The head of multi-manager investments at Rathbones (pictured) points out that funds investing outside of the mainstream asset classes of equities and bonds are increasingly being aimed at retail investors - especially those who are searching for income.
“You have to be cognisant of the risk that an investment entails. At the moment, I feel people are rushing for the yield and are not totally cognisant of the risks,” he said.
“Interest rates have been essentially zero for close to six years so people have been reaching for yield for six years now. You have to think logically - if there was any low risk yield to be had, it would have been had by now. If you find anything yielding over 4 per cent you need to ask yourself ‘what risk I am actually taking’.”
While some of these illiquid assets, such as commercial property and infrastructure, are hardly niche, others are more esoteric investments like aircraft leasing, litigation funding and catastrophe insurance that were “originally known only to investment bank proprietary desks”.
“This is not necessarily bad if the investor understands the multi-layered risks they’re taking and the returns are appropriate for the risk employed. Indeed, they are very useful in a well diversified multi-asset portfolio if the size of the position is suitable,” the manager said.
“However, these products are frequently sold using standard industry jargon, so the risks can be understated.”
Problems arise when ‘hot money’, or flows from investors other than those that take a long-term allocation to these areas and stick with them through ups and downs, comes into an illiquid asset.
He said: “Whenever you see these illiquid markets become the favourite of the day and no-one has a bad word to say about them, you need to be slightly cautious because your risks are rising.”
“Why are your risks rising? You get marginal or ‘visitor’ investors, who get sucked in by the story and maybe don’t understand the dynamics of the asset class as well as the long-term investors. If you see that then it’s the first sharp intake of breath.”
Once these visitor investors decide to quit, it can cause volatility to spike within the asset class or the funds that invest in them.
An example of this is commercial property, which has been the subject of much investor attention of late. IMA Property has been one of the most popular sectors for open-ended funds over the past year, with net retail inflows peaking at £505m in May, while the average trust in the AIC’s Property Direct - UK peer group is trading on a 9 per cent premium.
Performance of sector vs index over year to date
Source: FE Analytics
One of the key reasons for the attention afforded commercial property is the yields on offer in a world where not many assets are paying a decent level of income.
Although Coombs is not forecasting a crash within UK commercial property, he warns that now might not be the best time to buy - especially in light of the strong gains that have been made in the space over the past year.
The average fund in the IMA Property sector is up 10.50 per cent over 2014 to date, according to FE Analytics.
“The conversations I’ve been having with property managers show some are really cautious and might rather be selling property right now rather than buying,” he explained.
“So you have property managers saying ‘this all looks a bit hot, there’s been yield compression already in secondary markets, looks like it’s played out and I’d be a seller at these levels’. But then you hear there’s more money going into the asset class - there’s a disconnect.”
While property is viewed by many as a mainstream asset, Coombs argues that its risks are similar to those of most illiquid assets and not well understood by the bulk of investors.
It tends to have a high downside, especially if marginal investors all move to exit at the same time when they are no longer enamoured with the asset class. In the bear market year of 2008, for example, UK commercial property dropped 28 per cent.
The asset class is also thought of having low volatility, especially when compared with equities. Coombs says this really isn’t the case either as, while prime property tends to display low volatility, it’s much higher when you get to the secondary market - where investors are increasingly hunting for value.
“People say commercial property is a low volatility asset class. West End offices and prime residential aren’t very volatile but industrial sheds in the north-east are. Outside of the M25, it’s much more cyclical,” the manager said.
“There is a good time to buy those properties but they are more volatile. They have been very good investments this year but ultimately they are now on yields that make them look pretty expensive.”
Coombs also notes that investors have flocked to infrastructure funds over recent years, but this has also made the asset class look expensive compared with history. The average investment trust in the AIC’s Specialist: Infrastructure sector is trading on a 12.3 per cent premium, while yielding 5 per cent.
“I’m not saying the commercial property market is going to crash or the infrastructure market is going to collapse. I’m just saying that the early warning signals are flashing for me.”
When it comes to the more esoteric investments, such as specialist property, aircraft leasing, litigation funding and catastrophe insurance, Coombs believes retail investors should steer well clear.
“They really should avoid anything like that,” he said. “There’s no way they can get enough information to make an informed decision - it just isn’t out there. I can’t find it with our resources, so how a private investor can I have no idea.”
