We have received several questions from our clients regarding the attractiveness of many alternative investments and private equity funds. Usually the sales pitch for those types of products revolves around the apparently lower volatility that they offer with similar return prospects or the higher and steady income stream they can offer compared to the measly one offered by traditional fixed income instruments. Are these claims legitimate or have the salesmen purposely left out some of the less apparent risks inherent in these kinds of investments?
- Liquidity: when one invests in stocks or bonds, these instruments are traded on a daily basis on recognized exchanges or through proprietary trading desks. One can see their market value whereas in many cases, private equities and alternative investment funds invest in assets that do not trade on any exchange. The latter are evaluated using mathematical models so the fund managers can come up with a theoretical market value. Unfortunately these models tend to be out of whack under unusual market conditions. The resulting effect is an illusion of liquidity during normal circumstances until the market conditions are under stress and liquidity disappears and investors are no longer able to sell and/or redeem their investments. The Asset-Backed Commercial Paper (ABCP) crisis is one prime example of this lack of liquidity that ended up costing la Caisse de Dépôt billions of dollars when marked to market in 2007. Worse, some speculators might just come in and low-bid for the assets in the funds, knowing the managers will have to sell to meet redemption, requests which effectively lock in a permanent loss for the funds.
- Volatility: when prices change, academics define it as volatility. Unfortunately, they also define it as a measure of risk. Since the assets inside private equity and alternative investment funds tend to not trade on any exchange, there is no price transparency. It is easy to reflect constant prices week in and week out on assets that have no transparent market until one wants to actually sell. In the meantime, no price change means no volatility; i.e. no implied risk… As an example, some real estate funds come to mind. Buildings are evaluated annually. However, it sometimes takes a while to sell a property and the price might be very different from the appraisal value, especially when the funds are forced to sell.
- Priority in the capital structure: lots of investors are attracted by the higher income stream coming from some alternative investment funds. The extremely low interest rate environment has made some of these funds quite popular. We simply would like to caution investors that in finance, it is important to pay attention to companies’ capital structure, especially when things don’t go well: in case of liquidation, bonds and debentures rank ahead of preferred equity and preferred equity ranks ahead of common equity. Lots of alternative investments are more equity-like than fixed-income like. The fact that it pays 5% does not make it a fixed income instrument. Think of Real Estate Investment Trusts (REITs) and income trusts as examples. They are actually equities and in many cases, they are returning your capital and not income that may have been earned in the funds. It also means that when things go awry, they will rank behind the bonds and creditors in terms of claims on the assets of the company.
We believe that private equity and alternative investment funds are designed for institutional and pension funds with a much longer time horizon. Moreover, they have much more analytical resources to determine the pros and cons of these types of investments within their mandate. As for the average investor, the risks are not worth the rewards.
As we approach the 30th anniversary of the biggest one-day crash in the history of the stock market (does anyone remember October 19th, 1987?), many will no doubt warn of the likelihood of another crash, citing reasons such as overvaluation, length of the current bull market, social inequality, over-indebted societies and more. To put it in perspective, the same magnitude of drop would mean the Dow Jones would shave off more than 5100 points in one day (no longer probable because of market ‘circuit breakers’). So do not be surprised that some would use the anniversary of 1987’s crash to warn of another one.
The good news is…
- Although we have had the second longest bull market in history, the market’s valuation still seems quite reasonable relative to the level of interest rates;
- Researchers are unable to find any correlation between bull market length or high valuation and the probability of a crash;
- The economy seems to be chugging along quite nicely worldwide;
- Despite the tightening monetary policy at the Fed in the US, central banks worldwide are still rather expansionary, printing quite a bit of money…
Meanwhile, the more worrisome news is…
- Crashes are inevitable over time. They occur when many large institutional investors decide to get out of stocks more or less in unison. Judging by the many flash crashes that have happened in different parts of the financial markets, we are kidding ourselves if we believe that regulators and exchanges can institute systems that can prevent these from happening;
- With the ever-rising popularity of computer-driven trading, indexing and exchange-traded funds, the chances are more of these flash crashes will happen in the future. In fact, there are more ETFs listed on exchanges than there are public companies right now. Herd mentality combined with lack of liquidity do make markets more crash-prone;
- Interest rates have been moving up, albeit from very low levels. If rates are to rise significantly, stock valuations will not look as reasonable at some point. As a simplistic example, a 10-year treasury bond trading at 2% yield basically reflects, in terms of P/E, a ratio of 50x (100 divided by 2) earnings. That makes the SP500 reasonable at 22x earnings. If rates are to move up to 5%, that will reflect a P/E of 20x. The current level on the SP500 will not look as attractive then…
The good news again…
- At Claret, we have always believed that investment in stocks is about the long term: our philosophy revolves around finding companies that are profitable, well managed and if the prices are right, buying them and keeping them indefinitely. Consequently, flash crashes or big crashes should be viewed as wonderful opportunities to buy great companies at bargain prices;
- We also believe that with new technologies, despite some short-term dislocation, the economy becomes more efficient and people become more productive. Markets will go higher to reflect these economic advancements.
The Claret Team