Everyone wants to be in the exclusive club

Everyone wants to be in the exclusive club
By Philip Coggan
Published: February 18 2006 02:00 | Last updated: February 18 2006 02:00. Copyright by the Financial Times

Nobody goes there any more; it's too crowded. This famous Yogi Berra phrase* is wiser than it at first appears, especially when it is applied to financial markets.

What Berra meant, of course, is that some venues attract a discerning clientele who treasure exclusivity. When the venue becomes packed, it loses its appeal to such people.

Investors face a similar dilemma. A strategy may look perfectly sensible if they are the only ones to implement it. But if everyone else wants to make the same trade, the rationale can quickly be eroded.

One could call it the tipping rowing boat syndrome. If everyone rushes to the same side

of the boat at once, it capsizes.

A recent example has been the turmoil in the index-linked gilts market. Pension funds have decided, with some help from the regulators, that they should try to match their assets with their liabilities. The asset deemed closest to a pension liability is the index-linked gilt.

As companies may easily be paying current workers pensions in 50-60 years' time, this has created a lot of interest in the long end of the index-linked market. Unfortunately, there is very little stock available.

So a surfeit of demand over supply has forced prices up and yields down, at one point to a historically low real level of 0.38 per cent.

A strategy that made sense at an individual level now makes little sense when followed across an industry. Why lock in such a low yield when, historically, cash has offered a real yield of 1 per cent?

But it seems unlikely that pension funds will give up on this trade any time soon. As Watson Wyatt points out, companies are under pressure to take the risk out of pension schemes, and schemes are becoming more mature (and thus naturally want to own more bonds). There is also the risk that pension funds who wait may find that real yields turn negative.

But the result of all this is that deficits look larger than they probably should (were the market not distorted) and as a result, companies have to make higher contributions to their pension funds, thereby taking money away from capital expenditure or research and development.

Another example of the Berra problem is in commodities where, as I mentioned two weeks ago, investor demand is changing the market characteristics, in particular the relationship between spot and futures prices. This is reducing the long-term attractiveness of commodities as an asset class.

Hedge funds are another case in point. In certain niche areas, so much money can flood into the sector that returns disappear.

That seems to have happened in the past few years in the convertible bond arbitrage market. (Money has now been withdrawn from the sector so it may be becoming attractive again.)

This ought not to be a problem for some of the larger sectors such as long-short equity, which have the entire global stock market to play with. Nevertheless, it is possible that the most talented hedge fund managers were the early movers and the recent flood of hedge fund launches has diluted the talent pool.

Perhaps the greatest example of this syndrome is the cult of the equity market that developed in the 1980s and 1990s.

Equities have historically outperformed bonds and cash over long time periods. This fits in with financial theory; equities are riskier, and thus should deliver an excess return.

In fact, this return has been rather larger than theory would suggest. The Barclays Capital Equity-Gilt Study found that UK equities returned a real 5.1 per cent over 105 years, compared with just 1.1 per cent from gilts.

This led to the belief that equities were always and everywhere the best asset for investors to own. Indeed, one book argued that since equities always outperformed over the long run, they were not risky at all and should attract a higher rating.

The book's title, Dow 36,000, has yet to be borne out by events; the Dow is hovering around 11,000.

But there were a number of problems with this argument. The first was that widespread enthusiasm for equities pushed share prices, and thus valuations, higher. At high valuations, future returns from equities should be lower.

Second, part of the reason for the outperformance of equities was that they had been steadily revalued; share prices outstripped earnings and dividend growth. This could not continue forever.

Third, there is some survivorship bias in the data. Most studies focused on the US, the world's most successful economy. But other countries have been devastated by wars, hyperinflation or revolution. The London Business School found that, in some markets, investors could wait 50 years for equities to deliver a positive real return.

All this was exacerbated by the dotcom bubble, when some investors were convinced they could "day trade" their way to becoming millionaires.

And dotcom mania provided another example of the Berra problem; an internet business might be a good idea if one company attempted it, not when seven did so.

Alas, being rich is, by definition, a fairly exclusive process. When everyone else has the same investment idea as you, it is time to think again.

* Berra was baseball's equivalent of Mrs Malaprop. For some of his wonderfully garbled quotes, go to http://rinkworks.com/said/yogiberra.shtml

philip.coggan@ft.com