by Lars Kroijer
If you do go ahead with adding property investments to your portfolio then consider the following:
Invest broadly geographically and cheaply – there are some good global property ETFs (including one from iShares) that track the FTSE NAREIT Global index, or similar.
Avoid concentrating in countries that you as an investor are already exposed to via your non-portfolio assets.
Be clever about tax (REITs are tax-exempt from certain taxes); tax advantages could favour a larger allocation to property investments for some investors.
When you consider adding property investments to the portfolio think hard about the exposure you already have to property, both indirectly via securities in your portfolio, but also potentially via your home.
Private equity, venture capital and hedge funds
I used to run a hedge fund in London and wrote a book about my experiences, Money Mavericks: Confessions of a Hedge Fund Manager (FT Publishing International, 2012), and still sit on the board of a couple of hedge funds. Also, earlier in my career, I worked at a private equity fund called Permira Advisors.
Private equity, venture capital and hedge funds (I will refer to them as alternative investments) do not belong in the rational portfolio.
All the alternative investment vehicles claim an edge in the market. They are essentially saying, ‘Give your money to us and we will provide you with a superior return profile.’ Time will tell if they are right or not, but by selecting them you are essentially saying that you yourself have an edge, not because you can make all the underlying investments yourself, but because you know someone who can, namely the manager of the alternative fund.
The perception of the alternative funds is often shaped by a couple of well-documented success stories. When John Paulson made billions for himself and his investors in 2008 from betting on a collapsing sub-prime housing market it was the kind of investment everyone wished that they had in their portfolio. Or when Sequoia Capital partners tell you that they have backed Apple, Cisco, Google, and other names you know too well the question almost turns into, ‘How can you not invest money in alternative funds?’
In many ways, the logic behind picking an alternative investment is like that of picking an active manager. You do it because you think someone is able to perform well when investing your money. While you may acknowledge that you can’t do so yourself, being able to pick an investment manager who can consistently outperform would be an incredibly valuable tool. But like stock picking it is a rare skill. Someone whose job it is to select alternative managers may say something like ‘the East Coast biotech sector will massively outperform over the next decade’, ‘I think convertible arb will be resurrected’, or ‘John Doe fund manager is just brilliant’. Rightly or not, these are not the kinds of statements an investor without an edge can or should make. Particularly when you consider that the liquidity of your investment in alternative funds can be so poor that you may not get your money back for years, the need for an edge and superior returns is further increased.
Fees are very high
Besides the fact that investing in alternatives suggests a claim of having an ‘indirect’ edge on the part of the investor, the funds are also typically very expensive.
Many alternatives charge an annual management fee of 1.5–2% in addition to a 20% share of all profits above a certain hurdle rate, plus other expenses. While hedge funds in particular, at times with great justification, claim that the return profile they create is very different from one you can get through the markets, the aggregate fees mean that only the best-performing funds will be worth their fees. And therefore only those who have an ability to consistently select the best funds should invest in these alternatives. Most people simply do not have this ability.
To get an idea of the magnitude of fees consider Warren Buffett, one of the most successful investors over the past generation. If Buffett’s fee structure had been that of a hedge fund instead of an insurance company the return to the investors would have looked very different (see Figure 9.4).
To illustrate the cumulative impact of fees, consider the example of a pensioner who invests money into a hedge fund through the normal route of a pension provider, via a fund of fund, with all the aggregate fees and expenses. Suppose further that the hedge fund made a return of 10% in a year, before any fees or expenses, and that it was a typical long/short fund with normal trading. What would be left for the pensioner once all the finance people had taken their bites? (See Table 9.2.)
Figure 9.4 $100 invested with Buffett versus one with an ‘alternative’ fee structure
Based on data from Berkshire Hathaway, www.Berkshirehathaway.com
This is, of course, before we have even asked how the hedge fund made its 10%. Was it because it simply had market exposure as it went up or was it all unique value added that could not be achieved elsewhere? If it was mainly because of markets going up, our pensioner has paid a shocking level of aggregate fees for exposure to the markets.
I’m not just picking on hedge funds: private equity and some structured products have as much to answer for. Despite similar fees they are unapologetically long the market often in a geared way: investors could do much better themselves through leveraged index trackers, and an investment in private equity is typically very illiquid. Be sure you get paid for the investment being illiquid, and that you don’t pay to be long the market – you can do that much more cheaply with an index tracker.
This is not to say that alternatives never make sense but rather that the high fees mean that the bar is very high indeed.
Table 9.2 What’s left?
Alternative funds often argue that they provide investors with access to a different part of the economy (like a venture fund finding the next Facebook) or returns that are uncorrelated to the markets (like market neutral hedge funds). And they are sometimes right. Some alternative funds will undoubtedly do extremely well in future both in terms of providing investors with a unique exposure or just great returns, but the challenge is to select which one. Studies suggest that past performance is a poor guide to future returns so that doesn’t help us. (That would almost have been too easy – just pick the past winners and away you go!)
In addition to staying away from alternatives because picking the right alternative manager suggests an edge, many investors already have a lot of the same exposure that alternatives give, for all its high fees. The correlation between the returns of alternatives and the stock markets is quite high as the alternative funds often invest in assets similar to those represented by the stock markets. (Venture funds would argue that they invest in companies too small for stock exchanges, but they are still exposed to the same economy and exits often involve sales to large companies or initial public offerings (IPOs).) It is not arbitrary that 2008 was the worst year in the history of the alternative industry. In the rational portfolio you have many of the same exposures you would have as an investor in alternatives, but at about one-twentieth of the fees.
In summary
Stay away from alternative funds for the following reasons:
Picking the right manager of an alternative fund requires an edge, which we don’t think we have.
In the unlikely case that we could invest in all alternative funds and thereby get exposed to the whole sector, the combination of very high fees, poor liquidity of our investment, and the fact that we could have much of the same exposure but more cheaply through our stock market investment would render alternatives unattractive.
In reality, most investors couldn’t get access to the alternative funds if they wanted to. Ignoring the access products or share classes that some funds have, this is often because either the minimum investment size is too large (often $1 million or higher) or there are other regulatory obstacles. There is, however, a good chance that you are already exposed to them. Public and private pension funds are among the biggest investors in alternative funds. If you are a present or future recipient of benefits you are therefore already exp
osed to their performance. You just hope that whoever chose the alternative funds to invest in on your behalf has the required edge that eludes most of us.
Commodities
Before the 2008–09 crash, certain commodities performed very well and often became an integral part of well-diversified investment portfolios. While gold and oil perhaps dominated the broader media picture there were also other success stories.
Until fairly recently it was very hard for most investors to buy commodities. Unless you were an institutional investor set up to take possession of the physical commodities or trade the futures contracts it was a cumbersome process to gain direct exposure to the commodities. This difficulty has greatly been reduced over the past decades. Today there are ETFs available on a wide range of commodities and gaining the exposure is therefore as simple as buying a share in the ETF of your choice. Some of the most popular commodity ETFs are the gold ones, but there is a wide range of other commodities also available in addition to some that track broad-based commodity indices.
The economics of commodities are different from that of equities or bonds. To physically hold commodities we may actually incur a cost instead of necessarily expecting our ownership of them to generate cash in the future. There are storage and insurance costs to holding commodities. Furthermore, commodities are not income generating: the cost of extracting the commodity may change and the usefulness of that commodity in the production of goods may change, but nothing suggests that this will be consistently positive.
Although the costs of commodity trading for most investors have come down greatly it remains an expensive proposition for most. Even if we hold a commodity such as gold through an ETF we are still indirectly subject to the same storage and insurance costs, in addition to management and trading costs. Also, unless it is our profession to trade specific commodities there is a great chance that we are at a significant information disadvantage. If you trade oil and do so while working at Shell or BP there is a reasonable chance that you have an information edge compared to someone in their pyjamas trading on their computer at home. Make sure you are not in the latter group.
Financial investors in commodities mainly invest through futures. The futures market for all sorts of things is many centuries old, but the first organised exchange was created in Japan in the 1700s. This was so that samurais who were paid in rice at a future date could lock in the value they received. We can buy or sell a future on cocoa, grain, oil or whatever for months hence and avoid the issue of storage, delivery, etc. The price of the future will depend on the expectation of the future price of the commodity and the interest rate we can earn on the money in the interim. The futures contracts are settled through an exchange that ensures payment on expiry so that we don’t have to worry about the person or company we are buying our future from or selling it to.
But like the other asset classes we have discussed in this chapter, the main issue with trading commodities is the absence of an edge. Do you really have the knowledge or advantage in the market to profit from trading commodities? Chances are that you don’t unless you work in commodities and trade them for a living. If you don’t, don’t trade commodities.
As with property or alternatives, you already have a lot of commodity exposure through your portfolio of listed stocks. In the world stock market index are many mining or oil-related companies with large underlying direct exposures to commodities, and adding commodities to the portfolio would lead you to double up on the exposure. For example, if you were to buy oil in addition to owning it via all the oil companies in your equity index you would be adding to an already large exposure to that commodity, but it’s often hard to figure out exactly how much hedging commodity-related companies do themselves and what your indirect exposure to commodities from owning shares in a company therefore is.
Returns from commodities
Perhaps we could turn the question on its head and ask which commodities you would want to buy exactly and why you want to deselect others. If you buy cocoa beans, then why not wheat? If you buy copper, then why not iron scraps? Those that pick the individual commodities clearly claim an edge.
Investors in commodities claim that lack of correlation with the equity markets makes commodities attractive. One of the oldest commodity indices is the CRB Commodity index which tracks the performance of 22 commodities and first started tracking in 1957. Figure 9.5 shows the 12-month trailing correlation with the S&P 500 since inception.
Figure 9.5 Trailing 12-month correlation between S&P 500 and CRB Commodity index
As can be seen from the chart, commodities do indeed exhibit low correlation with the equity market, 2008 being a notable exception when they plummeted with equities. (The index was down 36% in 2008, rendering it a terrible hedge.)
But should we expect to make money from commodities?
Spanning only a couple of decades, the organised price history4 of commodities is probably too short to be meaningful but Figure 9.6 shows a chart of the CRB Total Return index5 – this index was not created until the early 1980s – compared to an investment in US short-term bonds. This index does not include the implementation cost which I have included at 0.5% a year for the commodity index, more or less in line with current ETF costs.
It is not surprising that many advisers advocated investments in commodities until the crash of 2008. In the preceding decade, commodities had performed strongly with a history of low correlation to the equity markets. But you can’t get rich on low correlation; you need income and commodities are not income generating. Over the longer run, commodities trail the minimal risk rate of return and there is no reason to think that they will do so consistently in future. Because of that, and because you already have a lot of the same exposure through the existing portfolio, you should not include commodities in your rational portfolio.
Figure 9.6 Commodity index versus short-term US government debt
Gold as a special case?
Gold has of course been a very public success story with the price per ounce well above $1,500, up from around $40 in the early 1970s when the US abandoned the gold standard. Gold does not have as much production use as some other metals and commodities, other than as jewellery and to some extent in electronics, but it has always been seen as a great preserver of value in times of distress.
If you want to avoid risk you should buy more of the minimal risk asset, and not buy gold. Gold is certainly not a low-risk asset – it is in fact very volatile in value. What attracts people to holding gold is the perception that it tends to move up in value when markets go down. It is therefore considered a hedge to the stock market or general economic/political turmoil.
I would caution you against viewing gold holdings as a hedge against stock market declines. If the stock market and the price of gold really moved in opposite directions (they do not – see Figure 9.7) and you had equal amounts invested in both, then in an economic decline you would make as much from the rise of gold as you would from the decline of the stock markets, and vice versa when markets were good. The only difference is that you would have paid expenses on your gold holdings as well as minor ones on your equity holdings. In that case you would have minimised your risk, but also your profits, and still be left with your expenses. Instead of having equity and gold exposures off-setting each other, you would have been better off just buying minimal risk bonds.
Figure 9.7 Trailing 12-month correlation between S&P 500 and gold price
While the price of gold will continue to be volatile and perhaps even go up, as with the case of other commodities there is nothing intrinsic to suggest that gold as an investment will do better than the minimal risk rate, so I would suggest that you keep it out of your rational portfolio.
Private investments (or ‘angel’ investing)
In my personal life, the main way I differ from investing like the rational portfolio is through private investments. I’m incredibly lucky to have a group of talented friends and acquaintances who are doing very exciting thin
gs with their careers. Because of my background in hedge funds and finance, a large portion of this group is involved with finance, but certainly not all. Some are involved with various technology or related businesses. And quite frequently I’m approached to invest money as friends or acquaintances start something new or expand an existing business.
Private investments are perhaps an area of finance where we can slightly suspend the rational investment thinking. If you are approached by a friend to invest in his business you may have a lot of insight that other investors do not have. You know a lot about the principal and his history. You will also have heard him talk about the investment before he was trying to sell it to you so you have more of the real story. It could also well be that you are one of only a handful of people who was approached to invest money in the venture. As a result there is no real ‘market’ for the investment, but if there is then perhaps you are the investor with the most edge in that market. Since it’s essentially the presence of an active market for securities that leads to a price that we don’t think we can predict better, in the absence of that market there could be an opportunity for investing at favourable prices.
I was recently asked to put money into a New York-based private company that makes face recognition technology. A very snazzy presentation of how they will revolutionise social websites and everything else followed. The management team seemed very credible and knew the technology and the market very well. My main concern and reason I passed on the investment was that I felt that I was the one-thousandth person to be presented with the opportunity to invest. I also felt that most of the other 999 people who had passed on the investment were better positioned to gauge the viability of this company. This could be because they understood the technology or competition. Perhaps they could even write code and were able to look at the source code for the technology, which I can’t. There was also the issue of why they needed money from a London-based non-technical person in order to make a New York-based technology firm thrive – didn’t any of the locals want to do it? In short, I felt at a competitive disadvantage to others who had looked at but passed on the investment, and I did the same as a result. There was no edge.
