Portfolio recovery or Alzheimer's?

Unless something major happens in the run up to January 1, equity fund managers will be shouting from the rooftops about their best performance in four years. Even tracker funds look as though they will be in the money for 2003.

Yet two observations require digestion as marketing gurus ponder their 2004 strategy.

Observation one: with 40-odd trillion dollars in equity markets worldwide, major fund houses and financial brands do have the muscle to "position" their brand into the public perception for commercial benefit.

Take HSBC, a trusted brand. In 1999, their fund managers invested ad-spend in the glory of their Indian and technology funds. One devastating crash later and that spend was redirected into capital guarantees.

Conclusion: in promoting specific funds, ad-spend is based on yesterday's consumer research, rarely tallying with clever timing, or prudent portfolio management.

Observation two: because there is less volume in other asset classes, only about half a trillion dollars in hedge funds, portfolio and pension planning is historically bound to equity indices.

A fund manager with an 80 per cent equity weighting in 1999 would find it practically difficult (often illegal) to diversify and water-down to 40 or 30 per cent equities. Conclusion: the relief of a partial equity recovery is certainly welcome.

However, might this relief encourage a continuum of equity leadership, even though there is a pressing need for reform if stress is to be removed from portfolio and pension management? It doesn't matter if 2000 to 2003 was a never-to-repeat crash, but what's the chance? Or, who wants to take the chance?

Extreme end

At the extreme end of the push for reform are the alternative strategists. Those with the most to gain from the diversification story.

Daris Delins of Castlestone Management is an Ozzie operating out of an Austrian firm in the US. Delins is passionate on the need to reform the general attitude to portfolio construction, and today is a good day to start, "in my opinion, financial markets may well have developed a case of Alzheimer's.

Namely a collective memory loss of where we were in the 1990s — one of the biggest financial bubbles in modern history".

Alzheimer's! What are the symptoms? The most obvious to Delins relates to the cyclical nature of markets, "equity markets go up for 20-25 years, and then go sideways for 20-25 years, then up again, then sideways.

Since 1900 there has never been a period where a bull market rise has been followed by another bull market phase". The immediate future for Delins is therefore "volatile and trendless, a distinct change from the 1980s/1990s experience that so many investors remember."

Symptom two is price. "Even after a three-year bear market equities are not cheap. Again, viewed over a 100-year timeframe, the current P/E on the US market (at around 35) is more than two times its historic average (12.5)," says Delins.

Not bonds

Within traditional portfolios, bonds are the place to run to when the equity man scares you. Not for Delins, "You may say that interest rates are low. Don't be fooled. Bond markets are also expensive against historical levels. Look at what central banks almost everywhere are doing — flooding the system with liquidity. At the same time, government budget deficits are also rising in most countries. This cannot be good for bonds. Recent sell-offs of global bonds reflect investor nerves."

Surely, Delins sees some good news for traditional markets from the last six-month equity story?

"If any thing, the recent rally in global equities reflects (a) a technical bounce from pre-Iraq lows; (b) a shift in asset allocation by pension funds from bonds to equities; (c) the liquidity wave generated by central banks; (d) signs that the US economy is on the mend."

In that case, how would you be constructing pension portfolios, and generalised investment portfolios assuming a benchmark in the region of, say, eight per cent per annum? For Delins, the greatest weight would be applied to alternative strategies, with 35 per cent of the portfolio, "good global macro fund of fund managers are well placed to take advantage of the expected volatility in equities, bonds, currencies, and commodities. These managers are focused on an absolute return."

The "traditional" portfolio stalwarts of equities at 20 per cent, and bonds at 20 per cent are maintained in recognition of their leadership status. However, Delins is clearly nervous of long-only, passive fund managers, especially if markets stay "volatile and trendless".

A cash holding of 10 per cent is held for the benefit of buying any opportunity which might arise, leaving 15 per cent for a stake in commodities.

For Delins the short-term play is gold, "Gold may sound like yesterday' story. But if you look at the strong real growth in global money supply, the deliberate neglect of currencies by central banks/governments, plus the fact that Asian central banks typically have less than two per cent of their reserves in gold, then the recent rally in gold may well have some further legs to it."

A non-conventional approach, yes. However, if you agree that equities don't always rise, that bonds are expensive, that central bank policies will beget higher inflation, and that market volatility is here to stay, then the Delins view might well be seen as part of the growing trend towards absolute return, modern portfolio strategies. Time will tell as it always does.

Historical perspective
- Equity markets go up for 20-25 years, and then go sideways for 20-25 years, then up again, then sideways.

- Since 1900 there has never been a period where a bull market rise has been followed by another bull market phase.

The author is the managing director of Mondial (Dubai) LLC