08 Oct Playing the Hand You’re Dealt
There is a story about the violin virtuoso Itzhak Perlman. He was a few bars into a performance at Lincoln Center when one of the strings on his instrument snapped. Undaunted, he is said to have improvised and finished the piece masterfully. Afterwards he is reputed to have said: “You know, sometimes it is the artist’s task to find out how much music you can still make with what you have left.” (The Houston Chronicle, Feb. 10, 2001). The story is surely apocryphal; after all a violin has only 4 strings to start and there no other accounts of the event. But the message is a powerful one that comes to mind in the context of the current state of financial markets.
Following the outbreak of Covid-19 central banks flooded the markets with fresh capital without missing a beat. The lessons learned in 2008 were still fresh in bankers’ memories. If only the response had been as nuanced as it was prompt. While much of the governments’ largesse failed to reach the intended targets, the message to the markets was clear: expect rates to remain near zero for the foreseeable future. We have witnessed the response: soaring equity markets, a continuation of the boom in industrial and residential real estate and a declining bond market. In his most recent quarterly letter, Paul Singer, legendary hedge fund manager and founder of Elliott Associates lamented the Federal Reserve’s “infantilization” of investors by employing low interest rates to make sure everyone wins but having no regard to longer term economic consequences. As a result, many question the wisdom of holding traditional fixed income when rates can only rise. Stock multiples have reached levels not seen since the Dot Com Bubble suggesting that prices are influenced more by supply and demand than fundamentals. Prime real estate cap rates are largely in in the low single digits and the price of housing is fueled by debt that now exceeds 80 percent of Canada’s GDP. With traditional assets classes offering fewer opportunities, we are like a violinist playing with less than all of the strings. But, to paraphrase the above quote: It is the portfolio manager’s task to deliver returns with what they have left. Spoiler: it’s not as difficult as playing a violin concerto with 3 strings.
It is not unusual for a new client to come to me with the same 3 asset classes: some stocks, some bonds and some real estate. For the last 2 decades this has been a winning combination, but this classic strategy may finally be running out of the steam generated by accommodative monetary policy. At the risk of further abusing the metaphor, if those strings are broken, what do we have left to play with? Here are some thoughts.
Private Equity Secondary Funds. Traditional Private Equity has grown by $3.5 trillion since 2010 and yet, by some estimates, half of that remains unallocated. That’s a lot of capital chasing a finite number of opportunities. Unlike classic private equity partnerships, secondary funds are comprised of investments pre-existing interests in private equity (and other) partnerships that are sold by limited partners to allow the seller to realize on their investment prior to maturity. Because they are the only source of liquidity, and the buyers may have unanticipated cash needs, these positions typically trade at a discount. As they are often sold when much of the funds have been invested, there is the advantage of greater visibility into the nature and qualityof the assets, and the secondary investor is likely to see his capital returned earlier. Discounts have been on the rise. In 2019 (pre-Covid) the average secondary position was sold at an 12% discount, up from 8% in 2018. The dislocations created by Covid-19 are likely to have a sustained positive impact on PE secondaries as existing investors such as require increased liquidity to endure the pandemic.
Agricultural Funds. These funds offer excellent risk-adjusted returns while showing correlations to most asset classes that are very low (in the case of equities, gold and real estate) to negative (in the case of t-bills and bonds). This suggests the returns from agricultural funds are not linked to the performance of other assets. At the same time, the price of agricultural land has declined only twice, and very slightly, in the past 2 decades.
It also bears remembering that not all equity, fixed income and real estate opportunities have been exhausted by monetary policy. Emerging Markets, select non-US developed markets, credit markets, certain categories of real estate and hedge funds still offer opportunities as their valuations realign. All this to say that it may indeed be possible to play, and play well, with less than all of our strings!