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Investment Strategy
Sunday, July 1, 2007
Keeping it simple

We might not like it, be there is no doubt our industry contains superb spin doctors, according to Alphen Asset Management’s Adrian Clayton.

Writing in its recent newsletter, Alphen Angle, he said that their most obvious weapon was their oral ability, but probably even more instrumental in their success is the opaque structure of financial services that allows financial alchemists to hide in every crevice and cranny and beguile investors.
What is becoming increasingly clear to me is that investors are finding their hard earned salaries being directed towards complex investment vehicles and I believe that the blame should not be shouldered predominantly by financial advisors. I think asset management companies and particularly the large institutions are driving this trend.
Packaging in my opinion achieves little for the client and much for the packager. Mostly, it achieves the following - more fees at different levels and products that are often difficult to exit. Packaging tends to ensure that the institution which manages a client’s money does so for longer than their mediocre performance justifies. What puzzles me is that all of us as investors remain stubbornly stupid when it comes to this trickery and this is evidenced in the explosion of monies entering the hedge fund industry as well as the private equity space.
According to Jeremy Grantham in his quarterly GMO newsletter, 15 years ago the hedge fund industry contained 800 funds with assets under management of $35 billion; this has now grown to 8 000 funds and an asset base of $1.2 trillion. He suggests that hedge funds account for as much as 50% of the turnover in US markets these days. I am not saying that hedge fund managers or private equity companies are thieves and terrible at their task, but what I am saying is that literature tends to prove rather decisively that most are not exactly whiz kids; in fact most hedge and private equity managers are decidedly average.
An excellent study undertaken by Steven N. Kaplan and Antoinette Schoar, which was completed in November 2003, noted the following about the performance of private equity operators:
On average, LBO fund returns net of fees are slightly less than those of the S&P 500. Venture capital fund returns are lower than the S&P 500 on an equal-weighted basis, but higher than the S&P on a capital weighted basis.
There is a high persistency of LBO and VC fund performance. In other words, unlike the asset management industry where asset managers go through periods of excellent and then poor performance, LBO and VC managers tend to be either consistently good at what they do or consistently bad at what they do.
Whilst these points should do enough to discourage investors from blindly exposing their capital to Leveraged Buy Out or Venture Capital vehicles without serious homework being undertaken, of even further interest should be the following. LBO and VC managers have had the benefit of introducing debt into their funds to enhance returns and have still not on average walloped the S&P in terms of total returns. Grantham refers to Kaplan and Schoar’s research that many private equity firms have leveraged their portfolios by four times, yet if one had leveraged the S&P 500 by only two times, the returns would have been 21% annualised up to 2003 versus 14% for private equity funds. The large performance difference is ascribed to the fees taken by the private equity managers of 2% on the annual capital and then 20% in terms of a performance fee. The return issue in my opinion is merely one concern, the other being the high risk taken by many of these private equity managers by gearing the portfolios, yet achieving little pay-off for investors. Investors often do not appreciate risk until a major market event results in ruptures in the private equity space as was the case in 2000.

It is worth reiterating that our Alphen Angle is not intending to attack any particular hedge fund or private equity player and is also not suggesting that many participants in these industries are not huge value adders, but it does highlight the importance of keeping investing simple.
I feel that ultimately there are four basic asset classes: cash, bonds, property and equity (both in SA and offshore). By mixing these appropriately, all investors can achieve their required risk/return goals as long as they allow for the passing of an appropriate amount of time. So you should be totally exposed to real asset classes rather than hybrid or derived structures that are generally very costly.
I conclude by highlighting the difference in performance over time between a balanced portfolio containing 50% SA equities, 20% SA bonds, 15% cash and 15% MSCI exposure charging no fees versus the same portfolio where fees are 3% (see graph).
Alphen has looked at the returns to date from January 1926. As indicated, the return difference is staggering and suggests that an asset manager has to produce incredible alpha to justify really high fee levels.
Clearly, fees need to be fair to all in the value chain, including the client and the asset manager. Managers with skill should be compensated appropriately, but investors need to be careful handing out their cash willy-nilly to money managers, particularly those that are new and untested. As an extension to this point, we feel that a large part of the high fees paid by clients is for performance, which is justified.
Unjustifiable though is performance fees driven by beta, that is, where performance fees are derived simply by the market rising and has nothing to do with the manager’s skill. Performance based on alpha generation or the skill of the manager is highly prized and clients should be happy paying for this.
Lastly, fad investing is dangerous and this includes stepping into the unsheltered waters of LBO and VC portfolios without serious due diligence. Instead, a skilled asset manager keeping things simple is likely to offer most investors the desired returns at reasonable fees. By Adrian Clayton of Alphen Asset Management

Copyright © Insurance Times and Investments® Vol:20.6 1st July, 2007
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