Appendix F

Asset classes left out of the rational portfolio

The marginal case for commercial property

Despite the questionable history of great returns in residential property and its presence in many portfolios through home ownership, general property investing has been a thriving investment for some over the years and an integral part of many diversified portfolios. While there is good evidence that the return profile for commercial property has been attractive in the past, to my knowledge there hasn’t been a global diversified investable property index like there is in the stock markets with the MSCI World index and others. As an example, the FTSE EPRA/NAREIT Global index was not launched until 2009 and even while there is global data going further back, it is less clear how a globally diversified property investment product would have fared.

Proponents of property investment suggest that it is a separate asset class with limited correlation with equity and other markets. (Although only tracking residential property, the correlation between the Dow Jones Industrial Average and the Case-Shiller index since 1900 is only 0.19.) Limited correlation with other asset classes is obviously a good thing and if this low correlation is replicated in future then commercial property investment could provide a good diversifier (although virtually all publicly traded property investments suffered in 2008 along with the rest of the market, suggesting low correlation is not universally the case). With low correlation you don’t need that high a return expectation for a property investment to make sense and investing in a diversified global portfolio of property investments would also add geographic diversification.

But despite the promisingly low correlation and apparent good historical performance of commercial property generally, the FTSE NAREIT index mentioned above represents quoted underlying property investment companies with a market capitalisation that represents only 1–2% of the global equity market’s total market capitalisation.¹ At the time of writing, the largest constituent in the index has a market value of around $50 billion and the entire index of around 400 constituents spread around the world has a value of about $900 billion, or not much above the market value of a couple of leading individual companies. So while small in the context of the overall equity markets, the global real estate index provides the kind of good and well-diversified property exposure an investor should want, if you consider property a separate and attractive asset class that you want to allocate more to, and you can’t find a broad and representative (and cheap) property investment fund.

But also consider that investors in equities are already directly and indirectly significantly exposed to the property sector on top of home ownership. A major constituent of equity markets everywhere is financial institutions, including banks. Those banks obviously serve many functions, but a key one is the provision or facilitation of capital for the property markets. The banks do this both in the form of residential property markets, but also by financing and investing in commercial property. Even in the cases where the banks only act as a facilitator and pass on the principal risks to other investors (as opposed to other cases where banks hold on to a property investment), they still have a huge interest in a positive property market.

The bursting of the US sub-prime market bubble in 2007–08 and the subsequent default of many geared products connected to it was one of the primary drivers of the financial crisis. So even if the direct representation of property investment companies represents a fairly small portion of the overall stock market, we have indirect exposure to property through many other sectors of the stock markets. In addition to the banks, the listing of many large infrastructure and construction-related companies further adds to our indirect exposure to the property market because corporations in a wide variety of industries already are the largest holders of commercial property.²

Some might disagree with me for leaving out property investments and I can appreciate why. But I would encourage you to ask yourself ‘am I in a position where the probably small benefits from including commercial property in my portfolio is worth the added complexity and cost?’ For 95%+ of the readers I suspect the answer is a resounding no.

For those investors who wish to add an investment in property, I would recommend you invest in low-fee and geographically-diversified property investment companies. A good option is publicly traded REITs (Real Estate Investment Trusts). REITs have a favourable tax treatment, particularly for US investors, and distribute most of the income from their diverse set of underlying property holdings (often mainly commercial, like offices and retail, but also warehouses, apartment buildings, hospitals, etc.).

If you do go ahead with adding property investments to your portfolio then consider the following:

• Invest broadly geographically and cheaply – there are some good global property ETFs (including one from iShares) that track the FTSE NAREIT Global index, some broadly diversified and cheap property funds, or similar.
• Avoid concentrating in countries that you as an investor are already exposed to via your non-portfolio assets.
• Be clever about tax (REITs are tax-exempt from certain taxes); tax advantages could favour a larger allocation to property investments for some investors.
• When you consider adding property investments to the portfolio think hard about the exposure you already have to property, both indirectly via securities in your portfolio, but also potentially via your home or other assets.

Private equity, venture capital and hedge funds

I used to run a hedge fund in London and wrote a book about my experiences, Money Mavericks: Confessions of a Hedge Fund Manager (FT Publishing International, 2012), and still sit on the board of a couple of hedge funds. Also, earlier in my career, I worked at a private equity fund called Permira Advisors.

Private equity, venture capital and hedge funds (I will refer to them as alternative investments) do not belong in the rational portfolio.

All the alternative investment vehicles claim an edge in the market. They are essentially saying, ‘Give your money to us and we will provide you with a superior return profile.’ Time will tell if they are right or not, but by selecting them you are essentially saying that you yourself have an edge, not because you can make all the underlying investments yourself, but because you know someone who can, namely the manager of the alternative fund.

The perception of the alternative funds is often shaped by a couple of well-documented success stories. When John Paulson made billions for himself and his investors in 2008 from betting on a collapsing sub-prime housing market it was the kind of investment everyone wished that they had in their portfolio. Or when Sequoia Capital partners tell you that they have backed Apple, Cisco, Google, and other names you know well, the question almost turns into, ‘How can you not invest money in alternative funds?’

In many ways, the logic behind picking an alternative investment is like that of picking an active manager. You do it because you think someone is able to perform well when investing your money. While you may acknowledge that you can’t do so yourself, being able to pick an investment manager who can consistently outperform would be an incredibly valuable tool. But like stock picking it is a rare skill. Someone whose job it is to select alternative managers may say something like ‘the East Coast biotech sector will massively outperform over the next decade’, ‘I think convertible arb will be resurrected’, or ‘John Doe fund manager is just brilliant’. Rightly or not, these are not the kinds of statements an investor without an edge can or should make. Particularly when you consider that the liquidity of your investment in alternative funds can be so poor that you may not get your money back for years, the need for an edge and superior returns is further increased.

Fees are very high

Besides the fact that investing in alternatives suggests a claim of having an ‘indirect’ edge on the part of the investor, the funds are also typically very expensive.

Many alternatives charge an annual management fee of 1.5–2% in addition to a 20% share of all profits above a certain hurdle rate, plus other expenses. While hedge funds in particular, at times with great justification, claim that the return profile they create is very different from one you can get through the markets, the aggregate fees mean that only the best-performing funds will be worth their fees. And therefore only those who have an ability to consistently select the best funds should invest in these alternatives. Most people simply do not have this ability.

To get an idea of the magnitude of fees consider Warren Buffett, one of the most successful investors over the past generation. If Buffett’s fee structure had been that of a hedge fund instead of an insurance company the return to the investors would have looked very different (see Figure F.1).

To illustrate the cumulative impact of fees, consider the example of a pensioner who invests money into a hedge fund through the normal route of a pension provider, via a fund of fund, with all the aggregate fees and expenses. Suppose further that the hedge fund made a return of 10% in a year, before any fees or expenses, and that it was a typical long/short fund with normal trading. What would be left for the pensioner once all the finance people had taken their bites? (See Table F.1.)

Figure F.1 $100 invested with Buffett versus one with an ‘alternative’ fee structure

Based on data from Berkshire Hathaway, www.Berkshirehathaway.com

Table F.1 What’s left?

‘Gross’ gross performance		10.00%
Hedge fund	Fee:	Net of:
HF trading expenses	1.50%	8.50%
Standard quoted gross performance		8.50%
HF fund expenses	0.20%	8.30%
HF management fee	1.50%	6.80%
HF incentive fee	20.00%	5.44%
Fund of funds
FoF expenses	0.15%	5.29%
FoF management fee	0.75%	4.54%
FoF incentive fee	10.00%	4.09%
Pension fund
PF external adviser	0.15%	3.94%
PF fees and expenses	0.75%	3.19%
Net return		3.19%

This is, of course, before we have even asked how the hedge fund made its 10%. Was it because it simply had market exposure as it went up or was it all unique value added that could not be achieved elsewhere? If it was mainly because of markets going up, our pensioner has paid a shocking level of aggregate fees for exposure to the markets.

I’m not just picking on hedge funds: private equity and some structured products have as much to answer for. Despite similar fees they are unapologetically long the market often in a geared way: investors could do much better themselves through leveraged index trackers, and an investment in private equity is typically very illiquid. Be sure you get paid for the investment being illiquid, and that you don’t pay to be long the market – you can do that much more cheaply with an index tracker.

This is not to say that alternatives never make sense but rather that the high fees mean that the bar is very high indeed.

Alternative funds often argue that they provide investors with access to a different part of the economy (like a venture fund finding the next Facebook) or returns that are uncorrelated to the markets (like market neutral hedge funds). And they are sometimes right. Some alternative funds will undoubtedly do extremely well in future both in terms of providing investors with a unique exposure or just great returns, but the challenge is to select which one. Studies suggest that past performance is a poor guide to future returns so that doesn’t help us. (That would almost have been too easy – just pick the past winners and away you go!)

In addition to staying away from alternatives because picking the right alternative manager suggests an edge, many investors already have a lot of the same exposure that alternatives give, for all its high fees. The correlation between the returns of alternatives and the stock markets is quite high as the alternative funds often invest in assets similar to those represented by the stock markets. (Venture funds would argue that they invest in companies too small for stock exchanges, but they are still exposed to the same economy and exits often involve sales to large companies or initial public offerings (IPOs).) It is not arbitrary that 2008 was the worst year in the history of the alternative industry. In the rational portfolio you have many of the same exposures you would have as an investor in alternatives, but at about one-twentieth of the fees.

Commodities

Before the 2008–09 crash, certain commodities performed very well and often became an integral part of well-diversified investment portfolios. While gold and oil perhaps dominated the broader media picture there were also other success stories.

Until fairly recently it was very hard for most investors to buy commodities. Unless you were an institutional investor set up to take possession of the physical commodities or trade the futures contracts it was a cumbersome process to gain direct exposure to the commodities. This difficulty has greatly been reduced over the past decades. Today there are ETFs available on a wide range of commodities and gaining the exposure is therefore as simple as buying a share in the ETF of your choice. Some of the most popular commodity ETFs are the gold ones, but there is a wide range of other commodities also available in addition to some that track broad-based commodity indices.

The economics of commodities are different from that of equities or bonds. To physically hold commodities we may actually incur a cost instead of necessarily expecting our ownership of them to generate cash in the future. There are storage and insurance costs to holding commodities. Furthermore, commodities are not income generating: the cost of extracting the commodity may change and the usefulness of that commodity in the production of goods may change, but nothing suggests that this will be consistently positive.

Although the costs of commodity trading for most investors have come down greatly it remains an expensive proposition for most. Even if we hold a commodity such as gold through an ETF we are still indirectly subject to the same storage and insurance costs, in addition to management and trading costs. Also, unless it is our profession to trade specific commodities there is a great chance that we are at a significant information disadvantage. If you trade oil and do so while working at Shell or BP there is a reasonable chance that you have an information edge compared to someone in their pyjamas trading on their computer at home. Make sure you are not in the latter group.

Financial investors in commodities mainly invest through futures. The futures market for all sorts of things is many centuries old, but the first organised exchange was created in Japan in the 1700s. This was so that samurais who were paid in rice at a future date could lock in the value they received. We can buy or sell a future on cocoa, grain, oil or whatever for months hence and avoid the issue of storage, delivery, etc. The price of the future will depend on the expectation of the future price of the commodity and the interest rate we can earn on the money in the interim. The futures contracts are settled through an exchange that ensures payment on expiry so that we don’t have to worry about the person or company we are buying our future from or selling it to.

But like the other asset classes we have discussed in this appendix, the main issue with trading commodities is the absence of an edge. Do you really have the knowledge or advantage in the market to profit from trading commodities? Chances are that you don’t unless you work in commodities and trade them for a living. If you don’t, don’t trade commodities.

As with property or alternatives, you already have a lot of commodity exposure through your portfolio of listed stocks. In the world stock market index are many mining or oil-related companies with large underlying direct exposures to commodities, and adding commodities to the portfolio would lead you to double up on the exposure. For example, if you were to buy oil in addition to owning it via all the oil companies in your equity index you would be adding to an already large exposure to that commodity, but it’s often hard to figure out exactly how much hedging commodity-related companies do themselves and what your indirect exposure to commodities from owning shares in a company therefore is.

Returns from commodities

Perhaps we could turn the question on its head and ask which commodities you would want to buy exactly and why you want to deselect others. If you buy cocoa beans, then why not wheat? If you buy copper, then why not iron scraps? Those that pick the individual commodities clearly claim an edge.

Investors in commodities claim that lack of correlation with the equity markets makes commodities attractive. One of the oldest commodity indices is the CRB Commodity index which tracks the performance of 22 commodities and first started tracking in 1957. Figure F.2 shows the 12-month trailing correlation with the S&P 500 since inception.

As can be seen from the chart, commodities do indeed exhibit low correlation with the equity market, 2008 being a notable exception when they plummeted with equities. (The index was down 36% in 2008, rendering it a terrible hedge.)

Figure F.2 Trailing 12-month correlation between S&P 500 and CRB Commodity Index

But should we expect to make money from commodities?

Spanning only a couple of decades, the organised price history³ of commodities is probably too short to be meaningful but Figure F.3 shows a chart of the CRB Total Return index⁴ – this index was not created until the early 1980s – compared to an investment in US short-term bonds. This index does not include the implementation cost which I have included at 0.5% a year for the commodity index, more or less in line with some current ETF costs.

It is not surprising that many advisers advocated investments in commodities until the crash of 2008. In the preceding decade, commodities had performed strongly with a history of low correlation to the equity markets.

But you can’t get rich on low correlation; you need income and commodities are not income generating. Over the longer run, commodities trail the minimal risk rate of return and there is no reason to think that they exceed it consistently in the future. Because of that, and because you already have a lot of the same exposure through the existing portfolio, you should not include commodities in your rational portfolio.

Figure F.3 Commodity index versus short-term US government debt

Gold as a special case?

Gold has of course been a very public success story with the price per ounce around $1,200, up from around $40 in the early 1970s when the US abandoned the gold standard. Gold does not have as much production use as some other metals and commodities, other than as jewellery and to some extent in electronics, but it has always been seen as a great preserver of value in times of distress.

If you want to avoid risk you should buy more of the minimal risk asset, and not buy gold. Gold is certainly not a low-risk asset – it is in fact very volatile in value. What attracts people to holding gold is the perception that it tends to move up in value when markets go down. It is therefore considered a hedge to the stock market or general economic/political turmoil.

I would caution you against viewing gold holdings as a hedge against stock market declines. If the stock market and the price of gold really moved in opposite directions (they do not – see Figure F.4) and you had equal amounts invested in both, then in an economic decline you would make as much from the rise of gold as you would from the decline of the stock markets, and vice versa when markets were good. The only difference is that you would have paid expenses on your gold holdings as well as minor ones on your equity holdings. In that case you would have minimised your risk, but also your profits, and still be left with your expenses. Instead of having equity and gold exposures off-setting each other, you would have been better off just buying minimal risk bonds.

Figure F.4 Trailing 12-month correlation between S&P 500 and gold price

While the price of gold will continue to be volatile and perhaps even go up, as with the case of other commodities there is nothing intrinsic to suggest that gold as an investment will do better than the minimal risk rate, so I would suggest that you keep it out of your rational portfolio.