most

welcome; please contact info@markus-hill.com or Mary Daute (Asst. Manager). Phone: + 49

17 66 33 66 094

Markus Hill

Markus Hill (MSc in Economics) is an independent asset management consultant based in

Frankfurt, Germany Professional experience includes SEB Bank and Credit Suisse Asset

Management. In addition, he worked as head of sales and PR for a German fund boutique. Since

2005 he specialized in the management of mandates, sales, marketing, and PR (consulting,

"introducing"). Markus is also involved in selecting themes in the specialist areas of target funds

with a multi-management aspect, fund boutiques and mutual funds for institutional investors

(product scouting, fund selection). Furthermore he is actively engaged in cooperation with the

market-leading Private Label Funds/Master KAG in Germany (Universal-Investment) promoting

the idea of independent asset management and was the Co-Initiator of the first all-German

Consultant survey in 2005 and the first "UCITS-survey" in 2003. Market entry into Germany,

behavior of fund selectors and fund providers in German asset management industry are often

discussed by him, e.g. in his asset-management-publication MH-Focus. Through many articles,

columns and presentations (national and international) he has become a highly recognized expert in

the German asset management industry. "Industry multiplier" is a term often used by journalists and

clients to describe his style and personality. (Markus Hill/ MH Services assigned in the role of

Media Partner for: UCITS Alternatives Conference in Zürich, September 2011)

Markus Hill MH Services

email: info@markus-hill.com

website: www.markus-hill.com

phone: 0049 (0) 69 280 714 mobile: 0049 (0) 163 4616 179