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Steer clear of the free lunch, says Noster

Diversification is meant to be the only free lunch in investing.

But according to hedge fund Noster Capital, with most markets looking toppy and with problems ahead, it’s not necessarily one that investors would be wise to tuck into.

“This is not the time to be invested in broad ETFs or in very diversified funds, because the indexes will likely not do much in aggregate,” it says in its end of year letter.

“We feel that most asset classes are currently approaching untenable levels, and while they could certainly grow dearer for some time to come, in most cases we have long passed the level where investors are being adequately remunerated for the risks they are taking.”

Markets are likely to be range-bound for the next 3-5 years, meaning that just buying and holding stocks might not be the best approach, says Noster.

“The likely way to succeed in the years ahead is to be very selective and tactical about what one owns, to be ready to sell if assets approach fair value and, most importantly of all, to be protected and retain liquidity so that one can take advantage of opportunities that will transpire when any of the myriad things that could (and will) go wrong, do.”

A painful lesson in diversification

As if RAB Special Situations’ woes weren’t enough already (investing in Northern Rock before its collapse, putting a high percentage into illiquid assets, 70 percent loss in 2008, locking up investors), the company told me yesterday of more bad news.

Explorer Falkland Oil and Gas, whose shares more than halved on July 12 when it revealed it hadn’t found any oil at the part-owned Toroa well, accounted for an amazing 24 percent of Special Situations’ portfolio before the fall (and presumably rather less now).

Of course, concentrated bets are great if they work (and would go some way to making back the losses suffered during the credit crisis).

But, as RAB is probably painfully aware, supposedly the only free lunch in economics is diversification. It will be interesting to see how Special Situations’ portfolio looks 6 months from now, and whether caution over further losses has outweighed the temptation to keep on big bets in the hope of big returns.