Brent Sheather: Turning water into wine - beating the market

There's always someone prepared to believe that water can be turned into wine and never mind what economics has to say on the subject, not to mention common sense, says Brett Sheather

With so much historical performance data available and all of the best graduates opting for jobs in the finance sector you might think that the application of this much resource would mean that there was an acknowledged "best way" to invest.

Nothing could be further from the truth indeed it seems that views as to what constitutes the best investment strategy are becoming more polarized.

One group argues that "you can beat the market", that returns are independent of fees and therefore that hedge funds and alternative assets generally are the way to go. No surprises however that the main cheerleaders of this line of thinking are hedge fund managers and their acolytes - most of whom are deeply conflicted in one way or another.

Taking the other side of the argument are academics, the odd journalist and many regulatory institutions like the FSA in the UK.

Their argument is that it is difficult to beat the market, that fees are the best forward indicator of returns (in each asset class) and that passive investment strategies like those employed by most exchange traded funds should comprise a big part of most portfolios.

The proponents of the uber active, high cost strategies also frequently promulgate the view that alternative assets (A.A) are fundamentally attractive because they can somehow go up in price when everything else is falling.

It's a nice dream that gets regularly rehearsed by the alternative asset aficionados who know that there is always someone prepared to believe that water can be turned into wine and never mind what economics has to say on the subject, not to mention common sense.

A few months back the research manager of a local financial planning firm which specializes in alternative assets wrote an article in the Herald which put the case for A.A.

He noted that the US Federal Reserve was likely to end its quantitative easing programme and that this could mean negative returns for both the bond and equity markets. So far so good. But what I have a problem with is his conclusion that investors worried about such a scenario should invest in A.A because they would do well in such an environment.

He said that successful investing in these circumstances "requires identification of an all - weather asset class, one capable of performing in bull or bear markets. That asset class is alternative investments". Hmmm, really?

The author defined alternative investments as including forestry, private equity, hedge funds and commodities.

Forestry is a long duration asset and like virtually all financial assets the present value of its cash flows fall when interest rates rise. So it is hard to conclude that it would be unaffected by a rise in interest rates, in fact the long duration implies a much greater sensitivity to changes in interest rates.

Similarly private equity is frequently just public equity, privately owned, with lots of leverage and burdened with high fees, so theoretically private equity is going to be even more sensitive to a rise in interest rates than public equity. So again, bit of a problem here.

Now let's look at hedge funds, the last great hope of the fund management industry.

Two of the most common strategies adopted by hedge funds are investment in the bond and equity markets so again it is hard to see how these investments wouldn't be impacted by a rise in interest rates.

Let's be honest and acknowledge that the only genuinely profitable strategy employed by hedge funds in the past has been insider trading.

With a rash of prosecutions and jail time in the US and Europe this party seems to be at an end also. Last but not least commodity prices are a function of supply and economic growth. All things being equal a rise in interest rates should impact economic growth so commodities don't look like they will defy gravity either and, hello, they haven't.

The writer concluded his case for A.A by saying that most of the world's largest institutional investors have a large exposure to alternative assets and cited university endowment funds as having a 54 per cent weighting.

Coincidentally about the same time that Herald readers were being told about the wisdom of the "Endowment Model" Brad Barber et al published a paper entitled "Do University Endowments Earn Alpha?".

Mr Barber is professor of finance at the Graduate School of Management at the University of California in the USA. He used an attribution model which concluded that 94 per cent of the returns of endowments managing US$408bn over the 21 years ending June 2011 were explained by a portfolio which was 59 per cent invested in shares and 41 per cent invested in bonds. By adding a third factor, international stocks, 99 per cent of the returns were explained by that portfolio.

He concludes "we find no evidence that the average endowment is able to deliver alpha relative to the public stock and bond benchmark". Alpha is another word for additional risk adjusted returns. So what the professors from the University of California are saying is that the average university endowment over the 21 years ending June 2011 would have done just as well by investing in a 60/40 stock/bond portfolio.

This research is significant for local retail investors because university endowments with hundreds of billions of dollars to invest are going to attract the attention of the best managers and negotiate fees which are much lower than those which Mum and Dad in Tauranga will pay. If these guys can't beat a 60/40 portfolio then the clear implication is that Mum and Dad in NZ don't have a hope.

Let's look at some hard data rather than just opinion. One of the most highly respected hedge fund indices is the CSFB Tremont Hedge Fund Index and the 10 year return of this index in NZ dollars is just 3.9 per cent pa. This compares with 7.9 per cent for NZ shares, 5.3 per cent for international stocks and 6.0 per cent for NZ government bonds.

A cynic might observe that it is probably fortuitous that hedge funds are in the main limited to rich investors as less wealthy investors probably couldn't afford the poor performance.

Let's leave the last word to Nobel economics laureate Harry Markowitz who coincidentally had something to say on this issue in the Financial Times last month.

He said "sell-side analysts will say I have an asset class here that is not correlated but the goal of diversifying a portfolio by adding exotic asset classes have sometimes proved quite disappointing."

Markowitz cited emerging markets and commodities which were, before 2008, previously uncorrelated but both crashed with everything else when liquidity dried up.

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