Investing this autumn is like a donkey derby

Posted on 13 September 2008 with no comments from readers

Hedging market positions was something I first discovered as a small child. My father had taken me to a charity event called a donkey derby which was a bit like horse racing only with donkeys instead of horses. There were half-a-dozen book makers offering odds on the different donkeys in the race.

My father gave me a pound, which was quite a lot of money in those days and said: ‘Peter go and place bet on the donkey you think will win.’ I immediately saw that there was a great upside in winning but that I stood to lose this pound which I already had in my hand. So I decided to split the pound ten ways, and then I was bound to win.

When I told my father what I had done he said the odds would work against me and there would be nothing left. But the whole market-making process looked such a mess. I thought spreading my risk would probably produce the best result. At the end of the afternoon I went up to my father and gave him his pound back, and asked was it all right to keep my profit? He smiled and said all the other children had lost their money so I might as well keep it. I did not like profiting from charity and put the money in a tin. The lesson here was that spreading risk can be a strategy against hopeless situations like trying to pick the best donkey in a race when you know nothing about donkeys.

Investors in today’s markets face a similar situation. Most asset classes are in trouble, and spreading risk makes sense. Who really knows what is going to happen in markets that seem both on the one hand in serious difficulty, and on the other subject to huge interventions and manipulation. You need to hedge your positions.

Then if the US dollar rises in value you will lose on gold – although gold has lost less than many expected in the recent bear market rally in the dollar – and if gold surges in value then that would protect you against a depreciating dollar.

UAE revaluation

For UAE investors another hedge against a depreciating dollar is to hold your money in the dirham, which is pegged to the US dollar. There has been much talk of revaluation of the UAE currency and it has been squashed by the authorities. But surely the revaluation would come back onto the agenda if the dollar falls by another 20 per cent as some experts think; and revaluation could also be a part of the 2010 currency union which is not so far away now. Thus holding a dirham account is a free hedge against dollar weakness and 2010 might see a revaluation anyhow.

But is it wise to hold local and global stocks, bonds, hedge funds or real estate in the current climate? I think it has to be a matter of balancing a portfolio correctly, but the bias should be towards precious metals and cash which will hedge against each other as described above.

Then consider bonds as an investment option: the low yields paid by US treasuries do not look very attractive with inflation rates soaring around the world, even without the possible further devaluation of the dollar. But this is a hedge against exposure to equities which have a reverse correlation to bonds.

Bond strengths

For example, suppose the US stock market crashes – as it did as recently as early 2000 and indeed this year’s downturn is technically a bear market correction – then bonds would surge in value as people sold shares and bought a safe asset class in the expectation that Fed interest rates would be cut. Do not forget bonds carry a fixed interest rate, so if official rates fall then bonds rise proportionately in capital value.
If you want to have greater exposure to the UAE stock market than global equities – a sensible choice given the greater strength of the relative economic outlook – you could hedge your interest with the purchase of local Islamic bonds, known as sukuks which act in practice in an identical fashion to traditional bonds.

Hedge funds do all this for you, at least in theory. Plus global hedge funds typically buy shares both short and long, that is to say they can gain whether shares rise or fall – quite a useful facility in difficult markets, providing that your fund manager has great wisdom. The problem over recent years is that the hedge fund business has grown so big and attracted many players who fall short on genius while being long on fees.

Hedge funds of funds

You have to pay even higher fees to buy what is called a ‘fund of funds’ which hedges its bets by investing in a collection of hedge funds. This is the ultimate hedge against bad financial markets. But generally if you remove all risk from a strategy then performance suffers, quite apart from stacking up huge additional fees. However, some professional financial managers are backing ‘fund of funds’ and their performance is being keenly watched.

That leaves real estate to consider as an asset class. Property seems currently to be suffering worse from the credit crunch, liquidity squeeze or de-leveraging, however you care to describe the ubiquitous fall in bank lending on real estate. Put at its simplest, real estate was driven to higher and higher values by easier and easier borrowing, and is now falling and falling in value as loans are harder to obtain and more expensive.

Yet if you do not own a home to live in the alternative is to rent one. Anybody who chose to buy a home in the UAE just a few years ago is a lucky person because not only has their house risen in value it is saving them a fortune on sky-high rents. And the danger of selling out now is that house prices will continue to rise along with rents, so you would end up losing both on capital gain and the cost of renting another property.

Therefore, owning somewhere to live in the UAE probably makes good sense. On the investment side you would need to do some careful calculations comparing the total cost of ownership with likely rental income. Certainly if you can access home finance at a preferential rate, or divert money that would otherwise earn one per cent sitting in a deposit account, this will make sense; but it easy to get carried away and over-stretched investing in real estate.

Avoid global real estate

Local real estate is definitely a better buy than global real estate which should not be touched until prices have stopped falling, and currencies too in the case of the pound and euro. The yields available on global property also have to improve significantly before it looks an attractive asset class again. If you already own property overseas consider selling it if you can. If you decide to hold this is a triumph of emotional attachment over good financial sense.

In conclusion, what you really want to achieve is a balanced portfolio, and one appropriately balanced for the troubled financial times we are living through. It is hard to generalize about appropriate portfolios as so much depends on your own life circumstances and things like age and health. But as a general rule the most conservative allocations, skewed towards cash, precious metals and bonds tend to offer the best protection in difficult financial markets. Real estate and equities are what you should be buying with your closely guarded cash and gold only when prices are on the floor. That might be a few years away yet, so this is not a time to be brave.