So Harold Camping, that delightful old fool, was wrong. May 21 came and went, and the Rapture did not arrive. He revised his Doomsday deadline to October 21, but if the man had any economic sense, he would have gone for June 30 instead. That's because four weeks from now, the markets will have to deal with their own Rapture, as QE2 -- shorthand for the Federal Reserve's second round of so-called quantitative easing -- comes to an end.
What's an investor to do? One would think you'd want to steer clear of the Treasury market, which is going to lose its biggest buyer. As remarkable as the following number may seem, it's true: the Fed has been buying 70% of Treasury issuance since the beginning of QE2 last fall. One might also consider steering clear of equities, on the assumption that the withdrawal of $1.5 trillion in monetary stimulus might negatively impact growth. Then again, if you go short equities, the Fed might surprise us once again with some new round of money printing, in the process giving equity investors new hope. Thinking of shorting the euro? By all means, go ahead, but don't be surprised when the European Union throws a wrench in that strategy by throwing even more good money after bad in yet another forestalling of the inevitable default of Greece.
The unprecedented level of intervention in the capital markets by governments all over the globe has changed the asset allocation game dramatically. There's a whole new category of risk that's been added to our portfolios, and it's one that isn't accounted for in a traditional allocation decision between government bonds and equities. That's where the folks at Evercore Wealth Management come in. They've got a product to fill that gap.
Founded in 2008 with backing from Roger Altman's Evercore Partners, Evercore Wealth Management has just 39 employees and some $2.8 billion under management. For a relatively small firm, though, it's been doing some pretty big thinking. The best evidence of that: their Diversified Market Hedges strategy, overseen by portfolio manager John McDermott.
Predicting extreme monetary measures
Starting in January 2009, McDermott and his team began offering Evercore clients a new strategy designed to find assets that benefit from policy extremes and distortions. Like, for example, the fact that the U.S. monetary base has more than doubled in the past two-plus years. They then invest in anticipation of impending adjustments or in opposition to government actions when the market dynamics seem likely to overwhelm policy, thereby reducing overall investment risk relative to a portfolio exclusively invested in stocks and bonds.
To those of you whose eyes glaze over and ears tune out when the conversation turns to currencies, commodities, interest rates, and deficits, take hope: a lot of what McDermott is talking about is pretty straightforward stuff.
The biggest winners in the strategy? Trades that sat in opposition to the orgy of money printing by the Fed. Evercore clients were sitting on gold from early 2009 -- when it was less than $1000 an ounce -- through early 2011, when it topped $1500 an ounce and they eliminated the position.
Another one: simple country-to-country comparisons. "If one country tells you they're going to print money with abandon and has low bond yields -- that would be the U.S. -- and another is not printing money and has high bond yields -- a few years back, that was Brazil and Australia -- which would you want to own?" asks McDermott. Evercore clients owned Australian corporate bonds paying between 5% and 7% and Brazilian bonds paying 8% to 9% instead of U.S. Treasuries yielding almost nothing. When Brazil and Australia were two of the first countries to raise rates, their currencies also appreciated, adding a kicker to the investment.
If this sounds a little George Soros to you, it should. McDermott and three colleagues spend their time trying to predict what policy makers are going to do, whether those actions are intelligent or insane. But McDermott is adamant that he and his team are not making policy judgments. Instead, they are simply looking for inconsistencies between a stated government policy, its likely objective, and the way that markets perceive that same policy. The goal: to find assets or collections of assets that could appreciate it interventions are ineffective or even counterproductive, but that would not necessarily decline if policy turned out just right. (Otherwise known as the elusive win-win proposition.)
Of course, when you're in the prediction business, you're sometimes wrong. The team bet that the Chinese would revalue their currency in the past few years, something that didn't happen. "We had quite a bit of money doing absolutely nothing in the portfolio during a wild bull market," McDermott says. Another mistake: going short both European equities and the euro itself. "In both cases, we underestimated investors' willingness to rely on further and further and further bailouts," he says. "We operate on the premise that a market has to clear at some point. If it's broken, it needs to default or be restructured. Apparently, the Europeans don't agree with us about that."
How are they positioned today? The Evercore team remains short Europe. But it's been trimming down its "liquidity vehicles"—gold, in particular—in favor of interest rate strategies that will benefit with weakening global growth and a flattening U.S. yield curve.
McDermott has $200 million under his purview right now (a shade under 10% of Evercore client assets, which is their recommended allocation), but doesn't see any reason why he and his team couldn't manage multiples of that amount, especially considering that they're investing in some of the most deeply liquid markets in the world. This is not a hit-the-ball-out-of-the-park kind of strategy. It's meant to help preserve wealth, and as such doesn't use direct leverage. Through the end of April, the fund was up 5% for the year, compared to an 8.4% jump by the S&P 500. Since inception, it's had 17.9% annualized returns with half the volatility of stocks. Very few investments in the strategy look anything like the S&P 500 or a U.S. bond account, so the returns have been largely independent of both of those markets.
At the end of my meeting with McDermott, I was so convinced of the merits of the strategy that I told him I wanted in. Unfortunately, though, I don't have the $5 million it takes to open an account at Evercore. Why don't they start a mutual fund, I asked? After some hemming and hawing, his public relations representative sent over this statement: "At Evercore Wealth Management, we are exploring opportunities to leverage the Diversified Market Hedges portfolio in various vehicles, including mutual funds." Bring it on, McDermott. You've got your first retail customer already lined up.
