News & Insight • Market Insights

10 April 2024 | Simon King

A View from The Bridge - Dancing in the Dark

Introduction

After another strong quarter for equities we thought it would be useful to talk about other areas of investment. We spoke in our last piece, which sought to identify a new normal, about the need to look at portfolio construction through a slightly different lens. We would never seek to teach our clients to suck eggs but we thought it would be useful to run through the various asset classes that are easily available to investors outside of the equities arena and remind ourselves of the pros and cons of investing in them. Many are misunderstood or are perceived to have a certain mystique and in the words of “The Boss” (Bruce Springsteen) investing in them can feel like “Dancing in the Dark.”

We do not intend to explore the extensive academic research and received wisdom on the benefits of portfolio balance and diversification but accept the principle that it is best not to have all your eggs in one basket. Even this is not an easy assumption since anyone with a 100% equity portfolio is likely to have performed very well over the past 15 years and could quite justifiably question why they would need to hold anything else. However, since we concluded in our last piece that the general economic background is likely to look quite different over the next decade, then we do believe that a balanced approach will be appropriate. In no particular order, we will discuss each potential asset class.

Fixed Interest

The traditional method of diversifying a portfolio has been to invest a certain percentage into fixed interest instruments variously known as bonds, gilts or treasuries. Initially this was focussed entirely on government issued paper but over time evolved to investing in debt issued by individual companies, collectively known as corporate debt. The traditional line of thought was that fixed interest was not correlated to equities i.e. when one went up the other went down. The reason this worked was that generally equities perform well when things are good and interest rates are high and in more difficult conditions equities struggle, interest rates go down and therefore fixed interest instruments go up. Overall, this relationship held, but after the Great Financial Crisis in 2008 and because of the artificially low interest rates that were enforced in the subsequent 15 years, both asset classes did very well. The flip side of this was that when Covid and then inflation hit the global economy, both did poorly.

This recent dislocation has led to much debate on whether traditional views on portfolio construction splits are applicable moving forward. Although this is certainly a healthy process, it is in danger of obscuring the underlying principle that investors should buy things they believe are going to go up. Remember many people bought fixed interest investments, which they knew they would lose money on when interest rates were 0% or even negative. There is a clear reason why fixed interest is attractive at the moment: yields are high and it is widely anticipated that interest rates will fall in the near future and therefore prices of fixed interest investments will rise.

We have increased exposure to fixed interest over recent months because we believe it is an attractive investment in its own right. If this thesis proves correct, then we will reassess the relative merits of the asset class and decide whether to continue to hold or divest. The decision should not be influenced by pre-determined percentages. If interest rates do not come down then, although we will not make any capital gain, we will at least have been paid a decent yield in the meantime.

Property

We have always been a little cautious on investing too much in property given the vast majority of our clients hold substantial portions of their wealth in residential property via their own homes and it is largely free from capital gains tax. The sector is also extremely sensitive to interest rate movements and the market forgot this, due to the incredibly low interest rates witnessed from 2009 to 2022. Fans of this asset class claim it is less volatile, offers dependable long-term income and if carefully selected, can produce strong capital returns. Cynics point out that its underlying assets are very illiquid ie it can take a long time to sell a property and that the level of yield required by investors is very dependent on the level of underlying interest rates. With rates at 5%+ the market says it requires at least 7% yields from property stocks and vehicles to justify the risk of investing.

We continue to be circumspect on the outlook for property, particularly in the UK where despite tight supply the market could deteriorate further if the UK were to go into recession. In addition, many property companies will need to refinance their extensive debt piles in the next two years and unless interest rates fall very quickly, they will be borrowing money at a much more costly rate. In our view, it is important to be highly selective and seek out companies with exposure to high quality tenants, some ability to raise rents in line with inflation and in classes that are not subject to oversupply. Our preference remains to be exposed to specialist areas such as supermarkets and distribution warehouses.

Gold

The Wikipedia rationale for investing in gold is as follows “Throughout history, gold has been seen as a special and valuable commodity. Today, owning gold can function as a hedge against inflation and deflation alike, as well as a good portfolio diversifier. As a global store of value, gold can also provide financial cover during geopolitical and macroeconomic uncertainty.” Effectively at a moment in history someone decided that gold was a precious commodity ie, everybody liked it and because it was rare were convinced that its value would not go down due to an oversupply. For centuries it has been regarded as a constant and formed the anchor for the Bretton Woods system of monetary management from 1945 to 1971. Governments still use it as a store of value, its supply growth remains minimal, and it has a small alternate use for industrial and jewelry purposes.

We view the main reason to invest in gold to be the fact it is a low volatility investment, which provides protection in periods of turmoil. People believe it is a safe haven asset and want to buy it when things are very uncertain. Over the long term, it should be a hedge against inflation because of its limited supply. However, it is far from perfect and in the short term can perform counter intuitively. There is always the danger of an Emperor’s New Clothes effect ie, suddenly everyone decides it is not safe and it becomes worthless. More recently, certain investors have suggested that Bitcoin is a modern and effective alternative to gold (we discuss this later in the piece). As such we do not trade our gold position and have it as a constant small insurance policy in our clients’ portfolios.

Commodities

The main reasons for investing in commodities are similar to gold, namely diversification, inflation protection and capital gains. They are rightly regarded as “real” assets in that they have their own supply and demand profile, which is the main driver of their price. The asset class contains not only hard commodities such as oils, metals and gems but also “soft” commodities like food. Unfortunately, they have tended to be viewed as a homogeneous group when in fact, their strengths and weaknesses can be vastly different. Investors today have the option to invest directly into the individual commodities themselves thanks to an array of totally respectable instruments. Alternatively, they can invest in the companies that mine and trade in the underlying assets.

Commodities in general have performed well in the past few years both absolutely and relatively. They tend to do well in periods of high inflation and ironically are often a cause of inflation in the first place eg the post Ukraine rise in oil and gas prices. Commodity shares have performed less favourably, primarily due to a rapid rise in their operating costs, which has depressed profits growth and dividend payouts. They also suffer in the short term from exceptionally long lead times on expanding output, it takes decades to identify and build a mine or an oil well. This, however, is a benefit in the long term since supply tends to be restricted and therefore the underlying price is more sensitive to increases in demand. We believe that a number of individual commodities such as copper, uranium, oil and iron ore will see consistently rising prices and view this area as highly attractive.

Hedge Funds

The original reason for setting up hedge funds was to encourage supposedly talented individual fund managers to set up without the shackles of major investment houses and to provide more consistent returns by being able to go long and short ie buying stocks they liked and selling short to produce returns when they went down. Theoretically this meant they could make money regardless of market movements and conditions. This was obviously highly attractive as a portfolio diversifier, although it still relied on the fund manager actually being able to make the right decisions. As with many other bright ideas in the finance world, it started well as it tended to attract the best fund managers, since investors were willing to pay handsomely for what were often spectacular and consistent returns.

Unfortunately, over time the market reverted to mean as a plethora of average and below average players entered the market and financial engineering took over with huge numbers of over-complex strategies developed with very mixed results. Returns deteriorated rapidly, particularly once the still high fee levels were factored in. Many hedge funds also still have extremely poor levels of disclosure i.e. it is difficult to see what is actually in them, which, coupled with the high fees in our view, make them broadly unattractive. There are still some excellent operators in this area but they are difficult to identify and even harder to access.

Private Equity

Private equity as an industry did not really get going until the early 1980s and did not evolve into a major asset class until post 2000. Its only real attraction versus other asset classes was allegedly as a diversifier. We have always been very sceptical of this claim since the industry increasingly invests in the same type of companies that are available on normal stock markets. Initially, its focus was on start-ups and high growth companies that required funding but over time the industry has moved to invest in more mature companies which require replacement rather than growth capital. The only reason in our view that private equity had a low correlation with quoted assets was because the latter are valued daily whereas the former are valued periodically.

Once again, the best returns for investors were achieved in the early days with the usual crowding out effect occurring as the industry matured. There is a perception that Private Equity are better investors than their counterparts in the quoted world. There is little evidence to support this with the main reason for outperformance being their ability to apply much higher levels of debt to their investments than would be normal in the quoted sector. We also hold the view that many Private Equity financed companies are under-invested and run for 5-year cycles rather than long term success. Hence, we are always cautious of buying companies from Private Equity sellers when they are offered at flotation or Initial Public Offering (“IPO”). As with hedge funds we find poor levels of disclosure and high fees to be a major obstacle to investment and have little exposure in this area.

Infrastructure

One of the major parts of Private Equity, Infrastructure, has effectively become an asset class in its own right, due to its size. The Private Equity industry correctly identified that large infrastructure assets such as roads, schools, hospitals, electricity networks, water systems etc, could provide very consistent and predictable cash flows over long periods of time. This was ideal for both pension funds, operating with exceptionally long timescales and Private Equity because they could load up the companies they bought with extremely high levels of debt. The core attraction was correct at the time and remains so. Unfortunately, the original concept was tinkered with over time and various scandals and disasters have occurred. Examples include the current issues in the UK water industry (poor regulatory and government control), the UK Public Finance Initiative (“PFI”) (poorly conceived at the outset) and a general movement towards higher risk assets and those with demand sensitivity (eg toll roads).

We remain broadly positive on Infrastructure as an asset class due its high levels of visibility. It has some exposure to interest rates but on a relative yield basis rather than the actual interest costs, it has to bear. However, we have been very selective when committing client funds to these areas. We have a preference for very high-quality assets, often leased to governments and offering a degree of inflation linkage. Many contracts include automatic inflation linked price mechanisms. We also believe investments providing debt to infrastructure operators are an attractive option.

Cryptocurrency

We have been cautious on cryptocurrency since its inception and in terms of its price performance we have been very wrong. The basic theoretical argument for holding it revolves around it being used to exchange value ie people trust it to be worth something tomorrow. It is also recognised as a unit of account i.e. people can see what it is worth, and it can be accepted as a medium of exchange i.e. you can use it to buy goods and services. In addition, it should be scarce with a limited or finite supply. We have long argued that it fails to meet any of these criteria. We have been wrong on store of value, although would point out that it remains incredibly volatile and trust can be rather ethereal. We continue to believe it has no fundamental value and point out that it is rarely used for purchases, due to the complexity and costs of doing so. On scarcity we acknowledge the intellectual attractions of Bitcoin and its tightly restricted future supply but highlight the fact that there are already thousands of other cryptocurrencies and we could easily start “VermeerCoin” tomorrow.

Aside from the theoretical reasons for holding, we believe that there are other forces at play. A minority of particularly early investors saw it as anti-establishment or “off-grid,” which has always perplexed us, as unless an individual lives in a 100% crypto world, they require a credit card or a bank account to invest or divest in a cryptocurrency. In addition, investors are attracted by its decentralised approach, as it may reduce the risk of systematic collapse in contrast to a bank failure or run on a currency. The problem in our view is that it makes a fundamentally inefficient solution with every task repeated by thousands of separate processors. Proponents of cryptocurrencies tend to ignore the enormous consumption of electricity to power the servers required to produce and maintain it, and its attractions for money laundering given its relative anonymity.

Given its spectacular performance it would be easy for us to admit defeat and go with the crowd but we believe in sticking to core principles and at present see no place for it in portfolios. Many investors regard it as the New Gold but it is interesting that there is no evidence of a switch out of gold in to crypto and that gold has performed well in its own right.

Growth Equities

Although the focus of this piece is on non-equity investment, we could not resist commenting on the attractions of high-quality equities over the long term. Our industry is often guilty of over-complicating matters and sometimes needs to remind itself that its role is to make money for its clients and buy things that go up. We are firm believers that over any multi-year period, quality companies will produce better total returns than most other asset classes. These can be companies of any size and in any country, although increasingly there are opportunities further up the market capitalisation range and companies operating in economies exhibiting higher levels of growth. As such, they will always form the core of our client portfolios.

Conclusion

Despite the recent strength of major equity markets, we remain of the view that growth overall will be scarcer in the next decade than it was in the previous one. As such there will be fewer opportunities to invest in growth assets. We therefore believe that having a balanced portfolio purely for the sake of balance is not an attractive proposition. Every individual asset and asset class must have the ability to produce total returns. This may be from capital appreciation, from income or from both, but it must go up. Our approach has always been bottom-up i.e. we seek out attractive individual investments and blend them together to construct portfolios that have multiple opportunities to make money. We never say we will not invest in a certain area, but we refuse to make investments purely in the name of diversification. Even within some of the areas we have discussed that we find unattractive, there will be some diamonds and it is our responsibility to find them