How to become an asset hotshot

Published by Fiona Hamilton on 13 October 2009.
Last updated on 14 October 2009

Basketball shot

The dangers of putting too many eggs in one basket are well understood. Staking all on a handful of UK blue-chip shares or, worse, emulating the man who had always banked with Royal Bank of Scotland and believed he could safely invest all his savings in its shares, are strategies that have ended in disaster.

However, a much wider variety of asset classes offering a smoother path to wealth acquisition have become accessible over the past 30 years.

Spoilt for choice

The increase in choice is illustrated by a multi-asset class mosaic produced by Seven Investment Management (7IM). Formed in 2001, 7IM bases its advice to clients on the principle that asset allocation accounts for 91% of the performance of diversified portfolios, compared with 5% from financial asset selection, 2% from market timing and 2% from other factors.

Funds under management in its multi-asset class funds recently topped £1 billion.
Its mosaic shows annual returns on 15 asset classes* over the past 13 years, although 7IM has tracked them back over 30 years, measuring their volatility and correlation as well as their performance.

A cut-down version of the mosaic from Frontier Capital Management highlights the difficulty of predicting which asset classes will do well in any given year.

Half the asset classes it covers were difficult, if not impossible, for the average investor to access in 1979, as were others that are not included, such as emerging market bonds and infrastructure.
UK, US, European and Japanese equities, cash and gilts were easily accessed, directly or through funds and trusts. But private equity was just starting to emerge as a distinct asset class. F&C Enterprise (launched in 1981) and Candover Investments (1984) were among the first of a cohort of specialist investment trusts.
The public could not buy UK index-linked gilts until 1982 and small investors were excluded from the nascent hedge fund industry until the 1996 listing of Alternative Investment Strategies.Most funds of hedge funds were listed in London at the beginning of the present century.

Meanwhile, infrastructure was restricted to multi-million-pound investors until the advent of closed-end vehicles such as International Public Partnerships and 3i Infrastructure.

The present day
Today, an explosion of specialist funds has made it possible to achieve targeted exposure to a much wider swathe of UK corporate and global bonds - reflected in the creation of several new fixed income fund sectors.

This has been reinforced by the emergence over the past nine years of a wide range of London-listed exchange traded funds (ETFs) and their commodity-focused cousins (ETCs). Gone are the days when small investors had to put their faith in gold coins or wrestle with the political and managerial complications of mining companies.

Commercial property has long been indirectly available via property companies, insurance funds and a few specialist investment trusts. However, the 2007 creation of UK real estate investment trusts (REITS) and a flood of offshore property funds has led to much wider choice and more attractive yields - although investors need to be wary of vehicles with excessive gearing and unsustainable dividend distributions.
Emerging market equities have also changed beyond recognition in terms of size, shape, diversity and importance, following the collapse of the Soviet Union and the emergence of the so-called BRIC economies of Brazil, Russia, India and China.

These countries control much of the world's natural resources and in many cases enjoy better demographics, sounder banking systems, greater foreign reserves and faster economic growth than the developed world.

Eastern promise

Leading global investment managers such as Jeremy Tigue at Foreign & Colonial Investment Trust, James Anderson at Baillie Gifford and Bruce Stout at Murray International believe that economic power is moving inexorably to the east and that those without a significant equity stake are liable to miss out badly over the medium to long term. Emerging market bonds have become increasingly popular.

7IM's mosaic demonstrates that emerging markets and Asian equities have been the most rewarding equity classes, but also the most volatile, while Japan has been the least correlated with the other equity sectors and can be a useful diversifier.

Private equity has been even more volatile and has the added disadvantage of being closely correlated to UK and US equities, but 7IM believes it still merits attention because of its strong long-term returns.
Index-linked bonds have a low correlation with UK equities, and have made steady progress, so they can be a good diversifier for investors who are over-exposed to equities. Otherwise, gold, commodities, global government bonds and forestry have been the most negatively correlated with UK equities, so they also have diversification appeal.

As for hedge funds, 7IM suggests they are "a very sophisticated product" and need to be accessed with caution.

Tread warily

Hedge funds are also viewed warily by Frontier Capital Management. It warns that individual funds can be volatile, that most funds of hedge funds don't diversify out enough risks and have high costs.

But it favours hedge funds as an asset class, because, overall, it has displayed exceptionally low volatility. Frontier therefore runs a hedge fund tracker product giving wide coverage at low cost, but it is only available through financial advisers - who can split its $100,000 (£61,278) minimum between a number of clients.

London-based Frontier was formed in 2004 to deliver low-cost, passive, multi-asset and alternative investment products. It is inspired by US super endowment funds, such as those run by Harvard and Yale universities, which have practised multi-asset class investment for two decades.

With alternative asset classes accounting for more than 60% of assets - predominantly hedge funds and private equity - the top five endowments achieved double-digit annual returns, with below average volatility, over the 10 years to June 2008. Their long-term figures are expected to remain impressive despite upsets over the last 12 months.
The super endowments keep annual changes in strategic asset allocation to around 7% to limit costs, as does Frontier. It uses the same core asset allocation model for all investors, increasing the risk profile by gearing up by 100% to achieve moderate risk and adding extras such as gold and private equity for higher risk.
Frontier's multi-asset portfolio for 2009 has 15% in global equities, 5% in emerging market equities, 18% in global fixed income and 5% in emerging market bonds. The balance is 10% in commodities, 10% in global real estate, 25% in hedge funds and 12% in managed futures.
The most obvious difference between the portfolio and super endowments is that the portfolio excludes private equity. Frontier says this is mainly because private equity is not suitable for index tracking and is not very liquid - its onshore funds have daily liquidity.

It admits this may hold back returns, but its core model aims for steady rather than spectacular returns. Frontier hopes to partially compensate by including managed futures, which it describes as "investment funds targeting absolute returns from trading futures contracts, mainly in currencies, financial assets and commodities".

Frontier likes them because they have a low correlation to traditional assets and can flourish in the equity bear markets seen in 2008. But the minimum investment through funds such as the EEA Futures Program is $100,000 and EEA warns that in the short term they can be very volatile.
Frontier's caution about hedge funds is endorsed by Peter Spiller, chief executive of CG Asset Management, which manages more than £600 million. The success of CG Asset Management's absolute return approach is exemplified by its flagship Capital Gearing Trust.

Capital Gearing Trust's net asset value per share has risen every year, since Spiller took charge in 1982, until last year when it missed by a whisker.
He says hedge fund performances have been very mixed, their fees cream off far too much, and when they were put to the test in 2008 they failed. At the other end of the scale, he believes everyone should have at least some index-linked bonds. "It fulfils the role that gold was traditionally expected to play, as it preserves the real value of capital."

Reits can be another "arrow in the quiver" for investors who can time the property cycle. He thinks capital values are approaching reasonable levels and yields should remain attractive relative to other classes even if rental incomes fall by 30% this year.

Spiller expects rising living standards in the developing world to push up agricultural commodity prices, but believes it is hard to find a way to play them successfully. He is unenthusiastic about commodity ETFs on the grounds that they are based on three-month futures contracts that have to be regularly rolled forward and that the premiums on their renewal builds in a huge negative return.
Iain Stewart is another successful asset allocator who is cautious about some of the newer asset classes. A senior manager at Newton Investment Management, he manages the low volatility, multi-asset Newton Real Return fund - which is up 50% over the past five years.

He says: "Hedge funds are great if you can find the right one, but they are not a great asset class. They usually involve some sort of trading strategy plus a lot of debt, which can work well in normal circumstances, but can lose a lot when it all goes wrong.

The managers get paid huge amounts as long as all goes well, but lose relatively little when it does not. Funds of hedge funds impose yet another layer of fees so need tremendous returns."

Stewart thinks private equity is another sector that tends to charge too much, run too many risks and have too few top-quality managers. He suggests that a lot of the growth in private equity and hedge funds can be attributed to an era of cheap borrowing.

But he is keen on emerging market debt, which he expects to increase in importance, and shares Spiller's belief that agricultural commodity prices will harden. However, he does not share Spiller's reservations about ETCs, favouring those that invest in baskets of soft commodities such as soya, wheat, corn, sugar and coffee.

He may favour a similar basket of industrial commodities if he was more confident that China's growth was sustainable.

Mixed bag

Turning to other new asset classes, Stewart thinks forestry is interesting but is not sure about infrastructure.

Preqin, which provides data and analysis on a range of alternative assets, says infrastructure should produce relatively stable and predictable cash flows, due to the inelastic demand for industrial infrastructure such as roads, bridges and power plants, as well as social infrastructure such as hospitals and schools.

Stewart says: "It is not as risk free as it is made out to be. It has all the risks of government contracts. It can be hard to forecast how things will pan out and build in all the correct cost assumptions."

*UK, European, US, Japanese and emerging markets (including Asian) equities, private equity, hedge funds, commodities, gold, UK gilts, index-linked, corporate bonds, global government bonds, UK property and cash

This article was originally published in Money Observer - Moneywise's sister publication - in October 2009

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