Sunday, April 22, 2012

The Stay-Liquid-And-Wait Strategy?

It was a cold, rainy and dreary weekend in Montreal. Perfect for staying in, watching movies and political news shows (I'm a junkie). I also caught up on a lot of reading on markets, politics and health. If you're not following me on Twitter (@PensionPulse), you're totally missing out on a lot of great articles I post there (post in spurts).

Twitter is great because I simply can't cover everything on my blog, nor do I want to. Not a fan of Facebook, never created an account and doubt I ever will because I'm not into gossip. In fact, I couldn't care less about other people's personal stuff unless it is my close family and friends and then I prefer picking up the old telephone to see how they're doing. As far as professional contacts, just use LinkedIn, it's fantastic to keep up-to-date on people, topics of interest and employment opportunities.

As you can see I'm procrastinating. I've read and seen so much in the last few days that I simply don't know where to begin. My head is about to explode, swirling with ideas, but I'll attempt to cover volumes of information in a concise manner.

Let's begin with Reuters blogger Felix Salmon who recently spent a day at the National Strategic Investment Dialogue, a conference attended mainly by big institutional investors. After listening to best-case and worst-case plausible scenarios, Felix came away from that conference convinced we're now closer to a bimodal world and it would be wise to adopt a stay-liquid-and-wait strategy:
After a day spent talking about how much upside there is if things go right, and how much downside there is if things go wrong, I was reasonably convinced that we’re now closer to a bimodal world than one with thin tails. In other words, the most likely outcome is not that we stay more or less where we are, with [the outcome] becoming increasingly improbable the further you get away from here. Instead, there are two possibilities — up and down — both of which involve substantial market moves, and both of which are just as likely, if not more likely, than a muddle-along-where-we-are scenario.

In that world, an opportunistic wait-and-see approach makes a certain amount of sense: you wait to see which direction the bandwagon is moving, and then you jump on it. You’ll miss the first part of the move, but at least you won’t end up getting crushed.

Liquidity, here, is key — and equities in general are very liquid investments. Here’s the plan, then: sit on a portfolio of large-cap US stocks for the time being, and maintain exposure, if you have it, to expensive, fast-growing markets like Brazil. But look for market moves, and create a list of “tripwire” signs that the waveform has collapsed and we’re moving in one direction or the other.

Then, if Brazil falls by 15%, sell it, on the grounds that it could fall a great deal further. (The bearish case on Brazil was one of the more interesting ideas at the conference; it’s related to the country’s cocaine consumption, as well as reports that the Russian mafia now has substantial operations there; a violent Mexico-style drug war is far from inconceivable in Brazil, and could be hugely damaging to the economy.)

On the other hand, if Europe and/or Japan rise by 15%, that could be a decidedly bullish sign. There’s a serious zip-code arbitrage in the world right now: multinational corporations are valued much more highly if they’re based in the US than if they’re based in Europe or Japan. That doesn’t make a huge amount of sense given how global they all are.

In general, if Japan really is managing to bounce back from its torrid 2011, then the stock market there — which is currently trading below book value — could have a lot of upside. Similarly, European stocks have suffered greatly from a decidedly pessimistic economic outlook for the continent as a whole and for the southern periphery in particular. But the continent’s companies might well make good money even if Europe as a whole isn’t growing. On top of that, any further move towards fiscal union or eurobonds could do wonders for investors’ confidence that the eurozone will navigate through this crisis intact.

The one big area to avoid, it seems to me, is any asset class which is both illiquid and expensive. I’d include private equity and venture capital in that class, as well as high-grade debt. There’s really no reason, in a highly volatile world, to be invested in something which can fall a lot and can’t easily be sold.

Indeed, there’s a strong case to be made that equities are actually safer than high-grade debt, certainly if your time horizon is greater than a few years. When equities fall, they can bounce back; when rates come back from zero, they’re not going to fall back again. Which means that when investors take mark-to-market losses on their bond portfolios, those losses will be permanent, rather than being on paper only.

I’m not disciplined or rich or sophisticated enough to take my own advice on this: I’d never dream of trying to time the markets, make momentum trades, or otherwise try to be clever in a world where clever investors get eaten for breakfast every morning.

But big institutional investors don’t have the luxury of being able to abrogate decisions in that manner. And if I were in their shoes, I’d be looking seriously right now at trying to be as nimble and liquid as possible, which means moving out of credit and into equities. At least that way, if the world really does start falling apart, you have options.

Felix is a wise man but as he openly admits, there is no way in the world he can manage an institutional fund like a pension fund. In the world of pension investments, pension fund managers have to continuously take decisions on where to allocate risk across public and private markets.

Someone who does have experience managing assets is GMO's Jeremy Grantham. In my opinion, his latest letter, My Sister’s Pension Assets and Agency Problems (The Tension between Protecting Your Job or Your Clients’ Money), is one of his most brilliant comments ever, a must read for institutional and retail investors alike.

It is way too long to post here but there are some beautiful passages in Grantham's letter, my favorite one being:

Ridiculous as our market volatility might seem to an intelligent Martian, it is our reality and everyone loves to trot out the “quote” attributed to Keynes (but never documented): “The market can stay irrational longer than the investor can stay solvent.” For us agents, he might better have said “The market can stay irrational longer than the client can stay patient.”
I love that quote from Keynes as well as Grantham's twist because he's absolutely right, in the short-sighted, ultra-competitive world of fund management where clients continuously evaluate your relative (benchmark and peers) and absolute performance, patience is the rarest of all commodities. You might end up being right but it doesn't mean anything if you lose your job in the interim!

When I sit back and think how crazy the investment management business has become and the role of investment consultants in promoting this craziness, I can't help but wonder how we haven't experienced a major financial crisis every other year.

It's absolutely mind-boggling to see hundreds of billions being shoved into hedge funds, private equity, real estate, infrastructure, commodities and timberland funds, and not ask what are the collective repercussions of all these institutional flows.

When I did some research on CDO-squared and CDO-cubed back in the summer of 2006, it didn't take me long to realize that the U.S. housing bubble was being fueled by speculative flows into exotic credit derivatives whose yields did not reflect the true underlying economic risk. Unfortunately, my insights fell on deaf ears, and instead of making billions, the pension fund I worked for lost billions during the crisis while Goldman made a killing. I also lost my job shortly after that summer and was labelled 'a black sheep' in the pension industry.

But if I had to do it all over again, wouldn't change a thing. Maybe if I kept my mouth shut and didn't antagonize some senior managers I would have kept my cushy job which came with a decent salary and great benefits. I might have also developed a tumor in the process and died of cancer. No use harping on the past, that's why it's the past!

In the pension business, you're paid to take intelligent risk in both public and private markets. The key word is "intelligent". If pension fund managers take stupid risks with other people's hard earned pension contributions, gambling the future benefits of beneficiaries away, they and their board of directors should be held accountable for such decisions because they've violated their fiduciary duty.

This brings me to the most misunderstood four letter word in the investment world, RISK. Market Folly published notes from Seth Klarman's now out of print famous book, Margin of Safety:

Why should you care about this? Well, for those of you who are unfamiliar, Klarman's Baupost Group is one of the top 10 hedge funds by net gains since inception. And since numbers do the talking in the investing world, it's time to pull up a chair and learn from the best.

Redfield singles out prudent quotes from Klarman such as this gem on risk:

"Targeting investment returns leads investors to focus on potential upside rather on downside risk ... rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk."

And by focusing on risk, Klarman of course hints that investors should seek a margin of safety in their investments. He goes on to specifically address this topic, writing:

"A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world."

Redfield points out that Klarman says investors can battle risk via diversification, hedging, and investing with a margin of safety.

Klarman also touches on other tricky aspects of investing, such as forced selling. He writes, "The trick of successful investors is to sell when they want to, not when they have to. Investors who may need to sell should not own marketable securities other than U.S. Treasury Bills."

John Burbank of Passport Capital has echoed this via his timeless quote: "cash is most valuable when others don't have it." This refers to cash's utility as a hedge during a downturn as well as its ability to fund opportunistic purchases while others are forced to do otherwise.

What Seth Klarman is referring to is you want to have ample cash (liquidity) precisely at the time when you need to capitalize on opportunities. Even after the 2008 financial crisis, many pensions funds have still not learned the value of managing liquidity risk. This will come back to haunt them when the next crisis hits.

Klarman also refers to "forced selling", something which impacted some pension funds in early 2009, right before the market bottomed. Those who didn't manage their liquidity risk properly, were forced to sell public and private equities at deep discounts and many redeemed from their (illiquid) hedge fund investments at that time, exacerbating the violent downturn.

However, instead of scaling back risk, that was probably the best time to crank up the risk for pension funds looking to profit off post-deleveraging blues. It's a bit counterintuitive, and with the benefit of hindsight, very easy to make this claim but it never ceases to amaze me how large institutions act a lot like retail investors (and one can argue worse), panicking and cutting risk at the worst possible time. Goes back to what Grantham was referring to in his comment, everyone is scared of losing their job.

Elite hedge funds and long-only funds, however, seem to have a knack for cranking up the risk at the right time, like when they switched gears in Q4 2011. It is my contention that elite funds are still selectively cranking up the risk, buying the latest dip, taking intelligent risk in some sectors and industries. A lot of top funds are still trading La Dolce Beta (I still like financials, tech, energy and basic materials like coal stocks that have gotten destroyed).

How does that help you, the individual investor, or under-funded pension fund? It doesn't because you'll never be able to compete with elite funds and big banks profiting off money for nothing and risk for free. The very best pension funds will be able to compete because they're taking intelligent risk across public and private markets, effectively shielding them from these schizoid markets, but most investors will succumb to this wolf market, and lose an awful lot of money.

This brings me to some concluding thoughts. There are always going to be risks in markets. Investors are now worried about Apple's shares, Spain's sinking economy (another victim of savage austerity), and a crash in commodities prompted by a hard landing in China . They also fear a bubble in bonds and how a major backup in bond yields will impact the global economy. There is much to fear in today's hyper-sensitive, hyper-schizoid market.

Indeed, if you look at everything going on in the world, it's almost impossible to see how the U.S. will avoid a recession in 2012. And yet I remain convinced that the last jobs report was an anomaly, that the slump taught profligate Americans the value of saving, that there is a manufacturing 'renaissance' in the U.S. being driven by declining energy prices, like the drop in natural gas, and that earnings and the Fed will once again prove skeptics wrong.

In short, despite all the fear mongering, some of it very legitimate, I remain bullish on America and believe this market will continue to climb the wall of worry. I don't see a repeat of summer 2011. In fact, quite the opposite, instead of "sell in May and go away," smart money will be taking intelligent risk across public and private markets, trying to capitalize on fear gripping investors.

Finally, don't worry, we aren't about to hit the proverbial "BRIC wall," just another bump along the long road to recovery. If you don't believe me, check out the OECD's latest leading indicators report. Investors adopting the stay-liquid-and-wait strategy should keep the above arguments in mind as they watch the four clips embedded below. If they don't, it might end up costing them their job.