This is simply against the run of things – normally, bond prices rise when equities fall. The reason is simple: bonds are backed by governments and their risk is only that of interest rates, while equities must deal with risks to both their income and capital.
Changing regimes?
Since the banking crash in 2008, markets and economies have been buoyed by the flood of easy money, yet now there are ominous signs. Central banks in the US, Europe and Asia are cutting back on easy money policies, while highly leveraged commercial bond funds are still being bought as if no commercial risks exist.
Investors may believe that quantitative easing is still the preferred policy of central bankers, for economic growth is slowing around the world. But is the current risk more deflation, or instead a possible return to inflation? And how will trade wars and populist policies affect these trends?
Nothing goes up for ever, and Wall Street is approaching the end of one of its longest ever bull runs. In earlier years, this would be a signal to shift from equities to bonds. But no longer; now that central banks are players in stock markets, bonds have become as volatile as shares. What used to be known as the US Federal Reserve model of the 60:40 portfolio – split between equities and bonds – no longer works.
New opportunities
If government bonds can no longer be trusted, other methods of government financing can be. Opposition politicians may well complain of the cost of private finance initiatives, but once in office they appreciate the benefits of ‘stealth’ taxes.
Financing what used to be central government functions such as care homes, student accommodation, pipelines, fibre-optic networks and even roads and other infrastructure through private investment is more expensive, but avoids annoying voters by increasing taxes to pay for greater issuance of government bonds.
An unexpected advantage of this financing shift has been that stock markets have become central to banking stability. This was becoming apparent towards the end of the technology, media, telecoms boom at the end of the 1990s, then became accepted policy during the next financial crisis in 2008. And if equity markets are now central to banking security, governments must now stand behind them when they are faced with Minsky moments – the time when investors understand that financiers have moved from prudence to excess, and they themselves panic.
Investment professionals have moved on from a simple bond/equity split and private investors should do the same. This means identifying those investments that are not correlated to either equities or bonds, and instead offer alternative ways of buying income or capital growth.
Closed-ended opportunity
The best source for information on alternative investments is Numis Investments, although this month the Association of Investment Companies itself produced a full report on property opportunities.
The importance of these sources is simple: the majority of alternative investments are very illiquid and can only be held safely in closed-ended trusts. Open-ended funds are all too prone to suffer demands for redemption at precisely the moment when underlying investments cannot be sold.
But there is something more to investment than the metrics, or analysis of a security against its past history: the market as a whole, and its current price and dividend yield. This is the reality of the business itself – asking what competition does it face, what are the technological risks to its products and market positioning, and what changes in the social and demographic nature of its business have occurred. As Warren Buffett remarked many decades ago on his first business: “When a leader renowned for his skill comes across a business with bad economics, the business always wins.”
So investment is always more than metrics. It is also more than growth, for as Terry Smith of Fundsmith recently reported in the Financial Times, equities do not always do better than bonds; indeed the opposite!
Does CAPM work?
Hendrik Bessembinder, of Arizona State University, has recently compiled a study of S&P 500, Nasdaq and Dow Jones constituents over the past 90 years and, surprisingly, discovered that on average Treasury bills did better than equities. The main reason is that those companies that do well for investors are few and far between, and most businesses do not do well enough in terms of capital growth to make up for the compounding of the regular income from the T-bill.
Maybe the principle of the capital asset pricing model does work, but only if investors can identify the very few companies that outperform. This, then, is the appeal of hedge fund managers.
Finding good hedge fund managers is neither simple nor cheap, but there are plenty of good closed-ended fund managers with a regular history of producing T-bill like returns. The best of these do not look solely at the metrics of their would-be investments, but also the basics of the actual business. Nor do they neglect the most attractive element of an equity. As Mr Buffett has demonstrated with Berkshire Hathaway, the best way of compounding growth is not paying out dividends, but reinvesting them within the business; taxes are avoided and the full amount of cash profits are efficiently reinvested.
The least efficient is that which most investors do. Identifying high-yielding shares, taking dividends and paying taxes, then reinvesting in another company, paying yet more expenses, and hoping that the new investment is better than the old.
Companies that pay higher dividends than the market are suspicious, while those that pay less are not necessarily safer – just short of cash, and how can that be if they are profitable?
Once the basics of a profitable and secure model business are identified, then patience is needed.
If investment companies have satisfied investors for 150 years, from the days of horse transport, candles and water in buckets, to today’s WiFi, cross-ocean flights and potential self-driving cars, then they should also meet the needs of tomorrow’s most demanding investor.
