The Adventurous Investor

Global Investing in frontier markets and alternative assets

 The Problem.....

By this stage in the book you should be up to speed with three very simple concepts that underlay the whole Tracker revolution.

 

1. Most of the time trying to systematically beat the main global indices via stock picking is pretty much a mugs game, an expensive mugs game in fact. Better identify the indices you want to track and find a cheap and effective way to track them.
2. The really smart investor mixes and matches the indices they track, trying to master the dark art of asset allocation. The key principle though is that diversification, in principle, is good.
3. Part of the success of that diversification depends on your choice of indices and asset classes – using alternative asset classes to achieve diversification is, by and large a good idea. But that success also depends on a clear understanding of the returns of the major asset classes and the risks.

 

This chapter is all about that third point – an examination of the asset classes and the markets and a systematic look at the returns you’d have achieved in the last few years and the risks moving forward.

 

We’ll run through all the main asset classes and we’ll even touch on some ‘alternative asset’ classes that traditionally haven’t boasted any trackers but where new product launches – usually occurring after the main Tracker 101 list was drawn up – offer the investors real opportunity. That means we’ll look at new trackers from structured product providers like SG that are aiming to follow innovative, but risky, new indices that follow private equity for example.

 

The core challenge of this chapter though is to clearly lay out the balance between past returns and future risk and in particular to ask that awkward question – by buying into a particular market am I really buying into something that will help with diversifying my portfolio or am I simply buying into a market that correlates closely with  major markets like the FTSE All Share?

The difficulty in actually managing sensible diversification via alternative markets was wonderfully summed up recently by Phillip Coggan, the Burtonwood columnist at The Economist magazine. In a column entitled “We all fall down “ Coggan  pointed to research from US investment bank Merrill Lynch, which showed that over the past five years the powerful US Index - the Russell 2000 index of small companies – had “a 94% correlation with the S&P 500, the main Wall Street index. More alarmingly, international stockmarkets have not offered any diversification either: they have shown a 95% correlation.”

The culprit – probably that huge wall of liquidity we’ve all been hearing about. JPMorgan estimates that global liquidity increased by $3.9 trillion between 2002 and 2006, of which around 50% came from Asia and 40% from the oil producers. According to Coggan the “ bulk of this money went at first into risk-free assets such as Treasury bills and bonds. That drove down the yield on such assets. So other investors were then naturally tempted to look elsewhere for higher returns.”

This huge wall of excess liquidity has now moved on to new asset classes in desperate search of either capital gains or a decent yield. Suddenly markets that were supposedly ‘alternative’ like private equity or hedge funds have become, well….mainstream. The art of diversification, of sensibly balancing risk and reward has, in recent years become infinitely tougher – the only solution is to examine closely exactly what it is your tracking and understand the risks involved.

 

 

Equities - UK

 

	2006	2005	2004	2003	2002
FTSE ALL SHARE Benchmark	16.8%	22.0%	12.8%	20.9%	-22.7%
FTSE 100	14.4%	20.8%	11.2%	17.9%	-22.2%
FTSE 250	30.2%	30.2%	22.9%	38.9%	-25.0%

 

Strong returns…..

The table above – showing recent returns from the main UK markets conveys a simple message – you’ve never had it so good. The disasters of 2001 and 2002 are now history and all three main UK indices have recorded double digit growth in the last four years with the FTSE 250 especially strong. And these returns have been achieved despite the fact that yields have been fairly strong – 2.81% by the end of 2006 for the FTSE All and 2.88% for the FTSE All Share and 2.86% for the All Share. These relatively reasonable yield valuations were also supported by inexpensive market PE ratios – 13.4 for the FTSE 100, and 14.4 for the FTSE All although the FTSE 250 was looking very toppy at 19.1

 

 

	Yield	Correlation	Beta vs	Five Year	Five Year
		to FTSE All	FTSE All	Annualised	Annualised
				return	volatility
UK
FTSE ALL SHARE Benchmark		1.000	1.000	8.5%	13.12%
FTSE 100	2.81%	0.995	0.984	7.12%	12.97%
FTSE 250	1.84%	0.903	1.100	16.75%	15.97%

 

Dangerous concentrations

The biggest structural danger facing the UK indices don’t centre around on ‘valuations’ as such but in the constituents of the indices. The key concern centres around some dangerous ‘over-concentrations’ -

• The flood of Russian resources listing on FTSE 100 may already have skew the index - Russian copper miner Kazakhmys entered the index during 2005 while oil giant Rosneft, aluminium producer Rusal and banks Vneshtorg and Gazprom are likely to be future additions.
• Oil as a sector already accounts for 16.6% of the FTSE 100 index and banks 29.6%. With the FTSE All Share index, oils are 14.5% and financials 29.6%.
• The top three companies in both major indices – the 100 and the All Share – account for an awfully large percentage of the total value of the market. The table below shows the percentage of total market cap for both the top 10 holdings and the top 3 holdings across a shortlist of global markets – the Dutch AEX index is by far the most concentrated  (the top 10 account for 82% of index cap and the top 3 a staggering 39%) but the FTSE 100 is not far behind. The FTSE 100 top 10 account for just under 45% of total index value while the top 3 – HSBC, BP and  GSK - account for 19.3%. Add back in the two separate listings for Shell and ignore GSK and the top three accounts for just under 23% !

 

	total %	total %
Index	Top 10	Top 3
	holdings as	holdings as
AEX	82	39
MSCI Turkey	72	36.2
MSCI Eastern Euro	57.2	22.47
FTSE 100	44.9	19.3
FTSE All	37.2	16
DJ EuroStoxx 50	35.7	12.9
DJ Stoxx 50	35.6	13.2
Macquarie Global Infra	33.6	14.37
FTSE UK dividend +	32.4	13.2
Eurofirst 80	29.6	11
EuroFirst 100	27.3	11.6
MSCI Japan	24.9	12.4
S&P 500	20	8.35
MSCI Europe ex UK	19.84	7.2
MSCI North America	18.2	7.6
FTSE 250	10.31	3.3
MSCI World	10.17	4.32