Trends Watch: Low Interest Rate; Scrutiny of Fees; PE Bubble
September 04, 2019
By Elana Margulies-Snyderman
EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.
This week, Elana talks with Lukasz R. Tomicki, President, LRT Capital Management.
What is your outlook for alternatives?
There are several themes I see. The first is ultra-low interest rates driving continued interest in alternatives as a replacement to fixed-income strategies. Investors are looking for 6-9% returns with low correlation to traditional asset classes, not the +20% returns that characterized hedge funds in years past. I believe low interest rates are here to stay, and this will underpin continued demand for investment alternatives.
On the flip side, there is ongoing scrutiny of fees and managers truly have to provide alpha and deliver value. Fee compression is an ongoing issue for managers, which means that only larger managers, with large capital pools, can sustain profitable businesses. Small managers must add value and scale quickly. Managers must genuinely add value to justify their fees. The days of paying 2/20 for an undifferentiated long-short equity strategy are probably over. Fidelity has already released a zero-cost index fund, and ZERO fees is likely to be the default cost of index investing going forward. Investment vehicles with zero management fees are quickly becoming the default that is what you are competing against as an investment manager. One has to work very hard in this environment to justify any fees at all.
Finally, I believe there is a bubble in private equity, illiquid investments. Institutional investors have become convinced that private equity and private credit offer the holy grail of investing: high returns with low risk. Many investors have grown so scared of mark-to-market losses that they prefer illiquid investments that are not marked to market. These private investments offer the illusion of stability and safety because their valuations are subjective. The explosion in private credit and private equity funds that we have witnessed over the past decade is a testament to that. Most private credit funds have not been through a credit cycle and investors in those funds will experience an unpleasant surprise should the economy turn down and credit become tight once again. There is no way of knowing what the level of defaults for private credit will be in the next recession. Similarly, leveraged buyouts (LBOs) being done today are happening at extremely high valuations which almost guarantees investors in those funds will not fare well when the dust is settled. Because of the illiquid nature of these private funds, the true extend of the poor performance from private equity is likely to remain hidden for many years to come.
What is your outlook for the economy?
The U.S. economy is strong and the expansion is likely to continue at a moderate pace. Corporate profits will continue to rise with rising GDP. The stock market will climb a wall of worry, and market commentators will continue to try and scare people out of the market. Economic expansions do not die of old age.
There are always things to worry about such as the trade war, geopolitical tensions and a slowdown in Europe, but the reality remains that the U.S. economy is quite isolated from the rest of the world, with net trade being a tiny part of U.S. GDP. I believe the economy has more room to run than most commentators believe, precisely because the expansion has been so tepid during this cycle. Housing construction has not expanded significantly, U.S. corporate investment has remained restrained, and loan growth has been weak in the U.S. financial sector. All of these have held back the growth rate of the economy but also mean that there are few obvious excesses or imbalances in the economy. Without a significant macroeconomic imbalance that can "burst," it is hard to see a U.S. recession.
A slow but steady expansion with low inflation remains the default scenario for the U.S. economy. In such an environment, U.S. equities should continue to perform well.
What keeps you up at night?
A return of inflation is the biggest risk out there that almost no one talks about. All signs point to low inflation in the future, and we have become accustomed to low inflation and low interest rates. There is clearly something in developed economies (E.U., Japan, and the U.S.), that keeps inflation very low. I think that phenomenon is here to stay. The "Phillips Curve" is clearly a thing of the past. Lower levels of unemployment are not generating increased inflation. If this were to change it would change my outlook on my asset classes. A sustained rise in inflation would change asset prices in a meaningful way. I think a sustained and unexpected return of inflation is a key risk that markets are missing.