ASSET MANAGEMENT: New covenant
The turmoil over the past two years called into question some of the fundamental principles of asset management. Vanessa Drucker reports from New York on the 10 lessons to arise from the global market upheaval.
the global market meltdown of 2008 and 2009 proved a bitter, humbling experience for investors and money managers. Although the 2009 rebound mitigated some pain, and a handful profited from the volatility, no one called both top and bottom correctly. Lessons taken away from the financial upheavals have affected broad swathes of the world’s population, from individual savers and employees to business owners, endowments and public institutions. Faith in quantitative methods and free market regulation has been battered.
Some of the most esteemed asset managers report they are open to education at every stage, and that studying market cycles from afar is no substitute for living through them. Others, who are reluctant to admit to or correct mistakes, risk repeating them. those who claim to have learned little or nothing are probably not being honest.
Discussions with a sample of American asset managers yield a crop of analyses and resolutions. They confront concerns like, what rattled you most? how will you change your investing behaviour? how did the crisis affect your attitude to your profession and the money management business?
1. Portfolio theory in doubt
Modern portfolio theory (MPT), a model originated by Harry Markowitz in the mid-20th century, is premised on diversification. the theory states that investors can maximise returns and minimise risk by combining uncorrelated assets. Rick Ashburn, the manager of Creekside Partners in Lafayette, California, had long doubted both MPT and rational investor theories, which extrapolated the future from past averages. But when all asset classes converged in the crisis, correlating to one, the plunge in corporate debt stunned him. “Advisers need to let go of investment ideas that only work on paper in the netherworld of academia, and instead learn how the real world works,” he says.
Bard Malovany of Sagemark Consulting in Annandale, Virginia, notes that it may not be sufficient to know that various asset classes normally have low correlations. “One must know why they do so and how – and how those relationships can break down.” He points out that many managers who were using fixed income as a diversifier and a “bastion in a storm” sank under water by double digits when the asset class failed to perform as expected.
Beta, a key concept in MPT, describes how much an asset changes in price relative to its entire market. “Attention to beta as a de rigeur risk measurement tool has been a complete failure,” adds James Berman who runs JBGlobal in New York. “Volatility is a poor measure of risk, since it is the market’s own measure. If the market’s price is not right, how could the risk be?”
Are equities riskier in the long or short run? Michael Edesess, Denver-based chief investment officer at Fair Advisors, had always argued for the short term, based on the likelihood of outperforming any low interest rate as time lengthened. He changed his mind upon reading a study by Zvi Bodie, a finance professor at Boston University, which showed how the cost of insurance to make an investor whole – in this case a put option – grows more expensive over time. “This paper should have been regarded as a seminal work right away when it first came out,” Edesess says. “That it wasn’t reveals academia’s complicity in the bubble phenomenon.”
2. Liquidity injections
Many investors, particularly those who missed the early propulsion of the rebound, wish they had followed that old Wall Street saw, ‘Don’t fight the Fed’ (Federal Reserve). even more than the decline, the recovery reinforced a traditional rule not to ignore the impact of monetary and fiscal policy both on markets and market perception.
“I should have paid more heed to the massive global liquidity injections,” says Stephen Weiss, a New York-based managing director at Leerink Swann, an investment bank. indeed, it would be almost unthinkable to experience such inflows without some form of recovery. Weiss is reminded of another old adage, that it is the consumer that leads in and leads out of a recession. Weiss, who “missed out on the easy money”, wishes he had paid even more attention in March 2009 to the outperformance in retail stocks. “It’s critical to remember that the market is a discounting mechanism, so we should not expect everything to turn at once at the bottom.”
If the lesson is to follow the central bank’s lead, does that translate into a sell signal as soon as those institutions start reversing and raising interest rates? “Not necessarily,” argues Michael Kitces of Pinnacle Advisory Group in Columbia, Maryland. true, massive deleveraging will need to take place over many years and will operate as a headwind to growth. But Kitces makes the case that the Federal Reserve could raise rates as high as, say 3%, which could still be considered expansionary.
in future, most professionals will be paying even closer heed to the interconnection of politics and government power. Eighteen months ago, few realised the extent of the powers of the Fed and the Treasury for expanding the government’s balance sheet and bailing out certain industries.
3. Protecting principal
Will Rogers, an American comedian during the 1920s and 1930s, once quipped he was more interested in return of capital than return on capital. Edesess advises one should determine an absolute minimum real cash flow that must be protected. His chosen strategy is to buy a suitable laddered portfolio of inflation-indexed government bonds and hold them to maturity.
one timid client once told Elliot Herman, “I don’t want any part of that gambling thing,” when he suggested the stockmarket to her. Herman, at PRW Wealth Management in Quincy, Massachusetts, spent much time asking himself last year if she was right. He has embraced a new trend of absolute return exchange traded funds (ETFs), as a hedge against downside volatility, offering low correlations to broader American and global markets, with low minimums. He directs conservative clients to allocate 20% or more of their portfolios in them.
both wealth managers and institutional funds have explored various protective tools over the past months. Paul Tran, president of Focal Point Financial & Insurance Services in Irvine, California, safeguards clients’ assets with fixed income annuities, index life insurance and retirement plans with insurance provisions. Mark Pearson, president and chief investment officer at Anchor Capital Management, a value-orientated firm in Minneapolis, had overweighted his portfolios last year in basic materials and financials. in retrospect, he would have bought additional reverse ETFs to hedge those sectors, and plans to do so.
4. Behavioural psychology
Ashburn had always said that when stocks became cheap enough, he would not hesitate to dive in, but it turned out to be extremely hard to take the plunge as they nosedived. Berman, who teaches finance classes at New York University, regularly polled his students during the crisis, and discovered they always extrapolated in the direction of recent past movement. in March 2009, when the Dow Jones Industrial Average was at 6547, they predicted, on average, 3000.
Berman himself was unprepared, however, for multiple waves of rolling panic. “I underestimated the severity at first by a wide measure.” What made the emotion so extreme was the overlapping financial panic and market collapse, superimposed like a Venn diagram, which created unique levels of fear. while behavioural experts profess that markets must reach definitive levels of capitulation before they hit bottom, the meltdown brought many discrete points of capitulation. fear became so powerful, that even a collapse of, say, Citigroup or Morgan Stanley might have seemed incremental. (Studies of Israeli markets after terrorist attacks have demonstrated how a certain “numbness sets in,” says Berman.)
Trust broke down. “What struck me, on a personal note, was how people turned against one another,” recalls Michael Beattie, portfolio manager for Tradex Group in Greenwich, Connecticut. “Prime brokers turned against clients, clients turned against hedge funds, leaving the whole industry in broken disarray. A manager’s knowledge or sophistication or experience didn’t matter.” the panic had divorced emotion so far from reality that all banks were regarded as suspect. then, in a final twist, in December 2008 the Madoff scandal erupted. “It became even harder to trust the person at the other end of the telephone,” Berman describes.
During the crisis, the school of behavioural finance attracted increasing interest, as investors lost their moorings in classical theories of value investing. John Maynard Keynes described stockmarkets as a kind of beauty contest, where the most sophisticated punter seeks not the prettiest face, but rather the one most likely to be chosen by other judges. Edesess, who holds a PhD in mathematics, has always been fascinated by Heisenberg’s Uncertainty Principle, which basically states that no observer can be entirely detached. George Soros explored a similar notion with his “reflexivity” concept. the market turmoil caused Edesess to pay more attention to how the idea functions in the investment world. “The bubbles changed my thinking about market efficiency,” Edesess says.
for example, CEOs and heads of companies must act with confidence, whether genuine or not. otherwise they risk spooking investors. as another illustration of reflexivity, some of the subprime bankers might argue that, were it not for the naysayers, they would still be surviving and thriving.
sometimes it takes an upheaval to refocus attention on governance and transparency. at RCN Genter, in Los Angeles, president and chief investment officer Dan Genter has spent hours in discussion with his department heads over what they do differently today. “We radically underestimated the degree of leverage, especially off balance sheet, among banks, insurance companies, municipalities, across the board,” he says. His teams perused ratios, coverage, and cash flow to debt service. Yet although they knew they could not understand all the cross covenants and cross collateralisations in depth, they finally downplayed and “turned a blind eye to the glimmers of smoke”.
the tell-tale signs were difficult or impossible to uncover for anyone but an inside auditor. at the time, Genter and his peers were complacent to pick up an extra 600 basis points, or more, to boost alpha and enhance return. all were driven by competitive relative performance, which demanded representation in large banks to avoid underperforming benchmarks. “What we know now is that you must dig and dig and dig some more, and if you don’t understand it, don’t travel there,” he says.
in similar vein, Berman no longer accepts 90% transparency from companies, and demands more disclosure on governance. He should have been even more rigorous in analysing AIG, for example. while he had always been circumspect about off balance sheet obligations, he used to say that, as long as they were properly disclosed and footnoted, adequate supervision was in place. Berman, moreover, ranks as one of the conscientious ones. “Most advisers and investors don’t read prospectuses,” Tran says.
“Everyone took hedge funds almost for granted until 2007,” says Beattie, who manages funds of funds. “We got complacent, thinking most managers who accumulated assets with a three-to-10-year track record would be bullet-proof in nearly any environment.” Now he is more apt to regard hedge funds with the same scepticism as private equity or long-only investments.
6. Mediocre managers exposed
According to one of Warren Buffett’s most popular witticisms, it is only when the tide goes out one discovers who is swimming naked. in 2008, the tide began receding mightily. in a normal environment, a standard manager might experience disasters half the time, but that would be offset by the other half, when investments performed favourably. Anything that could potentially go wrong in an environment of increased uncertainty and volatility, will do so. Beattie warns, “You don’t get a second chance.”
“The crisis offered a rare opportunity to look carefully to see who outperformed,” Weiss suggests. Several long-only managers, or even hedge funds, typically hide behind the indices. They might mimic the S&P 500, or the FTSE 100, and goose their results by taking an outside bet on one or two stocks or sectors. Where did their swimming suits go?
7. Liquidity matters
Institutional managers found themselves locked into illiquid positions, while individual investors and wealth managers suddenly experienced the trauma of cash crunches. Todd Schoenberger, a managing director at LandColt Trading in San Antonio, Texas, has drastically re-evaluated the percentage of cash he advises investors to hold.
Before 2007, he recommended 10% of an entire portfolio; now he says a minimum of 30%, as a cushion for dealing with expenses. “We are too close to the recession and the threat of a double-dip still remains intact.” He considers it would be irresponsible to reallocate off the cash position before a sustainable recovery emerges, marked by three consecutive quarters of GDP of at least 2%.
from the institutional side, Beattie came to realise how illiquid certain funds turned out to be, such as those holding convertible bonds, levered loans, small or midcap equities or emerging market securities. Hedge funds needed to “side pocket” many positions, that is, segregate the illiquid portions from the rest of a portfolio.
Beattie vows to be more conservative in making judgments regarding the liquidity of the underlying components of the funds he buys. What types of assets give him comfort? He highlights managed futures, large cap equities, volatility traded in listed plain vanilla options, agency mortgages and liquid convertibles. meanwhile, he would shy away from any type of structured credit or less liquid over-the-counter derivatives.
8. Avoid noise/think long term
Blocking out the cacophony of news commentary and media pundits during market events is never easy. Herman receives many emails from clients who have been “bombarded by media that shapes their thinking,” as well as newsletters and magazines. He tries to boil the arguments down for them, presenting both sides. in the past couple of years, he sometimes found it helpful to bring out an old copy of Time magazine from October 1974, showing President Gerald Ford with a rolled up sleeve on the cover. the grim headline reads, “Trying to fight back (inflation, recession, oil).” He uses history as a starting point for framing discussions, rather than a means to discount concerns.
“Try to block out all the outside noise from the so-called experts being quoted daily on TV,” agrees Scott Kahan, a New York- based principal at Financial Asset Management. He emphasises the importance of a long term perspective, after his own 30 years’ experience as a financial planner, and having ridden the wave of previous downturns. Kahan adds, “Learn from mistakes, something many don’t do.”
9. Develop a sell discipline
Imagine a day at the races. you have lost your allotted gambling money. Do you go to a cash machine, to withdraw some more, or do you call it quits when you reach your threshold?
every investor knows that selling is much harder than going shopping for securities. “Our whole industry is predicated on buy, buy, buy!” sighs Matt Hudgins at Mosaic Wealth Management in Atlanta, Georgia. He likes to dollar cost average his way out of a position, just as he would dollar cost his way into one.
Clients claim they understand a sell discipline when it is explained to them in advance, but when the time comes to take a loss they may balk. Studies in Prospect theory, developed by Daniel Kahneman and Amos Tversky, showed that subjects felt the pain of a financial loss about twice as bitterly as they enjoyed the pleasure of gaining an equal profit. last year, however, investors were more willing to unload their losers.
“That difficulty was overcome by fear of the market going to zero, irrational as it may be,” Hudgins explains.
Hudgins himself has learned to understand better his clients’ risk tolerances, and how much volatility they can take. “They are all brave souls before a crisis, but during a crisis it is a different story.”
one more old Wall Street rule states that you never want to be wrong and alone, but it is permissible to be wrong if everyone else is as well. “That’s the pressure on the typical adviser, who is prone to do nothing,” says Ashburn. It is the practical challenge of the business that it is not enough to be right – you need to keep your clients too.
Keynes warned that markets can stay irrational longer than you can stay solvent. If momentum drives equities to the moon, and you do not buy stocks, you could be wrong and alone. in the same spirit, “being dogmatic about valuation investing or buy and hold can destroy your business, and disrupt your clients’ goals,” says Kitces.
one can only deviate from the trend for so long. “Remember those hard core valuation guys who were pounding the table in 1997, that markets were overvalued and investors wouldn’t get good returns for 10 years?” Kitces asks. “They were right – and they probably also lost half their clients if they stuck to their guns.”
So wind the clock back to 1997, and make one simple decision to which you must adhere for the subsequent decade. you can choose the standard recommendation for a 60/40 equities/bonds allocation, to be rebalanced annually. Alternatively you can put the entire amount 100% into bonds and cash.
the latter approach produces an astronomically higher return for your clients, but you have probably destroyed your business. even that loyal remaining crew who thought you were a genius by 2002 for avoiding that bear downturn, would have abandoned you by 2005, concluding you did not know how to get back into a bull market.
A glimpse back over the past 15 years reveals the hazards of clinging to an ideology. the moral is that it is impossible to be a pure valuation theorist and survive indefinitely. while that view may be cynical, those who are running investment management firms also must be realistic. “Welcome to the reality that we are in money management with other human beings,” Kitces says. “Ignore that to the peril of your business.”
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ASSET MANAGEMENT: New covenant