Investors have never been given so many options for their money but so few really attractive choices
'Water, water, everywhere, and not a drop to drink,' lamented the shipwrecked sailor. Investors are beginning to know how he felt. Never have there been so many financial markets open to institutions or individuals, and seldom have there been so few compelling investments. And even when they are offered a stupendous deal, investors are just not ready to commit.
Individuals may need income but there are other ways of securing it than playing the markets. Institutions, however, have to invest the money they are given. Doing nothing is not an option. But in difficult times, they find themselves manacled by rules and regulations designed to protect investors from a repeat of past incidents ' corporate raids on pension funds, insurance fraud, poor risk assessment and other hazards.
Insurance and pension funds are particularly vulnerable to regulatory requirements governing their investment processes. Forced selling due to compliance demands is now a major factor driving stock markets lower. Many fund managers are wringing their hands, as carefully constructed portfolios are blown apart by market volatility. Over two days last week, the FTSE 100 experienced the steepest loss for eight months, followed by the sharpest rise for 15 years.
Such massive swings play havoc with small players and big institutions alike. What are their options? Individuals are flocking to money market funds, where the fun and games is probably just beginning. The dollar is already under considerable pressure, without factoring the cost of war in the Middle East, but the euro has yet to claim world currency reserve status. Sterling is flip-flopping about in the middle and will remain in that state until the UK decides on euro membership.
For institutions, large cash holdings are currently indefensible, with returns lower than government bond yields. Most funds have cut back equity holdings ' in the US, typically 80% of portfolios are in equities but in the UK it has slipped from 60%-plus to 45%. In continental Europe, some insurance funds have as little as 10% in equities and even pension funds have just 15%. Over the longer term, asset liability modeling suggests these funds will have to return to equities but for the moment, say managers, they have run out of 'risk budget'.
The equity allocation is being redirected to corporate bonds and emerging market debt, symptomatic of the search for high yield. Although corporate debt does have an equity component, investors are creditors rather than shareholders. Nobody can say where a company will be in 20 years time, so demand is greatest for five to seven-year paper, with issuers that have strong and proven end-demand for their goods and services.
Emerging market debt is perhaps a surprisingly high-risk asset class for institutions to be considering but many sovereign issuers have come a long way since the emerging market bubble burst in the 1990s. The re-rating of Russia, for example, still has some way to run and analysts are already talking about investment-grade status within the next year. Emerging market debt offers nominal returns of 2%-plus over anything available in mainstream markets.
In the drive to manage risk as tightly as possible, the smart money is using alternative investments previously considered too complicated and costly. Hedge funds have disappointed over the past two years but there is growing evidence to prove they at least reduce the overall volatility of a portfolio. If their black-box technology renders salt water drinkable, it may just sustain investors for a year or two until they are rescued.
Senior Managers Regime
Interest rate outlook unchaged
FCA made demands last week
'Unsung' part of FSCS work