Heady valuations, low dispersion and lots of volatility:
The case for alternative investments has rarely been
stronger. Or has it? It depends in large part on whether
investors are adequately compensated for taking liquidity
risk (the risk of locking up funds and forgoing opportunities
elsewhere). Here is a rundown:
Private Equity (PE): Valuations are frothy. PE outfits are
selling everything they can in public markets at valuations
well above 2006 levels. Be selective: Leverage can never
turn a bad asset into a good one. The market has not
peaked yet, in our view. Beware when PE firms start
buying publicly listed stocks rather than private assets.
Infrastructure: The infrastructure story is tantalizing—
trillions of dollars needed in infrastructure upgrades
and a global wall of money seeking yield. Yet the
investable universe is small and funds take a long time
to invest. Infrastructure debt is long-duration (up to 25
years or more) with limited liquidity. This is fine, as long
as you are in for the long haul and get paid for your
patience. We typically avoid riskier greenfield projects.
Real Estate: Inflows from frustrated fixed income
investors have increased liquidity—but also inflated
valuations. Yet opportunities remain as prices vary
widely within regions, markets and property types. We
favor U.S. core real estate, especially office buildings
and multi-family dwellings, as U.S. growth and the
dollar are set to rise. We expect above-average annual
returns over 2015–2017 in this area. We also see
opportunities to refurbish office buildings in major
Western European markets. And we like China. A credit
crunch in the real estate sector has left over-leveraged
projects in need of equity injections. We particularly
like shopping centers in second-tier Chinese cities.
Credit: Debt covenants offer ever less protection in public
credit markets. Investors willing to take on liquidity risk
can negotiate better terms in private markets. Other
opportunities include peer-to-peer lending (although
here, too, an influx of new investors is starting to depress
returns) and the stable and unglamorous business of
mortality risk in insurance portfolios. Distressed credit is
largely dormant. We prefer to wait for a spike in default
rates to 5% or more to sift through the wreckage.
Volatility
Many asset owners have taken on more risk than they would
normally do to compensate for low yields. Many are out of
their comfort zones and ready to quickly pull the plug.
Ultra-low volatility and dispersion have reduced relative-value
opportunities. Momentum rules—and equity investments
are clustered around common return factors. Yield-seeking
trades dominate fixed income. This results in three trends:
} C redit: down in quality and down in liquidity.
} Equities: concentrated industry and company investments
that are tilted toward future growth.
} Outperformance = taking on more risk through increased
position sizes and leverage.
These trends can easily reverse. The result: Short bursts of
volatility, worsened by poor liquidity in popular markets such
as corporate bonds. See The Liquidity Challenge of June 2014.
We had two wake-up calls in 2014: the spring sell-off in U.S.
Internet and biotech stocks and the global risk-off move in
October on growth fears. These were painful shifts. Yet the spikes
merely mean markets are returning to their volatile normal.
wanted airbags
Many assume these volatility bursts will quickly subside and
be great buying opportunities, just as they were in 2014. They
could be right; and therefore it is smart to keep dry powder to
exploit these opportunities. (Cash will do just fine.)
Yet volatility may not calm down. Market swings can range from
a temporary 10% sell-off to a prolonged and disastrous 50%
loss—and the difference is hard to tell as events unfold. This
means it is important to put safeguards in place, such as
setting stop-losses and reducing momentum trades.
Generating alpha (excess returns above a benchmark) is in
large part about avoiding mistakes in this climate—not just
about hitting winners.
Even if a sell-off proves to be fleeting, it helps to have a
strategy beforehand: Do you take down risk at the first sign of
trouble or sit it out? For investors with long-term horizons, the
answer will likely be the latter—which makes a lot of sense.
For those with shorter-term investment goals, the answer is
not as clear-cut because alpha opportunities are fewer and
less lucrative. Consider.
} The cost of being wrong is likely to go up. It is prudent to
protect against downside risk when assets are richly
valued, even if this translates into mild underperformance
in the short run. Volatility is cheap, so this is the time to
buy put options to protect against market sell-offs, use
“upside hedges” through call options on risk assets or
employ more complicated hedging strategies. The point
is to have some airbags.
} Smart investors are going to be wrong often. (Exception:
Warren Buffett. It is tough to be a mini-Buffett, however.
Many try—and fail. And even He fails once in a while).
Being stubborn for too long does not pay. You may be
right in the end, but it is tough to make up for lost
opportunities elsewhere. A successful investor needs
to have an unequivocal answer to the question: “What
would you rather do: Be right or make money?”
} Stop-losses—selling (part of) a position that is declining in
value at a predetermined price to avoid further losses—do
not typically maximize returns. They do, however, minimize
drawdowns and cut risk. We use stop-losses in many forms:
One of us advocates “cut small and cut early,” a sort of
behavioral stop-loss that helps avoid panicky, “get-me-out!”
decisions when a position is down significantly. Another uses
an initial “soft stop” that forces a rethink of the investment
thesis, followed by hard-stops in case the position
deteriorates further.
WHO STOLE MY HEDGE?
Tougher hedges could be another challenge. Safe-haven
government bonds have been great shock absorbers for equity
downturns. Medium-term correlations between U.S. stocks and
bonds have been negative for most of the new millennium
and currently hover around a low. See the chart above.
This pattern may be an anomaly: U.S. bonds and stocks may
start moving in the same direction, as they have for much of
the past century. At the very least, bonds will no longer offer
a free lunch of both a solid return and hedge against stock
downturns. This challenges traditional diversification in
portfolios that allocate 60% to equities and 40% to bonds.
The other problem? Rates have fallen so low that there is little
room for them to decline much further. Paltry yields mean it
takes more bonds to hedge an equity portfolio. It would take five
units of 10-year German Bunds for every one unit of equities
to hedge against a 20% stock market sell-off, we estimate.
Ultra-low yields elsewhere make U.S. Treasuries a favorite
asset in our current arsenal. They offer good value compared
with other safe-haven bonds and remain a hedge against a
major equity sell-off. The question is how much “insurance”
you want to take out (forgoing opportunities elsewhere).
Answaring the call
How to find diversification in this climate? Here are a couple
of options:
} Focus on relative value strategies in fixed income. A marketneutral
approach is insulated from rate rises (in theory)—
and should thrive when volatility and dispersion rise.
} C onsider other potential diversifiers such as infrastructure
debt, real estate and long-duration assets chased off bank
balance sheets (page 7).
Rising dispersion and declining correlations between and
within asset classes should facilitate the search for hedges
(and theoretically improve the ability of smart active
managers to outperform their benchmarks).
The good news: Overall market correlations have fallen to
pre-crisis levels in the past two years, our research shows.
See the chart below. The bad news: Markets tend to revert
to moving in lock step during risk-off periods. The October
sell-off proves the point. This is the tricky thing about
diversification: It often fails when you need it most.
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