Rising risk and capital inflows

05May06

Timing is of course one of the most difficult task investors face on a daily basis. Research has shown that retail mutual fund investors actual portfolio returns generally lag the published returns of their underlying funds due to poor market timing. Some asset classes are now apparently experiencing capital inflows so much so that managers are finding it difficult to put the capital to work in a prudent and timely fashion.

James Picerno at the Capital Spectator has been on top of the topic of risk-seeking behavior in the markets. With the riskiest sectors of the capital markets showing the highest returns it begs the question, where can investors go now to achieve decent returns? Emerging markets which have been the beneficiary of strong economic growth is at risk if a domestic economic slowdown spills over. Investors should note that the emerging markets are not the only asset class experiencing significant inflows.

Paul Kedrosky (with a shout-out to Goscinny and Uderzo) notes the "insatiable desire of limited partners" to invest in venture capital despite the inability of the industry to handle the potential inflows.

The challenges of excess capital is also being seen in the real estate sector where private capital continues to seek out going-private transactions in publicly traded REITs. In a piece at Marketwatch.com, Barry Sternlicht has some ominous thoughts on the real estate market:

Barry Sternlicht, chairman and chief executive of Starwood Capital Group, said the glut of capital chasing after real estate "feels a lot like 1989 or 1990" before the real estate blow-up.

"It's the first time since the real estate crash, we've gone back to negative leverage in real estate," said Sternlicht….

"There's too much (cheap) money in the world," said Sternlicht. "It feels a little like musical chairs, where the last guy standing is going to get hurt."

The success some of the largest university endowments, i.e. Yale and Harvard, has prompted a number of smaller university endowment funds to rush headlong into alternative investments. Anne Tergesen at BusinessWeek.com documents the trend illiquid investments.

But the heavy reliance on hedge funds raises concerns that smaller institutions are moving into these investments just as performance may be peaking. Hedge funds create trading strategies that exploit anomalies and inefficiencies in the markets. When they see a strategy that works, other funds copy it — until the anomaly is gone. The more hedge funds there are, the faster opportunities can dry up.

None of these stories individually means anything. As we very well know market trends can continue far longer than anyone, even the most ardent supporters, believe can happen. Taken as a whole these stories are indicative of risk-seeking behavior on the parts of investors. The risk is that something will derail investors looking for higher returns.

As Picerno noted it could be a domestic economic slowdown, or alternatively substantially higher interest rates would make for greater competition in addition to making some leveraged investments less attractive. As the old saying goes, "nobody rings a bell at the top," but it doesn't hurt to keep your ears open.

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