INDICES ARE FUNNY old things. They were originally set up to give snapshot views of how markets were performing in general but since the investment world was taken over by quants, who spread like triffids in the early 1990s, everything has had to be indexed and benchmarked.
Not that everyone complains – without the bland basis point jockeying that benchmarking generates there would be no hedge funds. Let’s face it; they are in the final analysis nothing other than total return investors that get paid huge fees for doing what portfolio managers used to do every day of the week for a salary and, if they were lucky, a bit of a bonus.
When markets are going up in leaps and bounds, for investors – the ones who own the money, not the ones who manage it for them – tracking your relative performance really is a whole lot of fun. However, when it all goes down again they don’t want to be told that the investment manager is a genius because he only lost 10% of their capital while the index was off by 11%. Then they want managers to use their brains, not their indices. It is then suddenly supposed to be all about capital preservation.
However, what if the market is going nowhere at all. Fixed income has had a stormer over the past two years but with 10-year Treasuries at 1.83%, 10-year Bunds at 1.85% and 10-year Gilts at 2.09%, there is not a lot of performance to be squeezed out of the bond portfolios, either in terms of running yield or in total return performance. If your yield is 1.83% when you buy a 10-year security, then an increase in yield of only 35bp wipes out your coupon and puts you into negative total return, that is not a whole hell of a lot of juice to play with.
I HAD LUNCH with a pension fund manager last week – he treated me to egg and chips and a cup of tea at the local transport café – who was mightily apologetic that the prospects of his buying any bonds this year were pretty slim. Why should he buy 3% bond yields when he can buy 4.5% dividend yields with the optionality included?
If liability-matching is his objective, how can I argue? This is a man who understands the concept of total return but who also knows that if the bond market goes belly-up (which neither he nor I expect in the immediate future), he will struggle to get out of anything other than Gilts. The Street has already demonstrated sufficiently how miserable a business partner it is in the credit space when clients try to sell into a falling market.
Equities markets do, irrespective of how much bondies look down on them, appear to be capable of maintaining more than just a fleeting semblance of liquidity in difficult times. Investors value this highly and it goes a long way to explaining how and why we are experiencing the shift in asset allocation away from fixed income and into equities.
Of course, equities are supposed to carry a risk premium to bonds, which are, according to one equity geek I know and with whom I had dinner the same day I had lunch with the pension chappy (I need to go on a diet) “for girls”. But this premium is shrinking as the liquidity risk is beginning to tax the conventional idea of risk differential.
Money is heading for equities as much out of frustration as out of any form of fundamental conviction
So, how much of the equity rally we are experiencing, even in Europe, which is supposed to be on the way into recession, is due to investors quitting bonds in favour of equities? On an institutional level, so far as I can tell, it is not a lot yet. But private investors are clearly on the warpath. Key 10-year government markets are not only expensive but are also clearly in negative real return territory as well.
Bond indices say nothing about the erosion of capital value and nominal returns mean nothing.
WHEN I WAS born, my grandfather put £50 in a savings account that it might grow to pay for my university education. When I finally went it was £130, which just paid for my first term’s rent. Today, that wouldn’t even buy more than a couple of weeks of a flat-share or a designer T-shirt, depending to what the student in question would ascribe higher priority.
The beauty of bonds is that one can more readily measure real returns, which is, in its own way, their downfall too. Equities are more “touchy-feely” when it comes to measuring their real performance and the jury is out as to whether they constitute a valid inflation hedge or not. However, it is better to travel in hope than to arrive and the knowledge that bond investments are, if not going backwards, certainly not going forwards is enough to drive less regimented money into shares.
Lets face it, the banking crisis was at least partly due to the mad-cap notion that risk can be modelled and boxed and that it performs to the tune of correlation theory. Bankers in pin-striped suits who weighed up whether they liked the borrower or not and who based their lending decisions on experience and sheer “nose” have been replaced by twenty-something PhDs who appear to believe that game theory and standard deviations have the same relevance to lending billions to unemployed self-certifiers as they do to picking the winner in the 3:35 at Kempton Park. I just wonder if quants getting it right is a six-sigma event too?
Meanwhile, money is heading for equities as much out of frustration as out of any form of fundamental conviction. But as Keynes reminded us, one makes money not by buying stocks that are cheap but by picking ones that are going to be popular.