The room’s getting crowded, the party’s been going on a while but more people could arrive. Just beware fair weather friends and a sign it could be time to think about leaving…
Billed as the “most pro-growth budget for a generation”, attacked with the claim the “hurting isn’t working”…
In a growth-starved environment, with inflation figures stoking fears, today’s budget was awaited in eager anticipation. Aiming to simplify our complex tax system, increase competitiveness and boost domestic industry, the politically astute rhetoric rang loud while bottom-line impacts remained mixed. Most crucially as an investor, how has the budget impacted the outlook for investment?
Growth Alone does not Drive Equity Returns
Much noise has been made over the downgrade of this year’s growth forecast (from 2.1% to 1.7%) but studies carried out to investigate a link between growth and equity returns have come back empty handed. Taking the recession during the early 1990s as an example, during its duration the UK All Share Index increased in value by more than 16%. Furthermore, as I write this article, the FTSE 100 is barely reacting.
Outlook for Stock Pickers Remains Buoyant
The government has picked certain sectors for penalty, others for promotion and the budget will impact companies in different ways. Investors and fund managers able to differentiate and exploit this will be well-placed. The following bullet points give a high level overview highlighting some of the discrepancies:
- TOBACCO duty to rise by 2% above inflation,
- BANKS to not benefit from corporate tax cuts,
- OIL companies to fund the ‘fair fuel stabiliser’,
- SMALL R&D heavy companies will benefit from a 200% tax credit this year,
- private AVIATION hit with a levy,
- home CONSTRUCTION firms to benefit from first-time buyer incentives focused on new builds
In addition, Illogical moves may reverse. Consumption remains under pressure (unemployment still near record high levels) but the outperformance of consumer discretionary over consumer staples has reached almost 50% – illogical since spend on luxury goods should be hit the most. Therefore, there are opportunities for high quality companies with pricing power and strong demand for their goods to play catch up.
Diversifying into Other Currencies Supported
In reference to the recent tsunami in Japan, the Chancellor mentioned the support the UK has provided and, in doing so, confirmed the UK’s aim of building foreign asset reserves. With countries artificially pushing the value of their currencies down (read: Brazil’s $40bn intervention last year and Chile’s $12bn this year) and others keeping theirs low (read: China’s RMB believed to be 40% undervalued), the upside potential when this eventually ends is great. Stan Fischer, the Governor of the Bank of Israel revealed they “are diversifying into currencies which (they) would never have put in the reserves before”, supported by the Governor of the Bank of Canada with his belief that we will see a “multi-polar” system. Watching sterling’s moves today, the currency is off slightly against the dollar but the real moves will be versus emerging market currencies and over the longer term. Following the lead of Central Banks ‘spreading their wealth’, this form of diversification may be prudent.
Promotion of Alternative Schemes
The tax relief on EIS (Enterprise Investment Schemes) and VCT (Venture Capital Trust) investment will be increased from 20% to 30% next year, offering a substantial opportunity for tax efficient investing. More interesting and less noted is the move to allow larger companies to be eligible for the scheme. This has been claimed to reduce risk. To this, a footnote should be added. Lower risk opportunities may be available but the same level of due diligence is required.
Finally, although not strictly an investment, giving to charity now has financial benefits in addition to goodwill. Those who donate may be granted a 10% discount in their inheritance tax bill. Looks like the government may be targeting not just our wallets but our souls.
World unity is the wish of the hopeful, the goal of the idealist and the dream of the romantic. Yet it is folly to the realist and a lie to the innocent – Don Williams, Jr (American , b.1968)
There has been much in the news lately on the outlook for the European Union. In May, Greece was offered €120bn in EU government and IMF loans over 3 years to replace the need for new borrowing at exorbitant market rates – the “first bailout of a Eurozone country and the biggest bailout of any country”. Just last month Ireland joined the queue and received a €85bn injection plan. The flame of contagion was burning bright as investors worried Spain, Portugal and Italy were to follow suit quickly (The other members of the PIIGS acronym – and we’ve been advised what risks lie in an acronym!). Then just as markets calmed after the ECB staged their largest intervention and purchased mainly Portuguese and Irish bonds on Friday, the rating agency Moody’s announced it was downgrading Hungary’s debt by not one but two notches! This country isn’t even in the periphery of the EU, it’s outside of it entirely… and so the contagion spreads….
Why won’t the EU bailouts solve everything?
1. FLAWED LOGIC: attempting to solve the problem of debt with more debt
2. NOT SOLVING PROBLEM: without growth, the debt burden as a share of GDP will continue to rise. The latest European Financial Mechanism only covers maters until 2013, if Debt/GDP has not reduced significantly then bond holders start sharing the pain
3. UNCERTAINTY: ministers keep changing their minds! (“no bail out” to “bailout”, “no pain for creditors” to “sharing the burden”) – markets don’t like uncertainty!
The key discrepancy –
What the ECB wants EU countries to do: Be prepared to increase the size of emergency bailouts, consolidate budgets and reform (implement austerity measures and assume national responsibility so the ECB can avoid being a bailout tool)
What EU country economies need: COMPETITIVENESS AND GROWTH
- YIELDS may have fallen sharply for some periphery debt but as the chart before shows, they remain at elevated levels.
- FORCED SELLING – Pension funds, insurance cos and ETFs which are focused on matching the liabilities to their assets may have to sell certain debt when its credit rating is cut
How can you exploit this?
“Europe is difficult to understand for markets. They work in an irrational way sometimes,” Christine Lagarde, French economy minister
- Companies located in an EU periphery country, with strong balance sheets and demand insulated from worries about their homeland (i.e. international exposure and demand for their products from the east etc) making it a sound investment choice, may suffer from illogical moves in the markets that punish anything connected to the country regardless. This debt can be picked up cheaply.
- In addition, a downgrade in a country’s government debt may trigger a wave of forced sellers (the pension funds etc. mentioned above) that are restricted in holding this level of debt. If this is just an automatic trade, these distressed sellers may be exploited with the purchasing power in your hands…
“We will never have all the facts to make a perfect judgement, but with the aid of basic experience we must leap bravely into the future” – Russell R McIntyre
Click to listen to a ~1 minute clip of my views from the “N@ked Short Club”, Resonance Fm… The main points are highlighted below.
CONTEXT – A MARKET TREND
- 1w late May this year ~60% of trades on NYSE were down to high frequency and algorithmic traders
- Beginning of this month the ISE announced: opening up to algorithmic trading
- Result – will account for an increasing share of trading volumes on EM exchanges & beyond
ASSESSING THE DISTINCTION – Algo trading vs. judgement driven
- Humans are responsible for writing the code that identifies anomalies in stock prices
- Based on assumptions about what a hypothetical efficient market should look like
- Still at risk of errors – bugs in these systems – Flash Crash – May 6, 2010 when the markets crashed by 573bps in 5mins (a large order by broker via algo program was identified as the probable tipping point) but recovered fairly quickly- CFTC*/SEC says that early sell pressure was absorbed by algorithmic and high frequency traders – evidence of adding significant liquidity – beneficial (*Commodity futures trading commission)
AT RISK OF TRADING RESTRICTIONS? JUST THE REVERSE!
- The SEC is considering a requirement that high-frequency traders keep buying and selling shares during periods of stress, instead of abandoning the market.
BOTTOM LINE – Judgment driven strategies retain their use.
- NOT ENOUGH TO MAKE MARKET EFFICIENT – still opportunities / inefficiencies to exploit.
- TRENDS BREAKDOWN – when do – it’s opportunistic players w uncorrelated returns that save a portfolio.
- UNCERTAIN TIMES – the flexible players willing to adapt to their judgment calls benefit
“How often misused words generate misleading thoughts.” Herbert Spencer (British social Philosopher, 1820-1903)
When it comes to discussing hedge funds, the quote above rings true. Mis-sold and mis-understood, investors have been left disillusioned. Marketed as being able to generate “absolute returns” in all environments, and tarred allwith the same brush in a “one size fits all” sell, appropriateness was often overlooked. All the catchy phrases and vague promises have mis-managed investor expectation and clients spoke with their feet. As we look to the future, with the next generation of “more highly regulated funds”, we must be wary to not fall foul of over-promising and under-delivering…
1. “Shorts” as a means of risk-reduction to balance “long” exposure vs. ability of funds to be hurt on both the long and short side together due to e.g. unexpected deal surprises. For example, in late October 2008 hedge funds lost £18bn in two days of trading due to a costly short call. Managers had bet on VW shares falling because of the global economic downturn but once Porsche revealed they had been secretly building their stake to a controlling share, they scrambled to cover their positions.
2. “If so-and-so are investing, then sufficient due diligence must have been carried out”. Just take the Madoff ponzi scheme – half of UBP’s 22 fund of funds invested, HSBC provided finance to clients who invested, many successful individuals invested large amounts…. It comes back to the basic tenet – “Never invest in a business you cannot understand “ (Buffett)
3. “If I get nervous, I can always take my money out”. Following on from point 2, without investigating a fund – the liquidity of its underlying investments, the commitment of major shareholders etc., many were shocked when fund of funds, in particular, implemented side-pockets and gates to limit the amount a client could redeem.
4. “Larger funds are always safer” In actual fact it was many of the larger funds that found it hard to meet redemptions – needing to liquidate a larger amount in the market and slower to implement changes in strategy as markets sold off back in 08. Instead it was the smaller, more nimble players that were able to adapt quicker to navigate the markets better, and able to meet redemption requests more easily and avoid having to implement side-pockets or gates.
5. “Paying an extra layer of fees is worth the diversification benefits of a fund of funds investment” – although still true in some instances, many fund of funds are merely “best of breed” funds with less emphasis on portfolio construction and therefore less of an uncorrelated nature. In addition, those that paid less attention to the liquidity of their underlying funds were squeezed when these funds gated whilst they were receiving redemption calls.
What can we do with this information?
1. More accurately assess the risk profile of a hedge fund investment, size and position allocations accordingly
2. Ensure a full due diligence process has been carried out
3. Assess the liquidity of the assets the fund is investing in and interview large fund shareholders – a managed account is not always necessary, the emphasis should be on appropriateness – daily liquidity is suitable for a large-cap global equity fund but a more private equity-type fund could suffer from too much focus on managing flows than managing the money itself.
4. Look for the sweet spot that exists at the point when a fund’s running costs are comfortably covered and there are low operational concerns, whilst the manager still has the hunger to perform before becoming complacent and managing more than he is best at handling.
5. Watch the correlation of the fund to other parts of your portfolio and to the managers within the same asset class to ensure sufficient diversification benefits – mitigating some of the volatility for steadier returns.
MANAGE CLIENT EXPECTATIONS
“We cannot forget how in 1997-98 American hedge funds destroyed the economies of poor countries by manipulating their national currencies.” – Dr. Mahathir Bin Mohamad, (former Prime Minister of Malaysia, during the emerging market crisis).
The Hedge Fund industry has come under major scrutiny in the past few years. Blamed for stock market crashes, manipulating the markets and threatened with a ban on short selling, if a scapegoat was needed, they were ‘shortly’ targeted (!). Chargers of high fees and notoriously opaque – people naturally fear the unknown, and an expensive unknown even more so. Nevertheless, as Richard Wilson pointed out in his blog – back in 2007 the head of the Financial Services Authority (FSA) said that:
“hedge funds were not the catalysts or drivers of (that) summer’s events.”
Hedge funds trading in the financial markets can increase liquidity and aid price formation. Jed Emerson wrote a great piece at the end of last year taking he argument away from a debate between “good” and “evil” and instead concluding:
“fundamental fund of hedge fund investment strategies, when managed appropriately, may represent an emerging though as yet not realised opportunity for investors to pursue both full, commercial rate returns and affirm relevant aspects of Sustainable investment practice.”
Although I question the assertion the fund of hedge funds industry is emerging – since in some cases it seems to be retracting, I agree they offer an opportunity for returns and the claim of affirming sustainable investment practice balances the opposition’s argument.
What seems to be a rarely discussed topic is the value the industry provides the wider economy, outside the financial markets. Below I highlight some impressive information, sourced from a great article by Open Europe….
BOTTOM LINE: Job and tax contributions should not be under-estimated.
Benefits of PE / HF Industry to EU Economy
- Contributed ~ €9 billion (£7.9 billion) in tax revenues in 2008 – could fund the EU’s overseas aid budget for twelve years, or the regional budget for Poland,
- Directly employ 40,000 people in the EU – 18,000 of whom are employed in the UK (before taking those involved in real estate funds or dependent on the industry)
Benefits to UK Economy
- €6.1 / £5.3 billion tax income raised in the UK alone
- Enough to pay for over 200,000 nurses or 165,000 teachers.
- Tax revenues generated over 2 years could pay for the entire 2012 London Olympics.
- If the revenues were lost, would take 20% increase in av. council tax bill to make up