Investors are making a mistake by piling into alternative assets for diversification and income as many do not fully comprehend the risks they are taking, according to Rathbone’s David Coombs, who warns that similar events took place in the build up to 2008’s global financial crisis. 
Coombs, who is head of multi-asset investing at the group, recently told FE Trustnet that bubbles were developing in income producing assets as years of ultra-low interest rates and quantitative easing had forced investors into a narrow channel of securities.
He said that this hunt for yield, combined with very low levels of liquidity in fixed income, property and more esoteric asset income producing asset classes, was a dangerous mix.
“We need to take a step back and think what that means. Yes, spreads might look interesting but in terms of actual absolute return and risks you are taking for your clients, the returns have never been lower and if you look at the risks in terms of liquidity, the risks have never been higher,” Coombs (pictured) said.
“What normally happens when you get a lot of factors chasing a narrow range of assets? Well, it’s the ‘B’ word isn’t it? It is something that always strikes fear into any investor. I think we are starting to see, maybe not big fat bubbles like 1999, but small bubbles emerging all across the income producing asset classes.”
Coombs also says that many investors are buying into more niche areas of the market as very loose monetary policy, which has sparked a bull run in both bond and equities since the end of the last financial crisis, has significantly increased correlations between more mainstream and traditional asset classes.
Performance of bonds and equities since the global financial crisis
Source: FE Analytics
He says this is creating a very risky backdrop, however, as investors are buying into ‘alternative’ funds and trusts in the belief they offer uncorrelated returns to bonds and equities without really realising what they are exposed to.
Indeed, many experts have recommended that investors look to alternative assets to protect their portfolios.
Coombs, who is avoiding these ‘alternative’ portfolios in his various multi-asset funds of funds, points out that a similar phenomenon happened during the build-up to the 2008 crash and he shows that during the depths of the crisis, these areas offered very little in terms of protection due to lack of underlying liquidity.
“I would caveat my comments here because it’s very easy to look back and say what happens if it happens again and how do we avoid it. This is poor English and I apologise, but you can ‘over-learn’ lessons from the past because we all know crisis are not repeated in the future in the exact same way,” Coombs said.
“Nevertheless, I think it is useful to look at certain areas that have suffered from poor liquidity. Clearly, 2008 was an extreme event for liquidity but even if we saw a liquidity squeeze of 25 to 30 per cent of that extent, it could be very painful and that’s what I’m going to focus on here.”
His first example is the BH Macro Investment Trust, which is a hedge fund and aims to make money in volatile conditions as its 70-strong trading team can eke out different opportunities by shorting and going long various financial assets.
He points out that the closed-ended fund was regarded, and still is, as an alternative investment strategy with a very low or negative correlation to equities.
“The share price went along on a very nice premium up until 2008 and then look what happened. The NAV recorded positive returns. Fantastic. It did exactly what it said on the tin. It invested in sovereign bond markets, a very liquid asset class so a liquidity squeeze didn’t affect it.”
“But unfortunately, about 70 to 80 per cent of the shareholders were funds of funds that had redemption requests on their funds and could only sell the listed hedge funds rather than the open-ended funds they had in their portfolios.”
“You had a wall of people looking to exit so liquidity in the shares of BH Macro disappeared and that’s why that huge discount opened up.”
According to FE Analytics, while BH Macro ended 2008 with a double-digit gain, investors were exposed to a maximum drawdown of close to 15 per cent. As the graph below shows, the trust fell in line with equities during the initial phase of the crash.
Performance of trust versus index between Sep 2008 and November 2008
Source: FE Analytics
“That discount has slowly come back to par but (those falls) still affect your mark to market or, in your clients’ terms, it affects the value of their assets. If your client is a forced seller, during that period, they realise the loss.”
“As we know, the biggest risk is not volatility; it’s a forced seller when they need to match their lifestyle.”
Another example Coombs gives is the Picton Property Income trust. ‘Bricks and mortar’ funds have seen a huge surge in popularity over recent years as investors have looked for high yields and an uncorrelated source of returns.
Direct open-ended property funds have been among the best sellers over the past 12 months or so, while the equivalent closed-ended sector has traded on a wide premium to NAV for some time now.
“[Picton] invests in secondary properties: higher yielding properties and industrial units, etc. Again, looked what happened. This was a leveraged property fund in a lowly volatile asset class. Its NAV falls significantly because the leveraged gets pulled as it hit its loan to value ratio.”
“The NAV itself was bad enough, but look at the share price.”
Performance of trust versus index in 2008
Source: FE Analytics
“It’s not just about making an allocation to an asset class. It’s all about understanding the idiosyncratic risks and the nuances in each case of what you are investing in.”
“Also, I think the most important lesson I learnt from 2008 was who are you invested with? Look at BH Macro, if you had invested with sensible long-term investors you wouldn’t probably lost money during that period at all.”
While Coombs is mainly talking about investment trusts, Jon ‘JB’ Beckett – UK research lead at the Association for Professional Fund Investors – recently told FE Trustnet about the growing danger of redemption/liquidity risk in open-ended funds, especially those which are surging in popularity and are receiving huge inflows.
The first and most obvious problem with a growing fund, according to Beckett, is the issue surrounding the “quality of its AUM”. He pointed out that there are a number of issues with AUM quality, one of which is the changing dynamic of a fund’s investor base.
“As a fund becomes more successful and the ever increasing sales push to sell that fund to new markets increases, you get a deterioration in terms of the investor base. Your initial tranche of investors are very well suited to the fund strategy, your second, third are perhaps less so,” Beckett explained.
Coombs, who has comfortably outperformed his peer group composite since he began running funds in the Investment Association universe, says there are other examples where portfolios, which seemingly offered uncorrelated returns, were caught out by the liquidity squeeze in 2008. These include Carador Income and HICL Infrastructure.
Performance of manager versus peer group composite
Source: FE Analytics
He points out that Carador Income, despite the fact it invested in very high quality CDOs and CLOs and its NAV remained stable, fell a huge amount in share price terms as shareholders viewed it in a similar light to other trusts which were invested in more toxic parts of the asset class (which is seen as the primary catalyst for the financial crisis).
The HICL Infrastructure Investment Trust (which is very popular with investors today with a premium of 12 per cent) is also seen as a decent alternative source of income. However, again, Coombs notes while the NAV fell around 5 per cent during the depths of the crisis, the share price fell 20 per cent.
Coombs added: “What you see in these specialist areas where people don’t necessarily understand what they have bought, you do get significant volatility around the NAV.”