There was a time when David Swansen was every investor’s hero. Under his stewardship the Yale University endowment fund outperformed pretty much every other fund in the world between 1985 and 2008 and became the subject of a million business school seminars in the process.
How? He put very little of the university’s money into the bond market (a mere 4 per cent) and placed an unconventionally low amount into equities (about 27 per cent). The rest went into hedge funds, private equity and what he calls real assets (think actual oil fields, commodities timber and real estate). The genius in this, said his legions of starry-eyed fans, was the fact that the low correlations between the various asset classes allowed him to make supercharged returns on a regular basis. Note the use of the past tense. In is last fiscal year the Yale endowment posted a loss of nearly 25 per cent thanks to its losses on, well, on pretty much everything. The real assets part of the portfolio fell 34 per cent. The private equity holdings lost 24 per cent and the marketable securities bit (stocks and bonds) lost 13 per cent. Harvard, which runs a similar sort of strategy, lost around 27 per cent on its investments over the same period.
It turns out that the so-called Yale strategy didn’t always offer much in the way of diversification after all. Instead it offered lots of different ways to bet on low interest rates – rates that made money cheap and all the assets you can buy with cheaply borrowed money expensive. It made a lot of money during the credit bubble years not because it was particularly clever (although it could, of course, be explained in such a way that it sounded particularly clever) but because all asset classes were booming (or bubbling) at once. This is something today’s investors should probably be bearing in mind. Why? Because those asset classes are at it again. The FTSE just had its best ever quarter – up 20 per cent. The Dow is near 10,000 again. Brazilian stocks have gained 60 per cent so far this year. Commodities are booming, with oil back knocking around $70, sugar at a thirty-year high and my personal favourite for everything, gold, back above $1,000. Even the hedge funds are back in business: the Morningstar 1000 Hedge Fund Index was up 1.6 per cent in August and 13.7 per cent for the year to the end of August. And most amazingly of all, house prices in the US and the UK are edging back up. You might think this is all good news and in a way it is, in that making some of their money back makes everyone feel better.
But it isn’t particularly healthy, or normal for that matter, for all asset classes to rise as one. It suggests that instead of things moving on their merits – because there are fundamental reasons why they should – they are all moving as part of one great big government stimuli and liquidity fuelled bubble. Which of course they are. I’ve heard some complaining lately that post crash it has been tougher for private investors to get into the likes of hedge funds and private equity than it once was. But even if true that shouldn’t make much difference to most of us. If you want to make the same kind of returns as the average hedge fund all you have to do is take out a personal loan and bet the money on the UK stock market. Or on the gold price. Or a couple of Falkland Island oil prospectors. Or perhaps on the prices of 2-bedroom flats in Clapham. Whatever. In the short term they’re all going up. As one of the Morningstar hedge fund analysts put it last month, “many hedge funds claim to be uncorrelated to the market, but it appears that the rising tide has lifted all boats.”
The big problem with this is exactly as it was in 2007: just as the same thing (easy money) is driving the rise in asset classes so the same thing (the end of easy money) will drive their next collapse. And that, says CLSA’s Christopher Wood, might be closer than the bulls like to think. The more markets rally “the more policymakers will be tempted to take the view that life is back to ‘normal’ and that policy can, therefore, return to ‘normal’.” At that point markets will “freak out:” they know that without quantitative easing, without abnormally low interest rates and without a constant flow of “cash for clunkers” style consumer incentives, their recent revival hasn’t a chance of hanging on. The point is this: when markets turn all asset classes will fall together. There will be no non-correlated assets for Yale followers to cling to.
So how can an investor diversify in this kind of market? The most obvious way is just to hold a certain amount of cash – the returns on which, while minimal, really aren’t much correlated with the returns on, say, the biotech sector. In times like this it is a sort of anti asset class and at least if you cover yourself by having a reasonable amount of it you won’t end up like Yale which is currently “accelerating budget cuts.”
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