October 2006: Today's Investment Reality: A World in a State of Stable Disequilibrium
Borrowing a term from the scientific discipline, Paul McCulley (Managing Director at PIMCO funds) has aptly characterized today’s geopolitical scene and investment market environment as being in a perpetual condition of stable disequilibrium, barely a step above controlled chaos. He quotes from William Butler Yeats, early twentieth century Irish poet:
"Things fall apart; the centre cannot hold; mere anarchy is
loosed upon the world, the blood-dimmed tide is loosed,
and everywhere the ceremony of innocence is drowned."
Today, the issues are different from those Yeats had in mind, but the effect on how we deal with our current concerns seems similar. Alliances are shifting, economic power is evolving towards Asia’s emerging countries. Islam, after lying dormant these past 1,300 years, has once again taken up the sword. The displacement of large numbers of people due to the inexorable forces of free market globalization, the tensions between democratic and authoritarian governments, and the adoption of terror as a weapon in the struggle between militant Islam and the West, abetted by an all-pervasive sensationalist media, complicates the picture for those in power. However, through it all, the world’s economies continue to grow at a rate of 2-3% every year; even more remarkable, such growth has been above trend the past two years.
One result of this seemingly chaotic backdrop has been a series of worldwide power rearrangements. The motivation for many of these new alliances originates with the fact that as global economic growth continues, rising demand for the world’s natural resources empowers many emerging countries to assert their newly gained political advantages. Our investment in the natural resources asset class (in companies, not commodities) a few years ago has contributed to portfolio return results, but under the surface these companies are highly correlated to commodities, quite volatile in price, and since May of this year the category has been a drag on account performance. Longer term, we think the demand for these scarce resources will increase. A continued position (10% of equities) in this asset class strikes us as a sound investment.
As clients may also be aware, our shift last year from overweight in small companies to large (i.e., most of the companies represented in the Dow and S&P 500 indexes) has recently begun to positively impact performance. Often in the later stages of an equity bull market larger companies will outperform smaller companies. Although the financial media daily reports new highs for the Dow Jones Industrial Index, when adjusted for inflation, both it and the S&P 500 Index remain 15-20% below their previous record closes in early 2000. Nonetheless, there would still appear to be room for further gains.
The important point to keep in mind is that since March of 2000, U.S. and international stock markets have undergone a wrenching valuation readjustment when measured by the price investors are willing to pay for a given dollar of earnings. In the U.S. alone since 2002, corporate earnings have more than doubled while the multiple investors are willing to pay for those earnings has halved (i.e., from 30+ times in 2000 down to 14 times estimated 2007 large company earnings per share today). This stealth multiple decline reflects a reaction to the excesses of “new era” economics, the deflation of the internet bubble and the deteriorating global geopolitical scene. In effect this has been a discounting by the world’s investors of the prospects for continued prosperity in this mode of stable disequilibrium. During this period of readjustment, central banks around the world (until last spring led by Alan Greenspan) supplied more than enough liquidity to cushion the impact of all the political turmoil. If our central bank (FED, and now Chairman Bernanke) becomes convinced inflation is under control and has in fact stopped raising short-term interest rates, it is possible price/earning ratios might expand. Equities remain reasonably priced at current levels; we see no reason to shift portfolio strategies presently.
Alternative Investments – Are There Alternatives?
Investing in alternative vehicles (hedge funds, private equity pools, venture capital, or other illiquid partnerships, etc.) during the past few years has become the asset class du jour. Conventional wisdom in the investment profession has it that a segment of every balanced investment portfolio must be allocated to some form of non-correlating, “unique,” generally leveraged, other-than-market approach which will provide better-than stock-market returns at less-than-market risk. In plain words, there is a free lunch to be had, all one has to do is grab the brass ring. From 30,000 feet, as we suggested in our April letter, the emergence of all this hype has the feel of another bubble; a rush to climb aboard a trend which shows dangerous signs of topping out just as sophisticated and semi-knowledgeable investors and the media are clamoring for a piece of the action.
Some facts about the world of alternative investments might provide perspective. Today, the world’s combined stock market capitalization (i.e., the value of all publicly traded companies) is roughly $38 trillion. Hedge funds alone manage $1.1 trillion (see graphic “Follow the money”). Despite their apparently unimportant proportionate share of the market, hedge funds appear to be responsible for roughly 40% of daily transaction volume on U.S. stock exchanges, most likely a larger proportion of trading volume on our commodities exchanges. Since in the short term, most financial market pricing is driven by active traders at the margin, these speculators have a disproportionate impact on securities prices in our highly efficient capital markets. For example, it has been estimated that to a real end-user a barrel of oil (today priced at $60) would trade at $48-50 in the world’s petroleum markets, implying that hedge fund speculative activity accounts for the difference. One can argue that such speculation provides market liquidity, but when many of today’s hedge fund traders and managers lack the experience to play in such a high stakes, and now very crowded, marketplace, excesses can arise which trigger unintended consequences.
A hedge fund simply allows a manager to invest freely in existing securities in a variety of ways; the main difference being, unlike most traditional mutual funds, hedge funds are not limited to buying and holding long positions in a single asset class. Today, there are roughly 8,800 hedge funds in the U.S., many managed by untested, newly formed firms utilizing computerized, anomaly-driven trading programs. These firms provide brokers (even at current negligible commission rates) with an annuity they are loathe to forfeit. According to The Wall Street Journal, since January 2005, 2,622 new hedge funds have been formed. However, escaping the attention of most, 1,071 hedge funds have closed and the closure rate is accelerating. Many in the industry term this a “consolidation phase,” but a more critical view might reveal the unwinding of an over-extended fad.
The going-in assumption is that one merely finds the right hedge fund strategy and manager, determines the appropriate dollar amount to commit, and everything follows logically. A major problem with this rationale is that it is risky to assume an investor will achieve benchmark-like, or even average returns in the hedge fund world. Manager competence in this asset class varies widely and the difference in performance between good and bad hedge funds is greater than in any other asset class. Beyond this, the data used to prove the hedge fund case is seriously flawed.
Hedge fund returns, when carefully examined in a cost- and bias-adjusted framework, also reveal a less-then-stellar performance picture. Roger Ibbotson, Professor at the Yale School of Management, and Ibbotson Associates President, Peng Chen, report that the generally accepted rates of return advertised for the average hedge fund, when adjusted for both survivor and back-fill bias, fall well below those of the S&P 500 Index. (See accompanying table)
Additionally, since one of the touted features of the alternative investment asset class argument is offsetting risk diversification in a balanced account setting, it is becoming apparent that most previously uncorrelated sectors in the universe of alternative strategies are now almost fully correlated with the S&P 500 Index (i.e., the benchmark representing U.S. equity markets). As mentioned earlier in our April letter, Richard Bernstein, U.S. Strategist at Merrill Lynch, suggests that investors should realize that these assets’ risk-reduction benefits have largely vanished. “The Russell 2000, MSCI EAFE® and Hedge Funds all have correlations to the S&P 500 in excess of 90%,” he notes. The main uncorrelated asset classes today with the equity markets are bonds and cash. It’s back to the future, mean reversion and the basic fundamentals of portfolio structure. The desired diversification in balanced accounts today can be achieved through the use of fully liquid conventional asset classes (e.g., essentially riskless short term bonds and cash).
Aside from the recognized lack of liquidity, another unknown lurks in the hedge fund investment equation; the ‘hedgies,’ as they are known in the trade, have yet to be exposed to the white heat of any consistent regulatory oversight. Probably accounting for more than half of the trading volume on the world’s biggest exchanges, still no regulatory authority, state, federal, or global, has the legal responsibility to examine hedge funds’ conduct on behalf of their clients.
Worldwide, hedge fund managers tend to cluster in New York, Greenwich, Connecticut and London’s Mayfair district (i.e., London’s high rent neighborhood, not part of its financial center). In Greenwich there are entire office buildings occupied only by a variety of hedge fund managers. They dine together, talk over strategies, share gossip of the trade and work out what have become known in the profession as “clubbing strategies.” Some hedge fund managers, in order to force a desired corporate behavior, have become shareholder activists attempting to influence target company management conduct to realize a portfolio objective. In most business and financial disciplines, collusion is an ethical and legal breach. Whether people will wake up to what is going on in this part of the alternative investment world may depend on how many more Amaranth debacles ($6 billion loss of investor value during the month of August) lie ahead.
And now we are being tempted by hedge fund marketers to participate in the next-generation hedge fund, the multi-strategy hedge fund. Not merely a fund of hedge funds (FoHF’s), but an agglomeration of in-house strategies under one fund. Even more seductive, these vehicles may be offered as initial public offerings (IPOs) through underwritings flogged by your local broker!
One other alternative asset class sub-category slowly shedding its aura is venture capital. At a recent small Boston gathering of senior portfolio strategists and endowment trustees, the head of one of this country’s most successful venture firms admitted that one dollar committed to the average VC firm in 1982 (when U.S. equity markets bottomed at 1000 on the Dow Jones Industrial Average) today would be worth no more than that same one dollar. Removing the top 13 VC firms from this survey, he said, would yield a current pay back of roughly fifty cents on the dollar. Adjusted for liquidity risk and purchasing power erosion, the net result is far below what the perception held by investors is today.
Achieving Acceptable Risk-Adjusted Returns and Prudent Diversification Without the Inclusion of Alternative Assets
Can individuals and non-profit boards construct optimal portfolio mixes which offer the prospect of average to better-than-average total returns without exposure to undue liquidity and principal risk? Harvard Management Company reported a total return of 16.7% for the fiscal year ending this past June 30th. Today, Harvard’s $29 billion endowment is roughly 61% committed to private equity, real estate and hedging strategies. Much of the pricing for these holdings is derived from annual or periodic appraisals rather than conventionally reported daily auction market values. The profession of Asset Appraiser is subject to its own ethical and political behind-the-scenes crosscurrents and conflicts.
Although illiquidity discounts are a part of these valuation formulae, undoubtedly, real estate under forced sale conditions would pass hands at a substantial discount to stated carrying values. If Harvard, or any other large institutional investor with similar resources, were ever driven to liquidate its portfolio, the result would be a substantial haircut. Similarly, as was the case with Amaranth in August, the unwinding of many of the average hedge fund’s highly leveraged positions could yield devastating write-downs in portfolio asset value. This is a cautionary tale with its conclusion still to be written.
Year-End Capital Gains Distributions May Surprise
As the year draws to a close, we have begun to gather the preliminary capital gains distribution indications from your portfolio’s fund management companies. Most are not yet ready to estimate such distributions, but it would probably be safe to anticipate a greater-than-normal capital gains tax liability this year. For the most part, the cumulative imbedded losses incurred in the 2000-2002 period have been used up by fund managers. The nearly four year global bull market, which even today shows signs of continued life, probably leaves little room for even tax-managed equity funds to avoid the inevitable. Whereas the average annual equity fund capital gains and dividend distributions have approximated 3-4% in the recent past, it could be as high as 5-7% in 2006. The only solace one can offer is that most of these distributions are taxed at the current “bargain” rate of 15% for long-term capital gains (recently extended by Congress to 2010). A separate mailing in the next few weeks will summarize your capital gains situation to date and perhaps shed more light on what to anticipate as December 31st approaches.
As always, we welcome your questions, comments, and suggestions.
Sincerely,
James L. Joslin
Chairman, CEO