Clients run scared of hedge funds

The year ahead may not bring the market rebound everybody is hoping for after a catastrophic 2008. But some low-risk assets could offer attractive returns, according to Gary Dugan, CIO at Merrill Lynch Global Wealth Management in Emea. “We are very cautious about 2009”, he stated, with too many structural imbalances around the world that need overcoming. He referred to the huge amount of debt still to be paid off by countries, companies and individuals, which affects the level of consumption, investment and global growth. Mr Dugan’s advice to his wealthy clients is to take “limited risk to achieve modest returns,” warning investors against the mistaken idea of trying to rebuild this year the wealth they lost in 2008 – the worst year since the 1930s great depression - as that would take an incredible amount of risk. While encouraging investors “to put more of their income to work in financial instruments,” Mr Dugan’s recommends building credit exposure, mainly in government bonds and high grade corporate bonds, while reducing allocation to risky assets. “Investors still tend to have unrealistic expectations about the return they can achieve, believing that their portfolio should return 10-12 per cent in a normal year,” he said. But portfolio return should be more realistically set at a 3 to 7 per cent range. “That is a more realistic demand on companies, governments and on us, portfolio managers,” he said. “For the last 10 years a lot of people have been kidding themselves they can achieve a bigger growth figure. When they realised they could not do that, they started to cheat, back in the tech boom. We don’t seem to be learning from that and we have gone trough another wave of piling on a lot of debt and cheat yet again, until something broke in 2007-2008.” A real portfolio return of 3-4 per cent in 2009 will still be in line with long-term averages, given the expectation of negative inflation, said Mr Dugan. Bonds attractive Specifically, the real buying power for government bonds is going to increase making it an attractive asset class, because of deflation. High-grade corporate bonds are also a good bet but “we are very defensive in what we are choosing,” he said. “People believe ‘bond yields face a huge wealth of supply, it is great big bull market that is about to collapse’. But I just don’t see it,” said Mr Dugan. “If we have got inflation still at -1 in some of the developed countries, the bond yields which range between 2.5 and 4 per cent across the developed world, offer an incredible real return.” Even if this bet turns out to be wrong in the long term, investors are going to see a good performance in risky assets, which is going to overwhelm the losses they may have made in the bond part, he said. Broad equity indices could offer good trading opportunities but rallies stimulated by government action and further interest rate cuts “will run out of steam” in the second half of 2009 and investors should be prepared to take profits, he said. Healthcare and cyclical stocks such as media, technology telecoms are the favourite sectors to hold in portfolios. Gold is going to be a safe haven which will generate a good positive return. Continued worries in the global economies in the first half of the year and the forecast dollar weakness in the second half will lead to gold price appreciation. What Mr Dugan is “largely writing off” this year is the hedge fund arena, because of the huge outflows, growing gates, which have significantly increased the illiquidity of these instruments, and general turmoil in the industry. “Even the best hedge fund manager is going to be hampered by the current market,” he said. Moreover, investors are “running scared of hedge funds.” In Merrill’s absolute return portfolio, today’s allocation to hedge funds has decreased to 10 per cent from the 20 to 30 per cent range designed in the original model. The current crisis has also exacerbated that move from product-push to service provision which has been a much hyped trend in the private banking industry in recent years. “What is really important is to try and understand what clients are trying to achieve with their money, what their realistic expectations are for the growth of their wealth and how much money they need to fill all their different pots, such as saving for retirement, to raise children or to do philanthropy, and how much risk they need to take,” explained Mr Dugan.