Prognosis and strategies for a market that isn't pricing risk properly. Gordon Fowler Jr. is CIO of Glenmede Trust Company, an independent wealth advisory based in Philadelphia.

(Click here to see the first part of Review and outlook: Market risk miss-priced.)

Alternatives

Are alternative assets like private equity, real estate and hedge funds the answer? Broadly speaking, that would not seem to be the case.

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Meanwhile, the dividend yield on real estate investment trusts and the capitalization rate on private real estate property are quite low, indicating that investors have to pay a lot for relatively little rental income.

There has been a flurry of activity in the private equity market as a flood of money has moved into the leveraged buyout sector. In the process, prices have risen dramatically. Now, valuations are way above where they were only a few years ago. Part of the reason firms have paid higher valuations is that debt financing has been cheap and plentiful. However, leveraged buyouts are generally turn-around situations. They work best when the buyer can get the assets at some discounted level. Higher prices and plentiful, cheap financing are rarely a precursor to strong returns in any asset class.

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Hedge funds also must cope with excessive amounts of capital inflows. It is very difficult to make generalizations about hedge funds since they cover so many different strategies. Most seek to provide a high rate of absolute return with low risk to capital, via a variety of trading and arbitrage strategies. Unfortunately, many of these arbitrage and trading strategies have become more popular as money has flowed into hedge funds. As a result, the returns to hedge funds have steadily declined relative to cash or Treasury bill returns. The excess return from hedge funds seems in fact to have trended down below 3%.

To make matters worse, the remaining return that hedge funds have earned over Treasury bills seems on average to be due largely to exposure to various markets. Many hedge fund managers do their darnedest to eliminate “market” risks. Market risks are factors that arise from a fund’s correlation with stock or bond market returns. In other words, a hedge fund manager may beat cash returns just because his or her fund has a slight bias toward the stock market.

We can separate market returns from the manager’s true skill, or alpha, through regression analysis. This chart shows the portion of excess return to the same index of hedge funds that is attributable to “alpha,” and not market factors. It was quite high in the ‘90s and is now close to zero for the average manager. Going forward, it will be more important than ever to invest in the right hedge funds.

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Prognosis

If all of these assets and strategies seem to be offering fairly low prospective five-year rates of return, does this mean that the market is doomed to decline this year? It should. Investors should demand reasonable rates of return to compensate them for the risk they’re taking.

I don’t expect that to happen though, even though many industry professionals feel that risk premiums and longer-term expected rates of returns are quite low. Until news on the economy and earnings gets bad, I expect markets will look at the P/E ratios based on current – not trend-line – earnings, and keep right on rising. Assets that do well over this year will probably rise, not because they are selling at attractive valuations, but because they have good stories. With apologies to the singer Prince, there is a good chance the markets in 2006 “are going to party like its 1999.” But we don’t expect much exuberance. However, there’s a good chance that large cap stocks, after a first quarter dip, can return 5% to 7% by year-end.

There are several themes that investors may want to consider, in case the party comes to a close more rapidly than I anticipate.

Safety First

Keep your asset allocation diversified and use recent market moves to diversify further. We know this message is tiresome, and is as familiar as your mother telling you to brush your teeth after meals. But your mother was right, and so are we.

The good news is that market moves may give you an opportunity to diversify into assets you think you may have missed earlier. A good case right now is international, or global, bonds. Global bonds are driven by three factors. One, the levels and changes in global fixed income yields; two, foreign currency movements versus the U.S. dollar; and three, the managers’ ability to add value above a passive index. The third point is a perennial reason for investing in the non-U.S. fixed income. Given all of the different choices in the world’s fixed income markets, it’s far easier for a manager to add value than invest in the U.S. market alone.

The rise in the dollar over the past year serves as a good reason for initiating a position. The U.S. dollar started this past year at a fairly undervalued level. It subsequently appreciated versus a number of currencies, resulting in poor performance for global bonds as an asset class. The dollar is now at historically normal valuations. In the absence of a strong view on the direction of international currencies or yields, opting toward more diversification and initiating a position in tax-exempt accounts would seem to make sense. Investing in international bonds in taxable accounts is not quite as clear. Although there are diversification benefits, the income can be subject to ordinary income tax rates.

Invest in quality companies with strong earnings models. This, too, is a continuing refrain on our part. Companies with strong earnings models tend to hold up better under stress provided that they are selling at reasonable valuations.

Consider – shudder – an investment in hedge funds. I have a very hard time recommending an asset class that Wall Street is eagerly selling with great success. The danger to hedge funds (or more specifically pools of hedge funds) is not that they will produce big swings in returns, but they will produce too little in the way of returns. In fact, as noted above, when you pool all managers, there is a tendency for the net result to be a return fairly close to cash. There is a good reason why a pool of hedge fund managers will tend to earn a return that is highly correlated with cash.

It is in fact the tendency of hedge funds to earn a “cash plus” rate of return that makes them worth considering in a low-return environment. While a pre tax rate of return from hedge funds of 7% might seem unappealing by historical standards, it might be fine based on our projections for the next five years. It should be noted that hedge funds tend to be hugely tax inefficient.

Feel goodies

Assuming that the party continues, there are several investment strategies that take advantage of a trendy, feel-good market.

Continue to invest in overseas markets. A trend that probably continues, perhaps to an extreme, is growth in overseas markets. Emerging markets, in particular, started as a value play a few years ago. Even though they have risen, they are still relatively cheap. In fact, the P/E for Asian Emerging is only 13 times last year’s earnings. While this is not cheap by historical standards, it is still lower than the United States. As Asia becomes more of a center for growth and “good stories,” investors will be tempted to bid these assets up to premium levels.

Add to growth equity in the event that your portfolio has a bias toward value managers. Growth management styles tend to have an easier time coping with trendy markets that move with stories. While we would not necessarily recommend overweighting growth stocks, we recommend making sure that your portfolio is balanced between both growth and value styles.

Invest in Non-Core real estate. From our perspective, most commercial real estate investments appear to be overvalued. Income-producing assets like real estate have been bid up in price over the past few years as investors have tilted toward safety. Rather than buying expensive real estate income producing properties (a.k.a. core real estate), we think allocating money to properties that can be purchased at below-replacement cost and redeveloped (a.k.a. non-core real estate) may be an attractive way to play the market.

Most undervalued

In a world that fails to price risk correctly, the most undervalued asset would seem to be “put” options on the stock market index. Put options are, in a way, a form of insurance protection. They go up in value when the market goes down. Like insurance, however, if your house doesn’t burn down or the market doesn’t fall, the value of your insurance is worthless. Then the money spent on the premiums is wasted.

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Generally, put options become expensive after the market declines by a lot. Put options are relatively cheap right now, as shown in the above simulation of the cost of a put option with a 10% “deductible.” It strikes us that put options on the S&P 500 Index not only offer a way to protect a portion of a portfolio, but also may enable an investor to make some money by buying an asset that will potentially become more valuable in a more panicky environment.

Please note, however, that options aren't for everyone. They're complex and can contain risks that aren't found in other assets. –FWR

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Weekly Review & Outlook is intended to be an unconstrained review of issues, topics and considerations of possible interest to Glenmede's clients and is not intended to be applicable to any one particular client. Actual investment decisions for particular clients are made in light of applicable considerations and may be different from the views expressed here. Likewise, actual portfolio performance may differ from the results discussed.