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What asset class best meets my requirements? Back  
Frank O’Brien, founder of Investment Faculty Ireland, says the first question to ask when selecting an asset is ‘What does this asset do for me, how does it meet my requirements?’ Through asking three further questions he says the value of each asset can be determined:

• What’s the return (in real terms)?
• What risk does the asset have?
• What correlation does it have to other assets?

In order not to be over exposed to one asset class, the investor should investigate how best to diversify his assets. Each asset class offers the investor a different risk and return profile. ‘How to select the asset should be based on their correlations,’ says O’Brien.

Property, equity, private equity are all highly correlated. Bonds and equities held together offer good diversification. The typical real long term return for bonds is 2 per cent, with a 10 per cent volatility. The typical real return for equities is 6 per cent, with a 20 per cent volatility. Cash also is a good diversifier for equities. However, he says, ‘can we do better than bonds and cash with less volatility and a lower correlation to equities.’

Hedge funds offer a good solution giving equity type returns and are a good diversifier for equities. Hedge funds have similar volatility to bonds. He says ‘with structured products and bonds as you won’t necessarily get safety in prices. There must be a more rigourous definition of why to hold these assets.

Hedge funds therefore seem the answer however the problem remains of finding a succesful HF manager. He says, ‘behind success in hedge funds & private equity is managerial skill. It is not just the matter of replicating a portfolio.’ The biggest problem with both private equity and hedge funds is access. The top quartile funds make strong returns but there are also hedge funds that don’t.

The solution to the access problem with hedge funds is offered by fund of funds. Through fund of funds the investor can gain access to the top quartile hedge funds. He says, fund of funds are not ideal as they can ‘average out returns’. He says, in a fund maybe of 10 -15 funds benefits can be had but in 50 or more funds the return only has an average performance. O’Brien sees that alternatives ‘on the face of it look good’ when you look at the returns in the past ten years. But he says the ‘game has changed.’

Hedge funds are ‘more developed, more efficient. The market inefficiencies that existed heretofore have been ironed out. Private equity likewise had ‘a fantastic run’. He says, private equity’s success was based on cheap credit where the fund would takeover a company and load it up with debt for a geared up return. But he says, this ‘game is over.’

The global outlook is gloomy says O’Brien and he is bearish on the whole, and says ‘the world is lurching into recession.’ He sees that government bonds are currently a safe haven but that at current yield levels they offer few long term attractions. There is, he says, ‘little attraction in bonds and equities suffer in recession.’

‘Valuations are attractive say some’ but O’Brien finds this hard to see. He says, ‘earning forecasts are not bearish enough.’ ‘Valuations are not as attractive as they look.’ Commercial property has yet to be severely hit, he predicts ‘5 -10 per cent on the downside.’

O’Brien describes the problem in the market by invoking Pimco’s Bill Gross’ characterisation of the two banking systems: the conventional banking system and the shadow banking system. O’Brien says ‘we are on the back of ten years of the shadow banking system where securitisation, opaque instruments like CDOs, leverage and derivatives created a credit bubble which boosted asset prices and expanded bank balance sheets and return on equity. ‘This system implode.’ resulting in the credit crunch, a sharp deteriorisation in bank balance sheets and what will inevitably be a reduction in bank return on equity in the medium term.

This implosion has created what O’Brien says is ‘not a normal recession.’ There is he says ‘a bundle of credit banks can’t replace’. The ‘capital base has to be recreated. Raising this money will be a slow process.’ This recession is unusual he says. In a situation where banks are unwilling or unable to extend credit, the positive impact of lower interest rates may not have its usual effect.

‘Property as an asset class is normally slower to react to the economic background but equities react quickly because they are marked to market.’ He says ‘This time there is a liquidity problem and banks need money back quickly so in this instance property may be quicker to respond because the property market in recent years was debt driven.’

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