Investors today are getting used to life in a low-return world. No matter where you look, the picture in stock markets is much the same: after climbing strongly in the first few years from the lows of the 2008-09 financial crisis, markets’ momentum more recently has faded away. Now we seem to be wading through financial treacle. Much of the time, share prices plod along without going anywhere very much, until a squall blows up and markets temporarily tumble before picking themselves up and resuming their desultory trudge towards the horizon.
It’s a situation that has foxed even the canniest operators. Recent returns from many hedge funds have been so poor that one prominent manager, Dan Loeb of the US fund Third Point, suggested that the supposed superstars of the investment world were in “the first innings of a washout.” Leading UK manager Crispin Odey saw more than four years of gains in his flagship hedge fund wiped out by the market turbulence in the first quarter of this year. Events like this speak volumes: in their attempts to shine in this low-return environment investors feel compelled to take big, risky bets that leave them hugely exposed should things not pan out as hoped.
Discretion may be the better part of valour, but these days it brings scant reward—accepting that you cannot pick winners and simply tracking an index has not been a particularly profitable pursuit either. The FTSE All Share index, the broadest measure of the UK’s equity markets, is little changed from its level in early 2013; the S&P 500 index of the largest US companies has been flat for the past year and a half; the FTSE Eurofirst300 index came to life at the beginning of 2015 but has now subsided and is back to levels last seen more than two years ago; Japan’s Nikkei has also sagged badly as faith in the country’s ability to achieve a final escape from deflation has waned. Of course, these figures take no account of dividend income but here also growth is stalling: for 2016 Capita is forecasting the first overall decline in UK dividend payouts since 2010.
Numerous reasons are offered for the becalmed state of the major financial markets. Perhaps aging populations, a declining pool of workers and high household debts are sapping our ability to create robust growth. Maybe share prices are struggling because companies do not believe that demand for their products and services is going to grow and so they are refusing to invest. This will reduce their ability to increase profits in future and so keep a lid on their share prices. Perhaps everyone is gradually concluding that central banks’ ability to prop up our economies is running out and so they would rather keep their capital safe than risk it in search of profit.
Whatever the rationale, a lot of capital is being hoarded in bonds issued by governments in the US, Europe or Japan. And if equity markets are meandering across a plateau littered with occasional potholes, bond markets have climbed to an altitude where the air—and the returns—are dangerously thin.
Owning a 10-year UK government bond, or gilt, will now bring you an annual yield before inflation of around 1.4 per cent—knock off 0.3 per cent for inflation and that’s just over 1 per cent a year in “real terms” for the next decade. Investors who own the 4.25 per cent Treasury Gilt 2046 are currently lending money to the government for the next 30 years at around 2.25 per cent per year—1.95 per cent after inflation. Either people believe inflation is as good as dead or they are knowingly accepting the risk of big capital losses when it does eventually make a return. As inflation rises, investors demand higher yields on their bond holdings to make up for its effect. In order for a bond’s yield to rise, its price has to fall (they always move in opposite directions) so if you’re buying even super-safe gilts at their current yields, you run a very significant risk of losing money. First, if the gilt price falls and you need to sell before the bond matures, you may well get back less than you paid even after taking interest income into account. Second, even if you hold the gilt all the way to maturity you can still lose money because higher inflation will transform your “real return” from slightly positive to negative. When the best result you can hope for in a decade’s time is a return of around 1 per cent a year in real terms, the balance of risk and reward looks distinctly unfriendly.
It is hardly surprising that the difficulty of finding investments offering a decent return and acceptable levels of risk has prompted a lot of investors, both big and small, to look beyond mainstream markets to so-called alternative assets. These span a wide spectrum from commercial property, infrastructure (power grids, roads, schools, hospitals, dams etc) and private equity funds at the more traditional end, all the way to funds that target niches such as renewable energy, specialist lending to businesses (such as funding for private equity buy-outs, commercial mortgages, equipment leasing, or peer-to-peer loans), forestry, litigation funding, farmland and on to fields such as fine wines, classic cars, art and other collectibles such as stamps and coins.
"Either people believe inflation is as good as dead or they are knowingly accepting the risk of big capital losses when it does eventually make a return"In some cases, these niche alternative assets offer far higher income yields that investors can obtain from mainstream bonds and deposits, albeit with corresponding risks to their capital and rather less liquidity than mainstream shares and bonds (meaning that it may be hard to sell quickly and you may need to accept a discount to do so). Other alternatives are more focused on creating medium and long-term capital growth that does not depend directly on the level of equity and bond markets. The opportunity to diversify one’s risks across asset classes that are not closely correlated with the major financial markets is another of the welcome attributes of these alternative asset classes.
However, these are often pretty specialist investments and it generally makes sense therefore to access them via dedicated funds run by managers well-versed in their idiosyncrasies. Alternative investments have emerged as one of the financial world’s major trends over the past few years as investors big and small have diverted a steadily increasing percentage of their capital in this direction in search of higher income, new sources of capital growth and extra diversification. If today’s very low yields on long-term government bonds are any guide, it looks as though they will continue seeking those precious attributes among the alternative asset classes for a long time to come.
