Investor: Equity investors mulling over their portfolio valuations could be forgiven for wondering whether anything significant had happened during the first half of 2004. With the notable exception of Japan, most equity indices are hovering just above the levels that pertained at the beginning of the year.
The ISEQ Overall Index does stand out with a rise of approximately 9 per cent but much of this is due to the spectacular recovery in Elan. If the rise in Elan is stripped out then the Irish market's performance slips back into the pack with a year-to-date rise of just under 2 per cent.
When currency movements are taken into account the picture improves somewhat for the euro-based investor, because both the dollar and sterling have strengthened against the euro so far in 2004. For example, the euro return from both the S&P500 and the FTSE100 is around 6 per cent compared with local currency returns in the 2-3 per cent range.
These broad numbers mean the majority of equity investors will find that their portfolios will have achieved quite modest returns over the first half of this year.
After the sharp declines that occurred between 2000 and 2002 such an outturn may seem acceptable to many investors. However, in contrast to the 2000-02 period the returns from other asset classes have also been poor during the first half of 2004. It is worth recalling that, during the equity bear market, bond yields declined sharply as investors worried that the world could have been entering a prolonged period of deflation.
Falling interest rates and bond yields meant that the market prices of medium and long-dated bonds rose sharply. Therefore, the rising value of bond portfolios provided a welcome offset to declining equity portfolios. By end-March 2003 the yield on the 10-year US Treasury bond stood at 3.8 per cent compared with the yield of 6.4 per cent that pertained at the beginning of 2000. This fall in yields of 2.6 per cent meant that many bond portfolios would have enjoyed capital appreciation well in excess of 25 per cent over that period.
From end-March 2003 equity markets started to recover in response to the ending of the Iraq war and the subsequent improvement in global economic growth. Not surprisingly, bond yields began to rise and yields have continued to rise during the first half of 2004. At the beginning of the year the yield on the 10-year US bond was 4.2 per cent but this has now risen to 4.7 per cent.
This upward drift in yields was repeated across global bond markets and resulted in declining market values for many bond portfolios. Therefore, most investors will find that the bond element of their portfolios will have dragged down the overall portfolio return so far this year.
Another trend that emerged during the equity bear market was a large increase in the flow of funds directed into alternative investment categories such as hedge funds. It is estimated that over $1,000 billion (€826 billion) is now invested in global hedge funds. Hedge funds differ from mainstream equity and bond funds in that they adopt a variety of very active trading strategies across several markets.
The majority of hedge fund managers aim to generate a positive absolute return on a consistent basis irrespective of any particular market trends. For example, many hedge funds generated positive returns in the 2000-02 period by going "short" of equity markets. Effectively they sold stock close to the market peak and bought it back when the market had fallen. These strategies were generally implemented through derivative contracts such as futures and options that are tied to movements in equity market indices.
Up to recently hedge funds were the preserve of the very wealthy investor. However, over the past 12-18 months many large mainstream institutional funds have begun to allocate a portion of their portfolios to hedge fund managers. Also, some retail products have been launched that have made hedge funds available to the medium-sized retail investor. Unfortunately, many of those investors looking to alternative investments to enhance returns will be disappointed with the first-half 2004 outcome.
It is difficult to get hard and fast performance data for the hedge fund industry because it is offshore and lightly regulated. Nevertheless, it seems that many hedge funds did poorly in April and May and on average hedge fund returns are probably just barely positive this year.
With small positive returns from equities, declines in bond portfolios and little good news from hedge funds, diversified investment portfolios will do well to produce modestly positive returns over the first half of 2004. Of course many Irish investors have turned to property as their favoured investment asset over the past decade. Residential property values have continued to rise in 2004 even though rents have declined over the past 12-18 months. Conditions in the commercial property market have not been quite so favourable and the Dublin office vacancy rate is still quite high.
With all the main asset categories struggling during the first half of the year it has been a difficult period for investors and their fund managers. However, if economies continue to grow and interest rates rise in line with consensus expectations, the second half of the year could well bring a little more cheer to investors.
