What we can learn from the super-rich

The very wealthy have been sold a big lie and are buying into shoddy funds. Don’t make the same mistake they do, says David C Stevenson.

I imagine that some of you are fairly, or even very, comfortably off. But I think it’s probably safe to assume that most of you don’t fall into the category of ‘super-rich’.

Like me, you’ll probably be trying to work out how to achieve what sometimes seems like the impossible – preserving your capital and producing some capital gains. You might also quietly envy the fact that the super-rich have legions of overpaid advisers to help them navigate this conundrum.

Well, I’ve got some good news for you. The super-wealthy are in fact at a disadvantage to you, because most of their advisers have been taken in by a whopping great lie. Talk to as many wealth advisers as I have and you’ll know that many are obsessed with alternative assets.

This doesn’t mean investing in stuff like farmland or commodities (although a few do). It means pumping your rich clients’ money into hedge funds and private-equity outfits, making the managers of these funds astonishingly wealthy in the process.

The secret? To sell rich people the idea that there is a huge range of alternative financial strategies out there that can make money in all markets – and then to bundle these strategies into easily accessed funds – so-called ‘liquid alternatives’.

Not every hedge fund or private-equity outfit is a complete waste of money – I’ll look at the few good options in a moment. But by and large, the quest for ‘alternative alpha’ is a fool’s errand. It’s not just me who thinks so. The good folk at US asset-management giant Vanguard have examined the hard data on these ‘liquid alternative’ funds.

According to Vanguard, these funds “seek to generate returns using complex, non-traditional methods”, and are often sold as ways to diversify a portfolio. What they have in common is that they “can bet against traditional capital markets, use investments outside those markets, and/or tactically move within and across markets”.

These ‘alternative assets’ funds are capturing an ever-larger share of investor money. According to Vanguard, in the US they have bagged 70% of cash flows and 68% of new product launches since 2009.

Yet, this popularity comes at a high cost to investors – many alternative fund managers charge their customers anything between 0.5% and 1% more in fees than traditional funds, as shown in the chart below from Vanguard.

Yet, most super-wealthy investors don’t seem to mind the high fees – they’ll happily pay extra as long as they get positive, diversified returns out of it.

The trouble is, they don’t. Vanguard built a portfolio that reallocates 10% of its total holdings (compared to a global 60% stocks/40% bonds portfolio) to each and every ‘liquid alternative’ strategy – with 5% coming from equity and 5% from fixed income.

The results? Strategies designed for crashing markets – ‘bear market’ funds – “added the most during the financial crisis”, but went on to underperform badly.

Beyond that, other strategies “had a marginal impact… but certainly not one that would meaningfully alter an investor’s savings needs or spending ability for the better”.

In short, ‘liquid alternatives’ are not worth the bother. If you want to protect your capital in a downturn, invest in cash and fixed-income bonds. But if you want the upside that tends to emerge after such crises, stick with core equity funds and make your life less complicated.

That said – while my overall view on hedge funds is negative, there are some with unimpeachable track records.

Most are closed, or only open to the über-rich. But some of these funds have listed on the stockmarket in closed-end (investment trust) format – they’re after the long-term permanent capital that comes with a London or New York listing. This means you can get access to a handful of managers who have decent, and in some cases excellent, track records.

I’ve looked at data from analysts at Numis on this sector and three funds stand out: the Brevan Howard Credit Catalysts fund (LSE: BHCG); Third Point Offshore (LSE: TPOU), run by the inimitable Dan Loeb out of New York, and the Boussard & Gavaudan fund (LSE: BGHL), listed originally on Euronext but also trading on the London exchange.

All three have delivered real value to their investors over the last few years, although the costs are mind-boggling – according to Numis, after performance fees Brevan Howard Credit Catalysts charges 5.7%, Boussard & Gavaudan 4.8% and Third Point Offshore a whopping 8.8%. Yet, these funds might be worth it if they continue delivering on their very varied investment strategies.

Liquid alternatives funds chart

Shares to ride the China bull

I just want to make a quick observation on China. If you’re a regular reader, you’ll know that I’ve been suggesting for a while that an upturn might be coming for Chinese shares. Valuations are low and sentiment is finally starting to turn, helped along by a slightly more positive attitude towards emerging-market equities in general.

What we’ve been missing is a clear and obvious catalyst for share prices – a new development that would get the bulls’ hearts racing again. The good news is that we may be fast approaching that catalyst, if a recent note from ETF Securities (ETFS) is right.

Last week, the strategists at ETFS highlighted a slightly obscure development called the Shanghai-Hong Kong Connect, which is expected to arrive in October.

According to ETFS, the “initiative will open up access to the Shanghai stockmarket for foreign investors trading through Hong Kong. Systems testing for the initiative will start at the end of this month. We believe that the manner in which the quotas are applied will drive net flows into the mainland.”

According to ETFS, dual-listed stocks trade at an 8% discount on the A-shares market, compared to the more accessible H-share market.

“The introduction of the Shanghai-Hong Kong Connect should see that discount dissipate over time,” reckons ETFS, which would be good news for already cheap A-shares, where the prospective price/earnings (p/e) ratio now stands at 10.2, a massive 63% below its peak in 2007.

The ETFS analysts argue that it’s “not often that the stockmarket of one of the world’s largest and fastest growing economies is trading at one of the world’s lowest valuations. The imminent implementation of the Shanghai-Hong Kong Connect programme should help to speed the process of valuation normalisation”.

By my reckoning, there are currently four China A-share trackers on the London market – ETF Securities’ own ETFS E-Fund MSCI China A (LSE: CASH) exchange-traded fund (ETF), which is on a total expense ratio (TER – annual cost) of 0.88%.

There’s also one from Source, which tracks the CSOP FTSE China A50 (LSE: CHNA). It charges a TER of 0.99%. The Lyxor CSI 300 A-Share ETF (LSE: CSIA), on a TER of 0.4%, is another option, and last but not least is the Deutsche Bank db x-Trackers Harvest CSI 300 ETF (LSE: ASHR) on a TER of 0.5%.