Every investment age has its fads and the big one of the last few years has been “alternative investments” – any investments that aren’t equities, bonds or cash. The pull here is that you can somehow use alternatives in the form of hedge funds, private equity, property, commodities and so on, to get the kind of constant above-average returns that you just can’t get from traditional assets.
Property and commodities, for example, have been sold to us on the back of the claim that they will diversify a long-term portfolio and hedge funds on the basis that they are capable of making absolute positive returns regardless of the state of the wider market. But is all this true?
The jury is out on commodities as a diversifier for this cycle (anything you might have lost on the wider equity markets you’ll have more than made back on the oil price this year). But property isn’t putting on much of a showing either – residential and commercial prices have fallen along with equity prices in the last few months.
So what of private equity, which boasts it can make money even in an environment where others can’t? Look at the state of private-equity giant Blackstone and the boast rings hollow – its share price has halved since its initial public offering, not helped by a $251m first-quarter loss. Worse, a recent survey by Greenwich Associates reveals that only 22% of Europe’s largest firms now believe private equity has a “constructive role to play”.
Things don’t look so good in hedge-fund land either. The MSCI Hedge Invest Index shows the sector as a whole down 2.78% over the last 12 months and 3.24% so far this year. Even relatively diversified “fund of funds” are down 2.9% on average so far this year, according to French business school EDHEC. So what’s going wrong for these darlings of the “alternatives” sector?
Private equity: how it all went wrong
Private-equity firms make a living by buying up and transforming companies they see as inefficient. But the firms they buy are now being buffeted by the same malign economic headwinds (such as slower sales growth and higher input costs) as everyone else. Being owned by private equity doesn’t make a firm immune to slowdown, something that makes a nonsense of the idea that private-equity returns are uncorrelated to equity market returns.
Indeed, there’s a case to be made to suggest that when things are bad for the rest of the economy they can be even worse for private equity. This is partly because the methods private-equity firms use to ‘improve’ the firms they buy – slashing overheads and selling off prize assets – don’t always leave them operationally well placed for recession.
That’s fine if they can be sold on in a hurry, but not when – as now – they can’t. In bad times, leverage (private equity’s main weapon) can also turn against it. Consider a private firm with net assets of £100m, owned 100% by its shareholders. On the assumption that it now manages to grow by 10% a year for three years, the net assets will grow to about £133m (100m x 1.1 x 1.1 x 1.1) – a decent 33% total return for investors. If instead net assets fall 30% over the three years, they’ll have lost 30% of their investment.
Now assume the same firm was bought by a private-equity group three years ago for the same £100m using £70m of debt, with a post-tax cost of 5% per annum, and £30m of equity. Should the net assets grow to the same £133m after five years, all is well, since the debt, now £81m (70m x 1.05 x 1.05 x 1.05), could all be repaid, leaving £52m for the private-equity owners, a return of 73% on their original £30m.
However, should it all go wrong and the net assets fall, rather than rise by, say, 30% over the three years, there would only be sufficient assets remaining (£100m x 0.7) to pay off the original £70m debt. The result? The private-equity investors have lost their entire initial £30m stake.
The great hedge-fund myth
The statistics appear to show that most hedge funds (there are always exceptions) can’t make absolute returns in bad markets. Instead, just like conventional funds – with equity, property and bonds markets all sagging – they’re finding it hard to make any money at all.
Their problems are compounded by their sheer numbers. With around 10,000 of them all using similar investment strategies, the market anomalies they once found so lucrative disappear faster than ever.
The disappearance of cheap credit hasn’t helped either: it isn’t hard to outperform conventional funds in a rising market when you can goose your returns with millions in borrowed money. It is when you can’t. It’s not surprising that this industry, once awash in profits is, as Barron’s puts it, “in a funk”.
This is not to say we’re against all hedge funds – we aren’t. There’s always something that works. Right now, it is the ‘macro’ hedge funds – those seeking to profit from market moves caused by global political and economic events. On average, this type of fund has beaten the S&P 500 by 17% this year. The best one? Tim Price of PHP Group tips BH Macro (LSE:BHMG).