APRIL 2010                                                                         Download PDF Version

Looking at Risk


Clarmond’s portfolio allocation is based on a comprehensive understanding of an individual client’s risk profile and the returns they can expect from their investments. Therefore in this newsletter we wanted to explore risk.

Defining risk is a very tricky task. One of the most popular ways is through volatility; this is easy enough to understand as a concept but not very useful in helping people to understand the risk they are taking when it is expressed as a statistic. Alternatively examining downside risk is very helpful to ensure that clients are aware of what could happen to their portfolios under extreme circumstances. However, this only focuses on the negative side of risk when the whole point of adding risk to a client’s portfolio is to increase the expected return.

At Clarmond we will instead focus on the client’s risk of failing to meet their realistic objectives. From this perspective we are able to encompass not only the chance of substantial loss, from which it will be difficult to recover, but also the possibility of lack of capital growth, which will leave a portfolio lagging.

In the remainder of this letter we will discuss where the risk (and possible return) lies in the current markets and how our views on risk have altered following the market movements of 2008-2010. More specifically we will discuss how these view apply to the equity, bond and hedge fund markets.

Equity Markets

For Clarmond all equity market investments should be classified as ‘high risk’. It is certainly true that sectors within the larger markets will move in different fashions and geographically different markets can have periods of ‘decoupling’. However, generally markets are correlated and move in the same directions and at similar times. Therefore the decision for investors who need to invest in equity markets is to choose those with the more defensive characteristics in times of uncertainty and to rebalance in more positive times into the more leveraged markets.

The last 12 months have seen the blossoming of ‘alphabet economics’ with commentators not merely being content with ‘V’ and ‘W’ theories but also the letters ‘L’, ‘M’, ‘N’ and ‘U’ all making appearances; in general we think we can limit ourselves to ‘V’ and ‘W’!

The ‘V’ theory of the recovery is based on two main arguments. The first part of the ‘V’ was caused by ‘restocking’ as inventories that had been aggressively depleted start to be replenished. The second leg-up was provided by the massive and unprecedented stimulus packages thrown by global governments at their economies as well as the cheap financing that was extended to the banks in order to re-liquify them and stop collapse of the financial system. Therefore the ‘V’ in the equity markets was very real, but unless there is strong economic data coming through soon it seems likely that, as the stimulus packages come to an end, output will stagnate. This is where the ‘W’ theory starts to look more likely.

The S&P is already getting close to the year-end estimates of most of Wall Street’s main banks. Also if we look at the well-known Shiller P/E graph for the S&P (see graph below), which measures whether the markets are relatively cheap or expensive, it is now at 22x, which is 30% above its normal range of 16x. Some people argue that with interest rates low P/Es should be higher than previously. However, the graph also shows that this correlation does not really hold true, and it also sounds suspiciously like “it’s different this time”. It is clear that stocks can stay overvalued and undervalued for significant periods of time. We are now descending from one of the most extreme periods of overvaluation in the last 130 years and therefore it is reasonable to expect returns to be below average for the next cycle.

This is very disappointing news for investors who have remained narrowly invested in the S&P through the first 10 years of this millennium. In broad terms they will say that equity markets ‘have gone nowhere’ over that time. It is true that over the 10 years the S&P is flat to slightly negative, however, this fact hides the following returns:

  1. 1 Month US Treasury Bills: +31%

  2. Russell 2000 (US Small Cap): +41%

  3. 5 Year US Treasury Notes: +82%

  4. Dow Jones US REIT Index: +176%

  5. MSCI Emerging Markets: +213%

The above figures again show the importance of maintaining investment discipline and diversification. For investors following these principles there was no ‘lost decade’.

SHILLER P/E GRAPH and LONGTERM US INTEREST RATES


Therefore what should an investor, who sees high valuations and tends to agree with the ‘W’ theory, do?

At Clarmond we are neutral to negative on equities and are certainly happy to take profit from the more ‘growth orientated’ investments. The main issue is where to reinvest. There are areas of relative value in the markets, in particular there are a number of ‘blue chip’ income generating companies, often with global franchises, which are now looking attractive. Long-short hedge funds (discussed later) also will provide clients with lower risk equity exposure. Therefore we are rebalancing portfolios along these lines.

Turning briefly to the USA we believe that the US deficit will lead to a structural change. Whereas Ronald Reagan lowered taxes, which led, by default, to a cut in spending, the Obama administration is doing the reverse. They are increasing spending, which is going to lead to increases in taxes. We expect the next era to be one of higher taxes and much greater government intervention in banking, healthcare, immigration and the environment. Obama’s healthcare reform was voted through on the premise that healthcare would be expanded without an increase in the deficit. While the social benefits of this reform are undoubted it is likely that inflation in healthcare will remain high and therefore this will be another reason for taxes to increase in future years.

Campaigning for the important November congressional elections in the USA will start over the summer and rhetoric surrounding these elections is another reason to expect both negative market sentiment and general market volatility for the S&P.

Bond Markets

For Clarmond bonds and bond funds are an important low risk investments for client portfolios; therefore we have a problem. Interest rates in the USA and Europe are currently low. They may remain low for the remainder of 2010 and into 2011, as inflation does not seem to be re-appearing rapidly. However, the consensus, with which we agree, is that the stimulus packages will certainly lead to inflation at some point in the medium term and this in turn will necessitate rise in interest rates and a fall in bond values.

Greece’s near bankruptcy has also highlighted another important factor for investing in bonds. Would you rather lend to BP or the British Government? Would you rather lend to Coca Cola or the US government? One half of both of these pairs is a specialist in their chosen fields with decades of experience or running corporations and reporting and paying dividends to shareholders and bondholders. The other half is a government that has run up massive deficits who will be looking to pander their electorate as much as ‘doing the right thing’.

High quality bonds remain an important investment for clients. Although currently they may be less attractive there is a limit to how much an investor can lose. With the equity markets falling c.50% in 2008/9 bonds did provide a lower risk alternative.

Clarmond remains invested, although in relation to sovereign debt we will be looking at investing in the highest quality (i.e. Germany over Spain) and also at short duration. We will also be rebalancing towards high-quality corporate bond funds.

The events of 2008-2010 may also fundamentally change investors’ views on bond-risk. Should Greece really have enjoyed such a low rating (up to the crisis)? Have not ‘riskier’ emerging market countries actually managed their economies and deficits considerably better than Western governments? We anticipate that there may be a fundamental re-assessment of traditional risk metrics.

Hedge Funds

The term ‘Hedge Funds’ covers very wide spectrum of investments from Global Macro ‘trend following’ funds to more traditional Long-Short equity funds to the specialist arbitrage strategies. These strategies have come through the credit crunch with varying degrees of damage and success. The category that needs greatest analysis is the ‘low-risk’ arbitrage category.

A number of theoretically low-risk funds following strategies such as convertible arbitrage, asset based lending and fixed income arbitrage suffered massive collapses in value in 2008. These funds only made 8-10% in ‘normal’ times; however, their potential to lose significant investor capital in times of crisis was clearly misunderstood by the managers and investors alike. These out-sized losses have damaged the image of the low-risk hedge fund area. However, there remain a number of areas of arbitrage investment which do offer good risk-adjusted returns, and, ironically, it is after times of crisis that these returns are at their widest and safest. Therefore we are not scared off this area of investment but realise that a number of individual investors will never return to this sector.

Due to the single manager risk (as perfectly illustrated by the Madoff scandal) Clarmond will only invest in Fund-of-Funds and we are analysing a number of such suitable funds for our clients’ portfolios.

Turning to Long-Short hedge funds these are investments that have come through the financial crisis well. Long-Short hedge funds will follow the general movements of the market though with lower volatility. Therefore if the markets were down 30% you would expect and hope a well-run Long-Short fund to be flat to -15%. We believe that a well-run Fund of Long-Short hedge funds should become a core holding for the majority of our clients’ portfolios.

Conclusions

  1. ‘Low Risk’ needs careful assessment

  2. Expect volatility in equities; reduce allocation to neutral / negative

  3. Favour ‘blue chip’ and income

  4. Upgrade the quality of bond portfolio and maintain short duration

  5. Rebalance to high quality corporate bond funds

  6. Look for high quality Long-Short and Alternative Fund-of-Funds

  7. Due to low inflation cash is currently not a wasting asset


 

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