Investments we'll never wear again

PORTFOLIO POINT: They seem like a good idea at the time, but some investment ideas are best forgotten.

Sometimes it’s just as important to know how not to invest. Recent sharemarket instability has stress-tested investment theories, often to the point of failure. So below I have compiled a list of suspect investment theories, and the strategies or products based on them. Academics tell us they need at least 30 years of history to prove or disprove a hypothesis; until then we’ll just have to rely on your letters of support or dispute.

High-yield defensive investing

High-yield and defensive investing do not go together. Thousands of Australian investors in high-yield income and mortgage funds offered by reputable firms AMP, AXA, Australian Unity, Challenger, Colonial First State, ING, and from those offered by less reputable property developers, found the price paid for seeking just an extra 1% in fixed interest return has meant years of lost access to their investments and some write downs.

Hybrid securities, popular because of their higher yield and listed availability, proved they weren’t true defensive investments either. Rather than go up in value like an Australian bond index fund, they went down in value by more than 20%. While there is a case for investing in higher-yield funds, it certainly isn’t during periods of volatility. The safest defensive investments remain government securities and funds that offer a diverse exposure to many high credit quality bonds.

Iliquidity premium

Many Australian institutions and industry super funds have big holdings in illiquid, not readily tradeable, investments such as direct property, infrastructure, private equity and hedge funds. Part of the reason for investing this way is to earn a hoped-for extra return in exchange for surrendering liquidity. This concept was made popular by successful Yale Endowment Fund manager David Swensen, who suggested investors surrender substantial performance when demanding liquidity.

Swensen ran the Yale portfolio with a very high exposure to illiquid alternative assets and little to defensive bonds. This generated class-leading returns compared to other school funds, fostering “Endowment Envy”. During the GFC, however, the Yale fund fell 30% in the year to June 2009.

A consequence of applying Swensen’s model locally to defined contribution super plans meant many funds during the most profitable time of the GFC would not have had enough saleable assets to fully rebalance their portfolio or buy back depressed assets such as shares. It likely also meant some funds needed to rely on investor apathy and new cash flows to avoid having to restrict redemptions or switches.

Over the past five years the 3% annualised return earned by the median growth-style super fund reported by Chant West for many industry super funds (which reportedly allocate 28% to unlisted assets) equalled the performance of Vanguard’s multi-sector growth index fund (which had a nil exposure to unlisted assets). Time will tell whether a future premium return will emerge.

Highly geared and unlisted property trusts

Thousands of investors in unlisted property trusts have found access to their assets has been frozen, and that often those assets have been written down in value. The write downs come after correcting for over-optimistic valuations and after making equity injections demanded by banks. The illiquidity comes from the underlying investment being fundamentally illiquid: when there are more investors exiting than entering, any redemption facility must be shut or a property sold.

Those who invested in listed property trusts enjoyed access to their investments but they suffered an awfully scary collapse in share price. This is because the sound fundamentals of owning a diversified portfolio of commercial property was wrecked by high levels of gearing and the stapling together of property ownership with property management and development. Instead of investors getting rising rental income and price appreciation, they got an investment that resembled Frankenstein’s monster.

Agricultural investment schemes

There is nothing wrong with investing in hardwood, softwood, olives, almonds or lemons; and businesses in this sector. Indeed the S&P Global Agribusiness equity index is up 29% for the year to February 28, 2011 (and 10% annually over the past five years). Perhaps the discredited food shortage theory of Thomas Malthus needs to be reconsidered. BHP’s play for Saskatchewan’s Potash Corporation and recent interest by investment bankers in rural properties lends support to the idea there is money in food. However, the failures of companies such as Timbercorp and Great Southern and the schemes they ran resulted from how these investments were structured, especially being too highly geared. Investors were also the last to be paid, after the scheme arranger, land owner, plant supplier, debt provider and even the guy or girl with the pruning shears.

Infrastructure investment

There is a very strong argument for owning the inflation-linked income streams offered by infrastructure monopolies. They match the future liability of your spending and should fit somewhere between equity and bonds in the risk spectrum. Canadian pension funds have been a trendsetter in this asset class, which many have tried to capitalise on. However, when I and others (for Roger Montgomery’s comments about Transurban, click here) research this asset class, you often bump into the legacy left by financial engineers who stepped up the risk profile of these assets through excessive borrowing and/or lumbered them with fees and manager conflicts. Rather than being partly defensive, the S&P500 Global Infrastructure index fell 40% in 2008 in the midst of the GFC.

There are no shortages of failed or disappointing investments locally in infrastructure, including the Sydney cross city and Lane Cove tunnels, BrisConnect and investments through Babcock & Brown, Allco and Macquarie – the latter where investors lost millions in diluted profits to buy out the manager. Problems with infrastructure investment aren’t new. Those who backed Suez Canal builder Ferdinand de Lesseps in 1876 to next build the Panama Canal lost their shirt, leaving the project to be completed by others. While you should have an interest in investing infrastructure, it is better to start with a degree of scepticism.

Concentrated equities

Harry Markowitz proposed in the 1950s that by spreading your share investments around many shares you reduce risk without harming return; this is said to be the only free lunch in finance. However, many others argue instead that you should have conviction when investing and concentrate your equity investments. Even Warren Buffett is quoted as saying, “Wide diversification is only required when investors do not understand what they are doing.” Since he also suggests many private investors would be better off investing in an index fund, you might wonder what he is saying about the average investor’s capability?

Portfolios that in 2008 held a concentrated portfolio of only 10–15 stocks, including Allco, Babcock & Brown, ABC Learning or Timbercorp, have been permanently impaired such that they won’t likely ever catch up to an index fund that owned all of these. If you don’t want luck or need rare skill to play a part in your retirement security, avoid direct concentrated equity investing.

Given the evidence for passive investing it is not unusual that many active funds have been (re)marketed as high conviction or concentrated. For some of your speculative or satellite capital (see Put your portfolio into orbit) this approach may still make sense, but be wary of losing out to higher fees and tax.

There is some support that a small 10% of funds who focus their investing on individual stocks may indeed add value. New York University’s Professor Antti Petajisto (click here and here) studied 1124 non-index US mutual funds, classifying 45 as “concentrated” managers (those holding on average half the number of shares of others, or who darted in and out of industries) and another 180 as “stock pickers (who also have concentrated portfolios but the investments broadly mirrored and followed the market). He found only “stock pickers” outperformed; those who tried to also tactically allocate or who were only moderately active or were “closet indexers” underperformed after high fees and turnover costs.

Retail hedge funds

It would be wrong to generalise the hedge fund industry as it represents a diversity of different investment styles and products. Many are just equity funds with the enhanced capability to apply modest borrowing, short and vary cash levels. More worrisome are the complex funds that invest across borders in fixed interest investments, commodities, currencies, mergers & acquisitions often using substantial leverage. Perhaps the only thing funds have in common is the courage to charge high fees. Hedge funds promise to behave (or “correlate”) differently than listed company equity investments. Unfortunately investors in funds that blew up or are still frozen got a different experience.

In 2008, Forbes magazine reported 1471 hedge funds, or about 15%, closed. Local failed or frozen funds include those from Basis Capital, BT, Deutsche, Goldman Sachs JB Were, Gottex, HFA and Macquarie Bank. The most famous failure was that of Bernie Madoff, whose investment style borrowed more from 1920s Italian American Charles Ponzi than his hedge fund peers.

1910 mug shot of Charles Ponzi and of Bernie Madoff nearly 100 years later

Performance figures from the hedge fund industry paint a more optimistic picture for these alternative investments overall during the GFC. These funds remain a big part of institutional investing and not all styles have been discredited. I remain sceptical whether they belong in retail investor portfolios given their uncertain liquidity, high fees and the challenges of understanding all the risks involved and getting to the truly talented managers.

Beating the returns of a defined benefit pension

During the early boom years of the 2000s some transitioning retirees took a lump sum in place of an indexing pension, expecting to invest those funds and earn a better return. The GFC showed that it isn’t always guaranteed you can beat a conservative indexing promise. It also showed that one needs to be very careful converting a lump sum into equities at one time; time-based diversification is equally important in risk management as investment diversification.

Defined contribution plans have not been discredited. Indeed their introduction has let industry and government avoid the calamity that befell Canada’s old number one stock, Nortel Networks, which went bankrupt unable to fund its defined benefit pension. These risks are now shouldered by investors, a third of which I suspect are worse off for their replacement – being those who don’t take ownership of their super and top-up contributions, make wrong investment decisions or simply have the misfortune of retiring through unlucky investment periods and living too long. They should look to annuities to recreate a pension.

Life-stage investment funds

I am a great believer in many reducing their exposure to equities as they near retirement. However, investors in US Target Date Retirement funds at or near retirement lost on average a quarter of their savings (and up to 40%), which showed that something got lost in translation. It turned out that different funds have different ideas about how much is the right amount of equities for your age. For a 60 year old this ranged from 45% to 90%. This means you’ll have to do your own homework to ensure if the growing number of Australian funds are a good fit for you or instead create your own life stage strategy.

Avoiding offshore investing

Some retirement portfolios are highly domesticated, made up mainly of Australian company shares although some of those companies do trade overseas. While the long-term return from the Australian sharemarket is world-beating, 2010 showed that this doesn’t happen every year. The ASX 300 returned –2% last year versus both 18% for US stocks and the world market (in local dollars). There are many strategic offensive and defensive reasons to invest offshore as suggested earlier (see Buy the world). Should the Australian dollar revert to historic weakness, that would be another reason.

Dividend stripping

In this strategy, you are supposed to buy companies just before they go ex-dividend to pocket extra income and franked dividends. In 2008 Macquarie closed its Macquarie Income Timing Fund whose strategy was “purchasing securities before the ex-dividend date and selling them around their ex-dividend date”. The listed Aurora Sandringham Dividend Income Trust (AOD) goes further by being able to borrow up to 100% of assets during reporting season. Problems with this strategy include falling afoul of the ATO and the 45-day rule, paying substantial transaction costs and missing out on long-term capital gains tax deductions. A counter theory holds that stock prices fall ex-dividend in proportion to the value of the franked dividend paid. I think the related strategy of buying, but holding, high dividend paying stocks holds more promise.

Hemlines, super bowls, elections and other anomalies

There are a multitude of past patterns in stockmarkets that unfortunately only from time to time prove out.

Stocks rise in January – yes in 2011 but the rise started in September.
Stocks fall in September – nope, see above.
Mondays are the worst days to invest and Fridays the best – in Asia and Australia there is evidence Tuesday is also a poor day.
Small capitalisation companies recover faster – with Australian small companies up 30% over the past six months this seems to have held.
Stocks follow hemlines – this was true for many years albeit as a lagging indicator of when risk is in favour, current fashion trends seem to suggest all you need now is a nightshirt to invest!
Skinny ties foretell a bullish market and wider ones a decline – I’ll leave this to the fashion experts.
Lipstick indicator – lipsticks sales are supposed to increase during down periods as a low budget indulgence, however, this seems more like a lagging indicator and this didn’t prove true this time.
US presidential investment cycle – as predicted 2009 was a poor year for stocks being the first term of US President Barack Obama.
US Superbowl indicator – in 2007 AFC team Indianapolis Colts won which predicted a decline in the market. As NFC champion Green Bay Packers won in 2011, the market is predicted to keep going up.
While on the whimsical, I observe that companies whose name begins with the letter “W”, such as Wesfarmers, West Australian Newspapers, Westpac, Westfield, Woodside Petroleum and Woolworths, offer a good representation of the overall Australian sharemarket and offer some defensive characteristics. Over the past three, five (shown) and 10 years they outperformed the ASX 200 (thanks especially to Woolworths) with only a minimal increase in volatility. Time for another ETF perhaps?

Growth of wealth
Elliott Wave

Supporters of this 1938 theory proposed by Ralph Elliott argue the movement of the market follows multiple waves and use technical analysis to trade the market. While I have time for long-term shifts in the market being driven by changes in economic cycles, behaviour and lapses in memory, I don’t understand the proposed theorem and its many sub-waves.

In the New York Times in July 2010 current proponent Robert Prechter suggested the US market has entered a decline of “staggering proportions” and to expect the Dow Jones to fall from the then 9686 to under 1000. The fact that it is around 12,000 now apparently does not perturb him.

Let’s hope he’s wrong.

Doug Turek, Doug is principal adviser of family advisory and money management firm Professional Wealth.