as/when interest rates begin to rise…

Yesterday I was reading a brokerage report that was trying to lay out a conceptual framework for investors to use over the next few years.

The first part of the argument was relatively straightforward: that the key to future gains (my view: as always) is the level and direction of interest rates. That’s not true for stocks because they’re the funny kind of bond that academic finance makes them out to be. Rather, it’s because stocks, bonds and cash are the main kinds of liquid investment available to you and me. We may have a personal preferences that influence our willingness to switch among them. Nevertheless, changes in the price of any will exert an influence on the others.

An illustration–not so realistic, but the general point is still valid:

Let’s say the current return on cash, the riskless asset, is 1%; the return on bonds is 4%; and the return on stocks is 6%. For whatever reason, the return on cash rises to 10%, with expectations that it will remain there. What happens to bonds and stocks?

My answer: both stocks and bonds decline until their anticipated return reaches 10% plus a premium to compensate for the extra risk of holding them. Broadly speaking, bonds are total losers in this process. Why would you hold onto a bond that yields 6% if you can get 4% more from switching to cash? In the case of stocks, there may be offsets because the forces that are causing fixed income yields to rise (e.g., inflation) may also enhance cash flow and/or profit prospects. Even so, it’s a steeply uphill battle to avoid losing money in a rising interest rate environment.

Since rates are now at effectively zero, arguably the only way to go is up. In addition, since the principal cause of current economic weakness, an incompetent administration that has trashed the domestic economy, is in the process of being removed (kicking and screaming), chances are rates may begin to rise as early as next year.

The brokerage report investment solution? …alternative investments, like hedge funds, private equity and real estate.

Personally, I’m skeptical. Here’s why:

—alternative investments tend to be extremely illiquid. So it may be hard, maybe impossible, to reverse the decision

–the only pricing information may come from the promoters of the investment. It’s hard to know how accurate this will be

–there’s only infrequent pricing information. The fact that the promoters’ assessment of long-term prospects hasn’t change does not mean that the investment is still worth what it was in a lower interest rate environment

–except for a few years after the 2000 internet crash, hedge funds have consistently underperformed S&P index funds over the past quarter-century. Yes, there have been a few winners, but there’s no guarantee we’ll stumble into one

–my observation is that the fees to all but the top, top tier of wealthy individuals are high enough to reduce the net returns to pedestrian levels. I recall, for example, a private fund run by famous Hong Kong-based investors that bought mainland Chinese mid-sized growth companies, which was opening itself to new money. I got to see results to date. The results over the prior ten years for non-family investors was about the same as the return on the Hang Seng index. Maybe less, certainly not more

–early in my investing career I studied the small oil and gas companies that created and sold limited partnerships. The partnerships were typically filled with sub-standard drilling prospects and the limited partner got tax breaks but (my observation) nothing much else. One day early on I got up the courage to ask a successful partnership-selling company what the attraction of the product was …because I couldn’t see it. The answer: not the economics, which were bad, but the idea that the holder could hope to impress acquaintances at social gatherings by alluding to his private investment interests.

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