We are opening this quarterly review with this recent quote from legendary bond investor Bill Gross as it addresses what is maybe the most critical financial issue of the time(1). While the first three months of 2016 have largely been characterized by a financial roller coaster in equity markets, commodities and oil we think that the most significant economic development is probably the decision of the Japanese Central Bank in January to adopt negative interest rates which means that the majority of the developed world has now entered the land of negative nominal interest rates.
This is a revolutionary economic development of which the impact over the next years or even decades is totally unpredictable. While the notion of “uncharted territory” is frequently abused in a financial world often failing to look at history beyond the last few quarters, it unequivocally does apply to the current times. As far as one looks back at economic history, there simply is no precedent for the current situation.
In effect, negative interest rates are intended to punish prudent savers with the aim of pushing them to “put their money to work” with the hope that this will benefit the “real economy” which is in total contradiction to the basic principles of free markets. The benefits to the “real economy” remain to be seen and are highly doubtful but what is certain is that this will continue to distort the financial markets.
So what should investors do considering this level of extreme uncertainty? The first priority in our view should be to avoid the widespread temptation to forecast future economic developments. While many claim the ability to predict such developments the examination of past predictions shows that this is almost always an illusion. Therefore our view is that the right approach is to recognize that there are major unpredictable unknowns and to invest one’s wealth in a way that can succeed under a wide range of scenarios. In the words of Baupost founder’s Seth Klarman, one of the world’s most successful investors:
“[…] No one knows whether the economy will shrink or grow (or how fast), what the rate of inflation will be, and whether interest rates and share prices will rise or fall. Investors intent on avoiding loss consequently must position themselves to survive and even prosper under any circumstances. […]”(2)
The second approach should be “smart diversification”. We emphasize the “smart” qualificative because it is key. Diversification is not simply spreading an investment portfolio across a wide range of positions. It should also aim to minimize or exclude the asset classes which appear least appealing and put emphasis on the ones which appear to be more promising at a certain point in time. It is also, critically, about making sure that the correlations between the different investments are as low as possible, a task which requires considerable insight and experience.
The long/short equities funds in which we are invested provide both a broad exposure to some of the best listed companies while their shorting strategy allows them to limit or even benefit from the impact of adverse market developments. These high-quality managers have proven their ability to generate sustainable returns over time. Some other hedge funds in which we are invested have also proven their ability to generate alpha over time under a wide range of market developments following very different strategies with limited correlation between themselves. Some alternative finance funds active in credit niches also provide a source of reliable returns.
Thirdly and importantly, real assets are a great opportunity to improve long term portfolio returns. A start-up with a revolutionary new technology will do well no matter what happens to the economy. A good real estate project to restore a poorly managed asset can sometimes be structured by the right team in such a manner as to do well even under challenging market conditions. Illiquid assets have traditionally provided an illiquidity premium of 5-10%. In a world of low or negative interest rates this is particularly significant. We are starting to see a shift in attitude of both private and institutional investors towards liquidity and expect this trend to continue and to be supportive of real assets.
(2) Margin of Safety, p. 84