investment diversification, Merryn Somerset Webb

The only worthwhile way to diversify

20.08.2007

by Merryn Somerset Webb

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FOR investors, one of the big themes of the past few years has been diversification. Awed by the well-publicised success of Yale University’s money manager, David Swensen, who has returned an average of 16%-17% per annum every year since 1987, institutional investors around the world have concluded that his strategy is the best ever.

So they have taken large parts of their cash out of straight equity funds and, just like Swensen, they’ve poured it into “alternative investments” instead ? hedge funds, venture capital, private equity, commodities and property.

This has worked brilliantly for the past five years or so: equities have done well; global property has done brilliantly, as have most commodities; and hedge funds and private equity, turbo-charged with cheap credit, have regularly delivered splendid returns.

Cue much back-patting and smug mutterings about a new world for investors where everyone can outperform in the good times but is also so nicely diversified across the asset classes that they won’t suffer much in the bad times.

I have never been convinced by this one. Last year I wrote a column here pointing out that this strategy of diversification actually offered no such thing in today’s financial environment. Most assets classes have long been driven forward by the same thing - low interest rates and the huge availability of cheap credit.

When that stops, I said, investors are very likely to find that instead of holding lots of things that are going up in value at the same time ? and feeling clever - they are holding lots of things of questionable value that are all going down in value at the same time - and feeling a bit silly.
And that, it seems, is exactly what is happening. The credit-market mess has not just hit the credit-related part of diversified portfolios. No, it has hit the hedge-fund bit, the private-equity bit and the equity bit too.

Morgan Stanley Capital International’s World index is now down more than 10% from its highs, making this officially a global equity-market correction, and the hedge-fund industry, which was heavily exposed to the bad mortgage debt in the US that kicked off the whole crisis, is seeing some nasty high-profile blow-ups.

The Japanese stock market is down about 11% from its high this year, but some major Japanese hedge funds are more like 30% down. Call that diversification?

The same is true of funds operating in all other markets. We have not had the same kind of dramatic evidence yet of problems in private equity, but it is obvious that a business that relies entirely on cheap money for its balance-sheet alchemy is going to be badly hit.

Most studies done in Britain and America into private equity have shown that long-term returns are much the same as those from the stock market, just with less liquidity and higher fees. That’s something I think we are about to see demonstrated again.

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Finally the other favourite of the diversifiers, property. Property prices go up when people find it easy to borrow. They stop going up when they do not. Something to bear in mind if you are about to sign on the dotted line for a house in any of the UK’s bubbly areas, or borrow £2 billion to build a new office block in the City.

So what next? Last week I said that if there was any value about, it was in the big, listed blue chips that have been unfairly caught up in the market’s crossfire.

The key point with these is that the credit bubble never did much for them (they have not needed to borrow money, so its cheapness has been of no relevance, and being too big to buy they have not seen their share prices pushed up by the private-equity excitement) so its collapse probably won’t hurt them either.

They will also get a boost from the end of the diversification boom. Who is going to buy a hedge fund now? My guess is that much of the money that had been earmarked for alternative investments will soon find its way back into straightforward, long-only equity funds, and from there into the likes of Shell and Xstrata.

That said, I wouldn’t rush to join it too fast. This is not over yet. It will be months before the confusion clears and we know which risky assets are worthless and who has them - you usually have to give several months’ notice to get your money out of a hedge fund, for example, so assuming everyone is making their calls now they won’t know the worst for a while.
It is also likely that the market will start to worry that the fallout from the crisis will hit both corporate earnings and the US economy (which it already has).

Many of the bullish arguments doing the rounds at the moment rely on the idea that economic fundamentals are fine.

Two of America’s biggest retailers, Home Depot and Wal-Mart, have warned that sales are being affected by consumer indebtedness. The chief executive of Wal-Mart pointed out that it was hardly a secret that many Americans were short of money at the end of every month and that, presumably as a direct result of this, shoplifting from his stores was rising. Consumer spending is, it seems, under threat. And that means the earnings of companies that rely on it are also under threat.

Ted Scott of the F&C UK Growth and Income Fund, pointed out this week - as the FTSE 100 crashed back through the 6,000 level - that this was just as true in the UK as in the US. Here 70% of gross domestic product is down to consumption, so as tightening credit - and perhaps falling house prices - start to affect confidence, growth and earnings will fall. It is also worth remembering that Asian growth is still very much dependent on exports to the US and Europe, so as our growth goes, so might theirs.
For now, if you are thinking of diversifying why not do so in a new and exciting way - into cash.

First published in The Sunday Times 19/8/07