Ursa Major?

 

During the 2000 to 2003 bear market, many trustees witnessed a third or more of their investment portfolio disappear and charities embarked on a soul-searching review of their strategic investment policy. Surely, it was possible to build portfolios that could withstand a significant equity market correction better than theirs had? By introducing newer asset classes like hedge funds, structured products, private equity and asset-backed bonds, or by holding greater proportions in physical property, could a portfolio be protected from the wild swings associated with equities?

 

It appeared that several of the largest US endowment funds had navigated their way through the opening of the 21st century better than many UK endowments with similar objectives. At the same time, fund managers reviewed their own methodology. Had they reacted quickly enough to the changing landscape? Had they backed their judgement, or had they hugged their benchmarks too closely, fearful of presenting trustees with a ‘surprising’ result over an individual quarter?

 

Questions were asked about the validity of the FTSE All-Share as the basis of equity allocations. While the majority of charities had overseas equity allocations, were they large enough? Indeed, given the global nature of the largest companies, to some, the geographic listing of a share was of increasing secondary importance to where and how a company’s profits were being derived. Such arguments were given weight by the choice of accounting currencies: by size, more than a third of UK companies were now declaring profits and dividends in US dollars rather than sterling.

 

So, can one reduce risk while maintaining attractive levels of income and capital growth?

 

It is possible to make a very strong and simple case for there just being no reward without risk: one can alter risk, disguise risk and transfer risk, but ultimately it is always there. One suspects that many ‘low risk’ or un-correlated products, services, asset classes, strategies and funds, however cleverly conceived, were in reality more about transferring and disguising risk than eliminating or reducing it. There is nothing necessarily wrong with this – diversification of risk is generally a good thing. However, it is important that investors understand the fundamental ‘genetics’ of what they own: with the benefit of hindsight, one suspects that this was not always the case, whether the buyer was a professional or a lay person: both were fooled.

 

So, what has worked? In summary, not a great deal! We will review one ‘alternative’ investment (hedge funds), one ‘lowly correlated’ strategy (property), one simple diversification strategy (more international stocks) and one ‘style bias’ (greater judgement), before concluding with some unpalatable truths.

 

Some hedge funds have fared very well, but the majority have struggled. One should probably ignore most of the significant failures and equally some of the spectacular successes: both make great headlines and hedge funds are as much a talent class as an asset class. Importantly, the majority of charities will have invested in a diversified fashion and will use a ‘fund of funds’ approach. They are likely to receive average returns across a wide spectrum of funds and individual strategies. For most, the return from their hedge funds over 2008 will probably be about -20 per cent to -25 per cent: the HFR Hedge Fund Index has produced a return of -22.7 per cent in the period to 30 November 2008.

 

This is a very bad result for an industry claiming to produce all-weather absolute positive returns. It is obvious that too many hedge funds (after several years of positive returns across equity and bond markets) were less ‘hedged’ than they would like us to have believed and carrying far too much leverage.

 

Many were invested in illiquid assets that realised far less value than hoped for when sold during times of crisis. The spectre of the unwelcome margin call awaits most leveraged investors at some point: it is a poorly understood risk of many hedge fund strategies. For charities invested in hedge funds with a quarterly or monthly valuation and liquidity window, they are likely to be locked in as beleaguered fund managers use the small print clauses in scheme particulars to delay realisations to protect the residual value within their funds.

 

This risk of being locked in spawned the ‘listed’ hedge fund sector: hedge funds and funds of funds structured like investment trusts and listed on regular stock exchanges. However, here the extra layer of liquidity actually played against investors. As the shares in these funds were liquid, investors had the ability to sell shares on a daily basis. As a result, the share prices ended up falling quicker than the value of the underlying assets. Discounts widened dramatically increasing losses even if the underlying assets were sound. Shares in many of the London-listed funds have fallen by 30 per cent to 40 per cent – as much as the equity market itself.

 

So, having bemoaned low volatility and gently rising markets during the good times, most hedge fund strategies singularly failed to take advantage of their ‘fleet of foot’ claims when volatility rose. The hedge fund industry has failed to deliver on its optimistic claims of providing steady and consistent positive returns just when they were required. If you diversified out of equities into hedge funds, you are probably very disappointed but a little better off. If they replaced government bonds or cash, then your portfolio is significantly worse off. For such an expensive asset class, the future looks bleak.

 

 

Physical property has only produced seven years of negative returns since 1947. There were reasons for this period of superior returns that could be analysed and suggested significant problems ahead. However, many investors were lured by what appeared to be both a low volatility and high return investment. Better still for many charities, there was a good income stream.2 Sadly, property has been a very poor investment recently. Indeed, for many of us, it was the over-optimistic returns assumptions made by American analysts, investment bankers and mortgage providers of the American property market that drove us into the current abyss. There is nothing like a 20-year bull market to fool people into rewriting history and find plausible reasons to extrapolate the ‘too good to be true’ returns for the next 20 years.

 

Inevitably, fundamental economics and valuation patterns do tend to re-assert themselves eventually, even if the gap between valuations and an economically appropriate figure drifts apart by significant degrees over many years. To make matters worse, in many instances, most property investors will be stuck with their assets for the foreseeable future. Very few property funds are able to match investors’ current redemption demands. Unlike equities, where the decision to reduce or liquidate exposure can be carried out almost instantaneously, most property investors are stuck in an asset class where valuations are probably only just catching up with reality and where they know further losses are virtually guaranteed. Importantly, at least a good-quality portfolio will continue to produce reasonable income. If the losses are not realised and the income stream remains robust, precisely what has been lost?

 

 

The most widely trodden path of diversification has been greater exposure to overseas assets. It is rare to find a charity with no overseas equity exposure.3 Many now invest on a two to one ratio (say 50 per cent UK and 25 per cent overseas) and this is a significant change from five and 10 years ago. While overseas equities have fallen by at least as much as UK equities in local currency terms, this element of diversification typically allows for the sterling exposure to fall. With the dramatic fall in sterling,

holdings in overseas equities will tend to have reduced the impact of the stock market falls in comparison to charities with purely UK investments. It should also be noted that while capital values have been hit hard, the impact of overseas equity income has been a really beneficial element of the decision to diversify out of the UK. For any company declaring its dividends in dollars (and that includes a number of UK-listed companies too), even flat dividends will result in a boost in income to UK shareholders due to sterling’s weakness. So, if investors are able to see though the current volatility and losses, a maintained and possibly enhanced income stream from equities should allow business to continue as normal.

 

 

Lastly, it is worth considering whether a more ‘judgemental’ approach to investment might have helped. This is where a fund manager is encouraged to ‘take more money off the table’ if they foresee problems ahead, or to perhaps invest the equities in a less index-oriented fashion: no bank shares at all as opposed to holding an underweight position. A very quick conclusion can be reached: some fund managers will have got their judgements right and some wrong! Importantly, more will have failed to see the collapse in asset values than will have read the runes correctly. It was ever thus: for a brutal bear market to occur, the vast majority of investors must be appalled and surprised. While there will be a few heroes, most of these were bearish well before the markets fell and missed out on much of the gain. (They will also need to get back into markets before they rise too far again: maybe they will, maybe they won’t.) Frustratingly, there will always appear to be lots of people who have come out of this mess better than oneself. The grass will regularly appear greener elsewhere. Most fund managers will have at least one fund that has only fallen a very little: performance records over the next few years will need to be analysed very closely indeed to ensure that they were genuinely mainstream results.

 

 

In conclusion, it would appear that there has been no ‘silver bullet’ and no risk-free strategy that charities could have embarked on five years ago to avoid the pain of falling markets. Diversification will have helped a little, especially if it involved a greater exposure to overseas currencies. A few charities will have benefited from excellent fund management judgement, but most will have not: in this regard, investment is something of a zero-sum game, with a loser for every winner. If that seems like a cynical and rather depressed conclusion, it is. But then it is supposed to be and that is because we haven’t discussed ‘strategy’ at all in this article and it is in good strategic management that charities can genuinely protect themselves from crashing stock markets. Investing over the longer term is first and foremost about generating enough income and then increasing it in ‘real’ returns in such a manner that trustees can maximise spending on their current beneficiaries while retaining enough capital to spend as generously on future beneficiaries.

Author: Richard Maitland

Richard Maitland is a partner and Head of charities at Sarasin and Partners.

Richard specialises in the management of long-term multi asset portfolios for charities and has been a visiting lecturer at South Bank University Business School and the University of Stellenbosch.

He is author of the Sarasin & Partners Compendium of Investment for charities

www.sarasin.co.uk

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