News & Insights

CIO Notes - Don't Panic

09 June 2022, Grant Wilson

There is a growing consensus that inflation above 3% p.a. will be with us for some time. There is also much comment suggesting that if 3%+ inflation persists then bonds will provide poor diversification from public equity risk.

ARC seek to construct resilient investment policies that will achieve investment objectives in most market conditions over a suitable timeframe, so we have given serious consideration to the inflation threat and the possible reduction of the efficacy of bonds as equity diversifiers.

Mostly, investment managers are proposing higher allocations to “alternatives”, which is the generic classification of all that is not cash, bonds or equity. This includes, but is not limited to, private equity, property, infrastructure, gold, commodities, private credit, hedge funds (of all types) etc...

Managers hope these alternatives will offer different risks and returns than equities and bonds, so will provide diversification, and an average rate of return above inflation over the longer term.

What the alternatives almost certainly deliver is higher costs, less transparency, wider dispersion of sub-asset class returns and less liquidity. For the avoidance of doubt ARC is in favour of the prudent use of alternatives but the risks must be spotted, measured, and managed.

Generally, finding a good alternative investment is not as hard as accessing it (closed to new investment) at a reasonable price or size of commitment (min £50m), or exiting if conditions change. The challenges are significant, diverse, and much harder to effectively manage due to the lack of transparency and deep active markets.

Some readers might recall Warren Buffett's 2008 open challenge to the hedge fund industry to beat the S&P500 over ten years. We understand only one contender (Protégé Partners LLC), rose to the challenge, and lost. Understandably, many saw the challenge as beta against alpha; would the manager skill in hedge funds deliver enough value to cover costs? Well, a sample of one tells little, but the fact that only one stepped onto the stage probably says more. We should note that the return paths taken by the two contenders was substantially different (the hedge funds fell 23.9% in early 2008 when the S&P fell -37.0%) so diversification worked, but the ten-year annualised return comparison of S&P +7.1% versus Hedge Fund portfolio +2.2%, not so much.

ARC will be regularly reviewing investment policies and encouraging the dialogue between investors and their managers to ensure the challenges of alternatives are understood and managed effectively. Particularly during short term market volatility, we think it important to focus on long term policy. As interesting as the general issues discussed above are, the specifics of each investor are key to their investment success.

We welcome your comments and questions.

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