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Where to now?

The last few months have seen a sustained flight into cash by those charged with managing the money invested by family offices.

That is hardly surprising given the ongoing turmoil in financial markets when the concept of a reasonably safe, steady investment hardly seems to exist. Today volatility is the norm wherever one looks. Even traditional safe havens can no longer be trusted. Even gold, the traditional safe haven in troubled times, has been swinging like the proverbial yo-yo. Now well off the record $1,030.80 an ounce it hit in March 2008 experts are divided on whether it will regain that lofty height or fall back beneath $900.
David Buik, partner at the international money broker BGC Partners who has worked in financial markets for 46 years, sums it up: "It is quite simply unprecedented. I have never seen anything like it. The very fact that we are seeing bank shares moving by double digits in a day shows just how uncertain things are. Just look at GE. To see a company like that lose 16 per cent in one day and get it all back the next says it all really. The only day on which I have seen volatility like this was September 12 2001. And that was only on that one day."

Hardly surprising, then, that people have turned to cash. The problem is that doing this is not something that can be recommended for anything much longer than the short term given the low returns the asset offers at the very best of times. And now is anything but the best of times with interest rates hitting record lows around the world as central banks resort to desperate measures in a bid to stave off the threat of a dangerous deflationary spiral like that which has strangled the Japanese economy for years.

Philip Shaw, chief economist at Investec, the Anglo South African bank, understands the dilemma. "The only obvious other alternative short term haven is government bonds," he says. "The problem is if you risk getting a zero redemption yield because of the expectation that more will be issued, forcing yields to rise. This makes it a risky time to buy."

Shaw says there are, however, some short term measures that can at least be taken to protect the value of one's assets. "The one thing that could be considered when looking at cash is moving up the yield curve. Short term rates are close to zero but that is not the case for longer term deposits.

"In the current climate banks are keen on longer term funding and they are often offering substantially better rates for longer term deposits. Take the UK. The official base rate is 0.5 per cent but the one month LIBOR rate is 1.18 per cent and the three month rate is 1.84 per cent. That pick up is primarily due to the increased liquidity premium you get for longer term deposits. It is because banks are basically looking to lock in longer term funding."

Shaw also suggests that corporate bonds can provide an alternative to government bonds, with careful selection. "They are currently offering greater yields than those available in the Government markets and there are some solid corporate names out there that are offering attractive returns. Of course, the difficulty is that you may think that what looks good now could be even better in two to three months' time. The corporate bond markets are also suffering from a lack of liquidity and spreads are quite wide, therefore your exit costs may be large."

Commodities, of course, have always been an option but if avoiding volatility is the aim, then steer well clear. If the volatility in the equity markets is extreme, the commodity markets have become a white knuckle ride suitable only for those with the very strongest of constitutions.

But Shaw says Investec, at least, sees some hope for equities: "There is definitely value there. What the equity markets are pricing in at the moment is an extreme view of how bad things could become. This being the case, our view is that stocks should rally before the end of the year but, of course, there is significant uncertainty."

The corporate bond market has also caught the attention of Bill Dinning, head of strategy at Aegon Asset Management, the fund management arm of multi-national financial group Aegon.
Mr Dinning says the yields available on high grade corporate bonds – and the spreads above Government bonds – suggest that the market is pricing in a 1930s style great depression rather than simply a deep recession.

That thought is enough to make anyone shudder. But given that such a disaster is being priced into the product corporate debt, says Dinning, represents superb value, particularly if the dire predictions fail to come to pass.

"Companies seeking new debt have been forced to pay a heavy price because the market is pricing in a great depression. There is an argument that it is right on this, but it is not one we agree with," he explains.

"If this is a serious recession and not a depression the yields are attractive. New issues from investment grade companies are coming with significant spreads over government bonds, which means the yields are very attractive and enough to compensate for the risks."

Dinning says Aegon has been investing heavily in these bonds on behalf of its pension fund clients.

Phyllis Reed, global head of fixed income research at Kleinwort Benson, the private bank, also sees value in corporate debt although she cautions that investors are going to need strong stomachs in the months to come.

"In terms of spreads towards the end of last year what we have seen represents something beyond the valuation levels during the great depression," she says.

Figures show that US and Euro high yield prices predict in 53 per cent and 65 per cent default rates over 5 years assuming zero recovery. However, only 45 per cent of high yield companies defaulted over 5 years at the peak of the depression, albeit in a very different market. At the investment grade level the market is predicting default rates of 30 per cent (US) and 22 per cent (Euro) with zero recovery.

Reed says: "The prices suggest default rates well in excess of what we have seen in the past assuming very low recovery. Valuations undoubtedly look attractive but the problem is we are just working through the worst part of the cycle and investors are going to have to go through some difficult times. Default rates are likely to hit record level and you have to be very selective."

However, returns from cash have shrunk to almost nothing and ultimately, as she says: "Investors are going to have to take some form of risk to get returns this year."

The dash for cash has been joined by many family offices in recent months but there is one factor that has held back the tide. Many of those who invested in hedge funds during the past few years have found themselves caught in the midst of a nasty liquidity crunch, stranded in funds they are unable to redeem.

The liquidity crunch was created by the credit crunch and the resulting savage economic turmoil that stripped the Midas touch for many a manager's fingers and left their investors in limbo.
Are there any options other than toughing it out available for those family offices left in this unfortunate position. And would toughing it out be such a bad thing to do?

Will Maydon, a director of Campion Capital, which advises a number of family offices on hedge funds, explains: "The hedge fund story is not over yet. If you look at recent history, hedge funds had a good month in January and they were flat in February. Equities fell 15 per cent. Investors can be very fickle and if there are a few more positive months they way people look at things will change.

"Yes 2008 will be seen as a special year for all the wrong reasons given that the average fund was down 18 per cent but there are a number of institutional investors who are relatively sanguine."

However, Maydon accepts liquidity has become an issue – for all sorts of reasons and not just performance. The blowout in private equity, for example, is resulting in a number of investors facing substantial cash calls. Big, liquid funds investing in big liquid markets such as managed futures, for example, are feeling the pinch even though the performance of the best have been stellar.

What of those, however, who are invested in funds in a very different position? They do have the option of utilising a secondary market in hedge funds that enables those who are stuck to sell their holdings on to others. But they will have to face up to selling their holdings at a discount, and maybe a substantial one.

Hedgebay is, as one might guess from the name and its similarity to a certain ultra popular auction site, provides a secondary market in hedge fund holdings. Founded in 1999 it has been responsible for sourcing and executing billions of dollars of transactions by matching sophisticated buyers with sellers in this sort of illiquid security.

Clients include fund of funds, banks, pension funds, endowments and family offices with fees standing at around 1 per cent post completion. The only downside of the approach is that securities that were fetching premiums less than 12 months ago are now being punished with substantial discounts.

Elias Tueta, Co-founder of Hedgebay says trading volumes doubled from 2007 to 2008 and trade has been brisk over the past quarter. Customer numbers have also increased as the secondary market has become a more common place tool for hedge fund investors in their search for liquidity.

"All in all, customers, volumes and the amounts being traded have all increased significantly since 2007 and this growth is unlikely to slow down through the first half of 2009," he says.

However, discounts are now the rule – more than 70 per cent of trading on Hedgebay in 2008 was conducted at a discount to NAV compared to just 8 per cent of trading in 2003. Indeed, trading at a discount has been rising steadily rising to 15 per cent in 2004, 20 per cent in 2005, 39 per cent in 2006 and 57 per cent in 2007.

Maydon says: "Hedgebay does provide an option for those who want to get out and are prepared to trade. But in general I would say that the hedge fund model is not broken. Not by a long shot."

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