Clockwise - The "M" shaped cycle

Renewed euro stress brought forward a peak in growth. We are overweight bonds. With policy makers facing high thresholds to action things are likely to get worse before they get better. This month’s Hot Topic looks at some of the puzzles investors encounter when including less liquid assets in a portfolio.

Politics and a Premature Downturn
Political instability inGreeceand a relapse in the euro crisis brought on an earlier than expected peak in the global growth cycle. The subsequent plunge in commodity prices has caused inflation pressures to evaporate, moving the Investment Clock rapidly into the Reflation phase. Central banks are likely to ease monetary policy and there are encouraging steps towards burden-sharing in the euro area. However, it could still take several months before the conditions for a new recovery are in place.

Dealing with Short, “m” Shaped Cycles
The post-financial crisis world is one of short, “m” shaped economic cycles. A fragile and over-indebted financial system means downturns come on suddenly. Recoveries are equally abrupt as policy makers respond to market stress, but they fade as soon as stimulus ends. This environment poses serious challenges. Diversification across asset classes is more important than ever and strategic benchmarks should include safe haven or uncorrelated investments, like high quality sovereign bonds and gold. The wide dispersion of returns offers fertile ground for tactical asset allocation but practitioners need to ensure their decisions extend beyond the binary call on risk.

Overweight bonds and property
We moved bonds overweight during the month of May by reducing our exposure to stocks and commodities. However, we remain positive on global property and our portfolios are still overweightUSequities relative to those in the euro area. These tactical positions have been paying off irrespective of the risk on/risk off backdrop.

Hot Topic: Less Liquid Asset Classes – A Question of Measurement?
Many less liquid asset classes appear to offer a fantastic risk-return trade off but investors should be aware that things that seem too good to be true often are.

Defensive Positioning as Growth Slows
We traded to an underweight position in risk assets in our multi asset funds during the month of May. The high showing for an anti-austerity party in the first round ofGreece’s general election set off an intensification of the euro crisis. This brought forward a peak in global growth we expected to see around mid year when the Fed’s Operation Twist program was scheduled to end.

Our global growth scorecard is weakening on the back of falls in business confidence, economist GDP downgrades and a rolling over of the OECD’s lead indicators. The good news is that the inflation scorecard has moved sharply negative in line with the collapse in oil prices. This means our Investment Clock model is moving into bond-friendly Reflation, with the absence of inflation risks clearing the way for a wide range of central banks to ease policy. However, we are concerned investors may be too optimistic on the degree of ease that will come in the near term, particularly in the US where economic data is only just starting to weaken. High thresholds to action by policy makers suggest things may have to get worse before they get better and it could still take several months before the conditions for a new recovery are in place.

Short Cycles, High Thresholds
The post-financial crisis period is one of short “m” shaped cycles. The four mini-cycles since 2007 have seen upswings averaging a below par six months and downswings nine. Recoveries have been driven by policy ease, fading as soon as stimulus ends.

High thresholds to action exacerbate both the intensity of downturns and the abruptness of recoveries. InEurope, political leaders are faced with opposition both to austerity and to bail outs.

The June summit was positive as euro level capital injections into banks should weaken the negative feedback loop for peripheral sovereigns. However, political risks remain high with the link between austerity, unemployment and asset price declines intact. Stress is likely to intensify again unless global growth picks up.

Markets have high hopes of quantitative ease from the Fed but we see high thresholds to action here too. Unconventional ease comes in large multi-month programs, not easily reversed.

With stock prices near cycle highs, the Fed will want to keep its powder dry. In recent years, we’ve needed to see long term inflation expectations break to the downside and equity market volatility spike before they have eased with any force.

Polarised Correlations: Friend or Foe?
The 2008 Lehman failure marked a regime shift in correlations. Short liquidity-driven cycles have seen all economically sensitive assets move in step with stocks, posing some serious challenges to asset allocators. From a strategic point of view, we are dealing with this environment by designing multi asset benchmarks that include safe haven and uncorrelated investments, like high quality sovereign bonds and gold.
A wide dispersion of returns offers fertile ground to add value through tactical asset allocation but we are making sure our decisions extend beyond what has become an almost binary call on risk.
Global property remains our favourite asset class despite the move to overweight bonds. The resilience of property is supported by a progressive easing in US credit conditions since 2008.
Likewise, differences between the equity regions operate over a longer time horizon than the risk on/risk off swings. We have been underweight European equities since the financial crisis began in 2007. We prefer theUSmarket on the back of a superior economic performance we expect to continue.

Illiquid Assets in a Portfolio Context: A Question of Measurement?
The inclusion of less liquid assets in a portfolio raises some interesting intellectual challenges which we approach in a spirit of common sense and pragmatism.

Beyond Valuation
There are several different ways that we can value an asset. We can estimate its cashflows over time and discount them using an appropriate cost of capital or by some other modelling process. With some assets such as an antique or jewellery, we might turn to an expert appraiser who will tell us the value. With some we can look to markets to see what value is placed on the asset when it is traded. However, when we are trying to decide if including a given asset in a portfolio will help us to meet an investor's goals, it is not the value alone that we are interested in; rather the way that the value changes over time and the way the value changes relative to other assets in the portfolio.

We need to pay attention to characteristics such as volatility and the potential for drawdown in order to model the distribution of returns of our new asset. If we understand the distribution of the returns of all of the assets in our portfolio and the way that they move together (covariance), we are a long way down the path of being able to estimate the characteristics of our overall portfolio.

The Two Faces of Real Estate
Real estate provides a good example of the challenges we face when investing in less liquid asset classes in a portfolio context. The basic real estate model is pretty simple: you give me some money, I buy some buildings, I manage the estate, I keep the buildings in good repair and ensure the tenants are of suitable quality. The estate raises rental revenue which I pass onto you, after deducting my management fee. Over time the returns that you experience are a combination of the net rental income together with any change in capital value of the estate. The question is, how do I model the behaviour of this investment within my portfolio? Does property provide diversification against my equities and bonds?

In the case of real estate, I can get exposure to the asset class in two different ways which at first glace seem to offer two different answers to these questions. I can buy a non-quoted real estate fund. Alternatively, I can buy a quoted Real Estate Investment Trust (REIT). On a look-through basis both vehicles are the same in terms of their economics: there are underlying buildings, tenants, rents and management fees which give me income and a change in capital values over time. The way that the returns are printed for each vehicle is very different. For the non-quoted property fund the buildings will have been valued on site by a surveyor, perhaps once a year. In between times if a valuation is required, perhaps for a fund NAV, this is provided from the desk. For the REIT the returns are very simply what we observe, as the stock is traded tick by tick on the stock exchange. So the same economic model, but two very different methods of price discovery.

Unsurprisingly, the two return streams look very different. The non-quoted fund has very low volatility: the Investment Property Database index in theUK, for example, has a volatility of about 5%. In fact prior to 2008, the volatility was just 3% and the index had not had a single month of negative return since the early 1990s. There is typically a bid/ask spread on these sorts of funds, around 7% is not uncommon, reflecting the costs of transacting in property markets and protecting long term investors from dilution by flows. In contrast, the transaction costs for REITs are just what you’d incur on any traded equity security but the volatility is of the order of 20%, broadly in line with stock market volatility.

More significantly REITs saw drawdowns of 35% or so between 2000 and 2003, considerably more in 2008, and have had a relatively high correlation to equities. What we observe on exchange, is that the value that market participants ascribe to the underlying assets in the REIT fluctuate in line with sentiment and can trade to a large discount or premium over “fair value”.

If I am trying to model the behaviour of real estate in my portfolio, what values should I use for volatility and correlation? Is it low volatility/low correlation or high volatility/high correlation? This question applies equally to other assets or disciplines that have been put into a closed ended fund that is then quoted.

Advantages and Drawbacks of Quoted Vehicles
The practice of taking illiquid assets and putting them into a closed ended fund creates three sorts of opportunities for investors.  First, it provides a method of accessing assets such as
Catastrophe Bonds or deeply illiquid credit that might be otherwise inaccessible. Secondly, recognising that the price will swing away to discount may enable us to buy those assets cheaply. Thirdly, the market provides us with liquidity should our investment horizon not match that of the underlying assets: the alternative of trying to provide frequent liquidity directly into portfolios of illiquid assets has been tried, and often ended in disappointment. What we need to be aware of as investors, however, is that the increased convenience of a quoted vehicle comes at the cost of higher realised volatility than that indicated by the underlying assets when valued off-market.

Is Private Equity a Measurement Question?
On discovering how non-quoted property funds are valued, an equity portfolio manager might be tempted to think that if his or her portfolio was only a given a full valuation once a year, equity would be an asset class that had very low volatility and seldom declined in value. A cynic might suggest that this is exactly what happens in the world of private equity. At first sight it is hard to work out how it is possible to buy assets out of the stock market at a premium, increase the indebtedness of these companies and create a vehicle that has lower volatility than conventional equity. We understand the higher return. If I leverage my stock portfolio I should expect a higher return. But it’s hard to see where the reduction in volatility comes from.

Private equity did not have a great Financial Crisis.  Along with most leveraged investments there was stress, and if cash needed to be raised, transactions took place at fire sale prices. The question about whether Private Equity is a distinct asset class has been hotly debated. A number of quant papers in the various academic journals have suggested that in aggregate the returns to private equity investors can be cheaply replicated by leverage and a handful of sector swaps.

Modelling a Mixed Liquidity Portfolio
So returning to the portfolio modelling context, how can we deal with assets such as real estate or private equity that don’t have a regular or direct market valuation? In answering this, there are two questions one should ask. One is about the underlying nature of the assets, the other is about timescale. If I look through the wrapper of private equity, I can see that I hold stakes in companies, so the underlying risk premium I am exposed to is the equity risk premium. From experience I know that the price of that risk premium is considerable volatility. I may wish to bump up the return for reasons of stock selection and leverage but it is hard to argue that you can access the Equity Risk Premium (or the risk premia accruing to other asset classes) in a non-volatile fashion in normal timescales.

Which brings us to the point about timescale. If you have a genuinely long term horizon and certainty that there will be no cash calls on the portfolio then maybe it is appropriate to model the characteristics of the wrapper rather than the underlying assets. However, many investors have found to their cost that they did not have that certainty: the time when we need to tap portfolios for liquidity is often when markets are under stress and we are least able to get a “fair” price for the assets we are selling. Portfolios of illiquid assets can also be highly stressed by currency hedges. Many illiquid strategies failed in 2008 not because of external cash calls but because the underlying strategies used USD instruments but the portfolio was hedged back to GBP or EUR. The strong dollar meant there were cash calls on hedges which could only be met by the fire sale of assets.

Common Sense as a Cross Check
There is a certain purity in the notion that the only true price is the price at which a transaction takes place. Where we have portfolios of illiquid assets and we can see that transactions are taking place at levels below the asset NAV in the portfolio, this is a big red flag. If we wish to estimate the potential for drawdown, the behaviour of related traded assets is often the best guide.

For portfolio risk return characteristics, common sense is the best defence. The efficient frontier is a somewhat abstract concept and at any point in time we don’t know exactly where it is. However, if we see an asset that appears to lie way above our perception of the efficient frontier on the return axis – or way below on the risk side – it is worth asking whether we have collected the right data, or alternatively whether we are accurately measuring the risk.

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