Investors are right to question whether there is a better way to invest. To quote Winston Churchill: "No one pretends that democracy is perfect or all wise. Indeed, it has been said that democracy is the worst form of government except all those others that have been tried from time to time." The process that generated the returns of the last few years is not bullet proof, but unfortunately competing approaches have a different set of flaws.
What is currently considered to be industry best practice will now be revised. There will be a move "back to the future" where the question applied to potential investments will be "do they help investors achieve their goals?"
In the past few years, best practice has become blurred by investor desire for equity-like returns for bond-like risk, with the industry creating products to meet the demand. With the benefit of hindsight, equity-like returns with bond-like risk are clearly not achievable, but it did not stop the industry trying. The pursuit and apparent delivery of higher return/lower risk solutions helped create a perception of skill. As structured products have imploded, the perception of skill has evaporated and has been replaced with general mistrust and anger.
Going forward there will be a greater examination of the investment structures and incentive programmes of many parts of the finance industry. Clients will be more inclined to question whether the people selling their services and providing advice have their best interests in mind.
We have always taken a straightforward approach to asset management. Active mandates are structured with the objective of stock selection contributing the bulk of value added, with tactical asset allocation expected to boost the fund return by a smaller amount. Managers are monitored relative to industry standard benchmarks and are tasked with outperforming those benchmarks over a performance cycle.
This is all standard stuff, but the key is that we have stuck to it. We have deliberately avoided the path of complexity. Even so, recent returns have been dragged down as the leverage, which helped create complex structures, has been withdrawn and the structures have collapsed, having a debilitating effect on investment markets.
Hopefully the recent improvement in sentiment will allow a return to more stable financial markets, but if the definition of normal is based on the last two decades, we believe the outlook is for an abnormal period.
The last two decades can be characterised by firstly disinflation (inflation rates falling) followed by one of decreased savings and increasing consumer leverage. Disinflation helped boost equity market returns, while increased consumer leverage helped underpin consumer spending, which in turn boosted corporate profits.
Last years' dramatic collapse of global equity markets reflected a stark economic reality; overleveraged US consumers and impaired assets held by banks were at the core of the economic and financial market woes.
Consumers were already overextended ten years ago and in the period since then, global financial markets have experienced a series of rolling investment bubbles. Policy responses of cutting interest rates aggressively in response to crises helped clean up the mess of one crisis but contributed to an even bigger problem down the track. We have had the tech bubble developing then bursting followed by a global property bubble developing and bursting, and possibly now a bubble in government bonds being created.
Central to the creation of these bubbles has been the availability and relatively low cost of credit. Freely available credit has been taken as normal, but going forward this will not be the case. In these circumstances a sector that has come under great scrutiny has been the alternative investment industry, usually referred to as hedge funds.
Hedge fund managers invest in traditional asset classes. It is the techniques used which differentiate them from traditional managers. An important difference is that hedge fund managers are more inclined to exit positions if they are losing money. In our view hedge funds are best thought of as a different way of managing money rather than an asset class in their own right.
Historically, transparency within the hedge fund community has been poor and the fees charged were expensive. In our assessment over 50% of the return the alternative industry produces is re-packaged market risk. Most of the return from a traditional investment approach also comes from market returns. As the bulk of hedge fund returns could be achieved with a passive approach, it has made the fee structure of the alternative industry very hard to justify.
Unfortunately, when the industry most needed to perform it failed. Hedge funds have experienced large outflows and more are probable. However, in true Darwinian style, the strongest will survive. The survivors will have greater transparency and lower fees. In our view it is an industry you do want to follow as some managers do some interesting things.
We recommend the best parts of the current approach and the hedge fund model are adopted in your portfolio thinking. This incorporates the flexibility of the hedge fund structure and the transparency of the traditional approach. While the market had been moving down this path tentatively, recent events may accelerate the process.
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