Personal finance and investing columnist at the NZ Herald

Brent Sheather: On talking your book

Aircraft leasing, insurance, forestry and private equity are all part of the 'Alernative Investment world'.
Aircraft leasing, insurance, forestry and private equity are all part of the 'Alernative Investment world'.

Talking your book is an old stockbroking saying which refers to the not uncommon practice whereby a financial intermediary, often an investment bank or stockbroker, takes a position in a stock or bond then produces a research report praising the attributes of that security so that they can sell the holding at a higher price.

Goldman Sachs in the USA apparently took Talking Your Book to new levels with its marketing of sub-prime CDOs to its 'muppet' clients. There are of course various rules governing this sort of behaviour but most are ineffective and offer little in the way of protection to anyone. If you doubt this look at how much money the investment banks make from principal trading.

As an aside - there is a view amongst academics that principal trading, investment banking and retail stockbroking cannot exist under the same roof if a fair deal is to be had for retail investors and no amount of disclosure, rules or whatever is going to protect mum and dad properly. The reality of Investment 101 is that when it comes to the crunch investment banking always dominates retail stockbroking.

But I digress, today's story was inspired by a recent article in a newspaper which seemed to me to be, shall we say a little economical with the facts so as to promote a high cost investment solution. The story was, as is the fashion, critical of investing in bonds but this article differed in that it championed an ostensibly low risk alternative to bonds whose valuation would be impervious to the impact of rising interest rates.

This investment nirvana is called alternative investments (Ai) which are, to quote the article, a variety of assets with much longer time horizons so suit US endowments and pension plans and NZ super, for example, and include private equity, venture capital, aircraft leasing, insurance, forestry, unlisted infrastructure investments and hedge funds.

Note the subtlety, associating Ai with expert investors like US endowments and the NZ super fund. The writer also refers earlier in the article to savvy investors who will be looking to avoid the repeat of the 1994 bond rout.

The implication being that people who buy bonds are stupid and people who buy alternative investments are not. But, hello, the author works for a company which sells alternative investments and what's more the firm also alludes to an ability to provide investors with absolute returns, ie investments which go up almost as fast as the stockmarket but don't go down with the stockmarket. When I read that line for some reason a Raidohead song Nice Dream popped into my head.

So let's take a closer look at this story. Despite his smiley, confident looking photograph not everything the author said made sense, to me anyway.

First off he gave the standard warning that interest rates were going up and suggested that anyone with half a brain would realise that bonds would do badly in such a scenario. This is hardly new information but to be fair, looking back over the last 12 months, it would certainly have been good advice.

The problems though are, people have been warning about bonds being overpriced for ages during which time they have delivered excellent returns, and secondly whether or not the upward trend in interest rates continues in the medium term is anyone's guess.

Where the author does get into a bit of trouble however is when he says that bonds bonds may be a return free risk. Here he is being a bit economical with the truth because for all but the narrow class of perpetual bonds the worst case scenario for someone owning a bond that doesn't default is that they will get their money back and the return quoted at the time they buy the bond.

Hardly return free.

In the period they own the bond the value of the bond might go down below what they paid for it but, if you simply hold the bond till it matures the return will equal the yield quoted when you bought the bond. Not a disaster and certainly not return free.

Where an investment professional might have another problem with this article is the author's suggestion that Ai offers a solution to a simultaneous sell off in bonds and equities. Theoretically, there is no reason why alternative investments should offer any protection at all in a rising interest rate scenario because, as the author says, these are long duration assets and a rise in interest rates means a rise in the discount rate used to value the cash flow accruing to those assets.

Whilst this might sound a bit technical the argument is not complex as it simply means that rising interest rates can hurt bonds , shares and even alternative assets because the required return all of these instruments rises which means the discounted net present value of the assets falls.

In the past one of the biggest reasons these assets didn't reflect changes in valuation is because they were illiquid and didn't react - but shutting your eyes doesn't make the boogey man go away. The belief that alternative assets would defy the laws of gravity reached a high point just prior to the 2008 GFC during which time most alternate assets succumbed to the natural laws and slumped along with shares.

The GFC confirmed that historic correlations of alternative assets, notably commodities were worse than useless in terms of predicting future correlation. The lesson was that once an alternative asset becomes popular historic correlations count for nothing. Not only that but anyone who embraced the idea that Ai could be a low risk proxy for government bonds in an adverse environment got seriously burnt.

That is not to say that there are not some managers of private equity, venture capital, forestry, infrastructure and hedge funds who, because they have been able to find assets with attractive valuations can do well at a time when everything else does not.

The point is, as one fellow in the London Financial Times wrote I wouldn't buy shares in any hedge fund I could get shares in that these special fund managers generally don't offer their services to the great unwashed. You have to be a seriously rich individual and/or closely connected to get access to the best Ai managers. In addition the golden age of alternatives was some time ago when the idea was new. Today this space is crowded with wannabees.

So all in all not a great contribution to understanding how the investment markets work from this author in this column's view. However it is not hard to see why Ai is so popular with fund managers. The answer is fees. Not only can alternative asset managers charge a much higher base fee with alternative assets but they also inflict upon their clients a performance fee and, if the standard NZ practice is applied, the performance fee benchmark will be mis-specified so that huge rents are extorted from retail investors. If you are a fund manager or advisor charging high fees then buying low risk bonds for clients just ain't an option.

I'll stick with bonds, property and shares thanks very much and focus on the low cost managed fund versions of each mindful of some research by Morningstar quoted recently in the FT which said that the expense ratios of funds were the most dependable predictor of performance. Amen to that.

- NZ Herald

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request.

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Personal finance and investing columnist at the NZ Herald

Brent Sheather is an Authorised Financial Adviser and personal finance and investments writer

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