If you were to take the example of a client with $10 million. How much of that would you put into alternative investments?
Anything from zero to 100%, but that is not the answer you are looking for. What I am getting at is that it is so individual, and there is no one answer. The reality that I have seen with customers of ours is that it is anywhere between zero and 100%. Personally I am biased to the 100%, which is my area, but it is not everyone's cup of tea. Depending how conservative you are, I believe you should be looking to invest in a well diversified, hand-picked alternative investment portfolio. The more risk-seeking you are, the less you should be invested in these kinds of investments.
That's probably where there is a lot of misunderstanding. Many investors continue to perceive alternative investments as the risky part of the portfolio, and it is quite the opposite. They are not the get rich products, they are the stay rich products. They are the most boring part of the investment portfolio.
There is still a perception that hedge funds are risky. Do they have the wrong name?
The name is actually correct, because hedging says what they do. It's because they have always been somewhat enigmatic and don't disclose what they do to the same extent as a traditional fund. I find that quite understandable, because if you disclose everything you do, how are you going to live off inefficiencies in the markets - there is just no way.
Plus the LTCM story seemed to provide market commentators with enough juicy stories to continue to exploit for the coming years. But the more people begin to invest in these types of investments the more they come to like them. It has always been my experience that when investors put say 5% in and start to see what is going on and read the monthly performance reports, the more they feel comfortable with it.
Customers who began that way three to four years ago, are now 80% invested in hedge funds.
For the more conservative, cautious clients, is the best first approach to put them into a fund of hedge funds?
Absolutely. If you put them into a single fund you take the risk that you choose a fund that underperforms and then put the client off. So it is safer to begin with a well diversified hedge fund portfolio. It is also better from an educational perspective. The benefit is that as an investor, if you study performance materials that you then receive, you learn about the styles and when they do exceptionally well and give an unsatisfactory performance and will see how style diversification is different from the way you diversify across traditional asset classes. Within that, you will be amazed to look at the specific funds and be amazed to see that some of the unknown names will do exceptionally well, and some of the big names will have boring performance.
Then once you've got more educated, you may want to allocate more to funds that adopt a particular style.
The hedge fund industry does not have as long a track record as other asset classes; does this raise issues, especially when it comes to judging how they will perform when market conditions change very severely?
The oldest hedge funds date back 50-60 years. But yes, it is a rapidly growing industry and the vast majority do not have a long track record. However, to me, track record is the least important part when analysing a hedge fund. When I analyse a hedge fund I look at it the way I look at a balance sheet of a traditional company. The only thing that matters to me is looking forward and trying to find out why these guys should have an edge, and why they have technology that will help them execute professionally without any hiccups; and whether they are incentivized well, and whether they are co-investors. Those are the things I look at. Of course, I look at the track record as well, but frankly when you have a new team of managers, that is not very meaningful.
If I was a new client, and I was thinking about hedge funds, one of the questions I might ask is, how many hedge funds normally close per year through poor performance; ie what is the failure rate. Is that data available?
The transparency and the data availability has greatly improved over the last few years. If you look at the hedge fund indices you will see that one reason for their outperformance is their so-called survivorship bias. Those that underperform often get closed, liquidated and new ones will form. So therefore the underperformers will drop out of the index, and the index benefits from this.
We, obviously, adjust for this because it is well documented. You should probably deduct something like 20% of the total performance of the index to get a more realistic assessment.
In terms of fund of hedge funds, there have been a couple of hedge funds in Asia that have closed in the past year, and fund of hedge funds have played a part in this. When there are 4-5 quarters of poor performance, the fund of hedge funds all pull their money out simultaneously. This causes it to close. But some argue that the positions held by the hedge fund may not be bad, but they just need more time to work; and forcing a liquidation is the worst outcome. What are your thoughts on this?
Yes and no. I don't like the argument that it just takes a little more time to realize the value in the position. That's exactly what I don't want to hear. I am in the fund because I want positions to be successful in the short term. If I am told just wait for the long term, then I should put my money in the long-only industry, which is basically nothing more than the principal of hope.
In the hedge fund industry I am looking for wealth preservation in the short term and capital appreciation over the longer term.
It is true that some fund of hedge fund managers pull out for reasons that I wouldn't find justified. Some fund of fund managers are causing this reputation that fund of fund money is the "stupid money" that goes in and out very quickly. But a good fund of fund manager, knows the risks of the investment strategy are and will not pull out because of a negative month, but because of a deviation from style, or strategy. Those are the things that really make me nervous.
Given the interest rate environment, are you still seeing a lot of demand for structured notes?
Sure, and the demand today is greater than in high interest rate environments. Everyone is seeking higher returns in nominal terms than what you get by buying a straight bond. Some of that can be achieved by structuring a note that will lead to a higher yield. But when you do that there is always an element of additional risk in there. There is no free lunch. The range accruals have had a terrific run over the past few months and I see them peaking. I see a lot of brokers showing them to customers when they should have done that 12 months ago - which, by the way, we did. I believe they will peak this year and customers should be smart and not jump on that bandwagon anymore.
You think interest rates will go up this year?
Not in the short term, but by the end of the year the interest rate environment will have changed. In the second half I believe we will see a slight rebound in interest rates. That's not because I am necessarily optimistic on economic growth - I am not. It's because there is a huge government debt build up which will have to be funded in the capital markets and this will drive up rates.
What's your view on gaining exposure to rising commodity prices?
It has always been a good strategy to have some exposure to commodities. Going forward, I continue to see that as an attractive source of revenue.
A lot of people believe that with China's growth, it will import more commodities and this will drive commodity prices up in the long term. Do you agree?
Well, on a very long term trend, I do. But as Keynes said, in the long term we are all dead. But putting a decent allocation to commodities for the next 12 months seems like a smart move to me.
Does that include gold?
We began an asset allocation to gold in January last year. We have stuck to that position and will hold it. We may change our minds later this year.
What's your view on property?
I happen to disagree with much of the market here. I am not excited by property. I know the yields are attractive, but I feel the book values are expensive and the implicit leverage is very high. Those two risks are not well rewarded and in general I would not make a large allocation to property as a managed asset class.
Are you particularly negative on London property?
That's a bubble. We all know that's a disaster waiting to happen. Once the bubble bursts, it can overreact on the downside. London is obvious. Less obvious is the US property market. Here prices have only risen nationally by 3-5%, but what worries me is that 60% of residential property is mortgaged up to 90% of NAV. Why? Because mortgage rates are historically low and people seem to believe that will continue forever. So my conclusion is that property prices are looking fragile.
Finally, you are a great art lover. Is art an important part of a portfolio?
I think you should immediately write off everything you put into art. Art is not an investment. Anyone who tells you any different is trying to lure you into something that will end in tears.