Monday, October 8, 2012

When Career Risk Reigns?

It's Thanksgiving in Canada and Columbus day in the United States so I decided to catch up on some reading from Niels C. Jensen of Absolute Return Partners.

First, read his September letter on How to Unscramble an Egg, outlining five policy mistakes that got us into this crisis and a possible sixth -- return to the gold standard -- that will make things worse.

In his October letter, When Career Risk Reigns, Jensen picks up where he left off last month:
I concluded last month’s Absolute Return Letter by suggesting that only when policy makers begin to address the underlying root causes that lie underneath the current crisis will we be able to leave the problems of the past few years behind us.

What I didn’t say, but probably should have said, was that an almost universal lack of appetite amongst policy makers on both sides of the Atlantic to deal with those root causes will ensure that the crisis will rumble on for quite some time to come. To paraphrase John Mauldin, politicians are like teenagers. They opt for the difficult choice only when all other options have been explored.

So far, only Greece has reached that point. The Spanish are probably next in line. And there will be many more countries forced to make tough decisions before this crisis is well and truly over.

This has repercussions for asset allocation and portfolio construction. The credit crisis, now into its sixth year, has changed the investment landscape on two important fronts. Investors have had to get accustomed to low return expectations – not something that comes naturally to Homo sapiens – and they have had to adapt to what is often referred to as the high correlation environment.
As I wrote in my last comment, after years of relentless austerity which has disproportionately hurt the private sector, negotiations in Greece have reached a critical point and Europe's moment has arrived.

Jensen begins by questioning Modern Portfolio Theory (MPT), comparing correlations during the 2000-03 period (bright blue) with correlations in the current environment (dark blue). As you can see, with one or two exceptions, correlations are generally much higher now (click on image to enlarge):


He rightly notes that: "nowadays, only a handful of sovereign bonds are considered safe haven assets. Pretty much all other asset classes are now deemed risk assets and they move more or less in tandem. Even gold looks and smells like a risk asset these days."

He goes on to state:
Take another look at chart 1. In the 2000-03 bear market commodities were an excellent diversifier against equity market risk with the two asset classes being virtually uncorrelated (+0.05). Nowadays, the two are highly correlated (+0.69). It follows that we are not only in a low return environment at present, as evidenced by the paltry return on equities since the end of the secular bull market in early 2000, but we can’t rely on the ability to diversify risk either.

Now, perhaps I should define risk. In traditional investment management parlour, risk is usually synonymous with volatility risk. One could make the argument that volatility risk is a risk that most investors could and should ignore (provided no leverage is used) and that only one element of risk really matters – that of the permanent loss of capital.

Whilst theoretically correct, the reason you cannot ignore volatility risk is that it profoundly influences investor behaviour. Few investors have the nerve to stay put when a financial storm gathers momentum.

Buffett’s Alpha Part of the problem is that investors generally have unrealistic expectations. Andrea Frazzini, David Kabiller and Lasse Pedersen published an interesting paper a while ago called Buffett’s Alpha (you can find it here) which is packed with interesting observations. I quote from their conclusion:

“Buffett’s performance is outstanding as the best among all stocks and mutual funds that have existed for at least 30 years. Nevertheless, his Sharpe ratio of 0.76 might be lower than many investors imagine. While optimistic asset managers often claim to be able to achieve Sharpe ratios above 1 or 2, long-term investors might do well by setting a realistic performance goal and bracing themselves for the tough periods that even Buffett has experienced.”
Jensen goes on to show the Sharpe ratio of commodity traders (click on image to enlarge):

And states the following:
Chart 2 offers a solid piece of humble pie for a notoriously over-optimistic fraternity of money managers. When the reporting period is limited to 5 years or less, plenty of managers can claim to have a Sharpe ratio in excess of 1 (even a broken clock is right twice a day). Only a few manage to keep it above 1 for longer than 5 years, and after 10 years there are virtually none left. The lesson? Luck plays no small part in the short to medium term but reality gradually catches up with the lucky ones. Buffett is still the best!
Jensen then states that investors responding to low growth expectations in the U.S. and Europe, have been allocating increasing amounts of capital in recent years to emerging markets, expecting that the higher growth in those countries will lead to superior returns. "There is only one problem with this strategy; there is no evidence whatsoever to support the thesis that high GDP growth leads to superior stock market performance."

So, with economic prospects in Europe and the U.S. likely to remain subdued, with risk assets remaining highly correlated and with emerging markets not necessarily offering a way out for investors, Jensen asks what can investors do to generate a respectable return on their capital by appropriately diversifying risk?

He goes on to rightly criticize what he sees as a 'misallocation of capital' among the investment herd, paying more attention to career risk than investment risk:
I have been an observer of financial markets, and of those who operate within the markets, for almost 30 years. I have never before experienced investors paying more attention to career risk than they do at present. A preoccupation with career risk changes behavioural patterns. Decisions become more defensive, and sometimes less rational. (Before I offend too many of our readers, perhaps I should point out that what may be a dim-witted decision from an investment point of view is not necessarily irrational from a career perspective.)

According to the latest data from Hedge Fund Research, there were $70 billion of net inflows in to the hedge fund industry in 2011. $50 billion of those went to funds with more than $5 billion under management. This is a staggering statistic considering there is a wealth of research documenting that smaller managers consistently outperform their larger peers. I suppose nobody was ever fired for investing in IBM (sigh).

The misallocation of capital can also be driven by factors beyond the control of the individual. The UK pension industry is a case in point. With 84% of UK defined benefit schemes now under water, and with liabilities exceeding assets by over £300 billion, the UK pensions regulator, the plan sponsors and the pension consultants all apply considerable pressure on the pension trustees who are often lay people not equipped to deal with complex situations such as a credit crisis. One result is an exodus from riskier equity investments into supposedly lower risk bonds (chart 4). We shall see who has the last laugh.
At a time where UK P/E multiples are near 30-year lows, and UK gilts are trading at record low yields, capital flows should, if investors behave rationally, move in precisely the opposite direction – away from bonds into equities.
And on the illiquidity premium:
The illiquidity premium is the excess return investors demand for holding an illiquid investment over a liquid investment of the same kind. The illiquidity premium can move within a very wide range and is usually highest during times of distress. The credit crisis has resulted in a dramatic fall in the appetite for illiquid investments which has caused the illiquidity premium to increase substantially more recently.

At the same time as the appetite for illiquid investments has been falling, opportunities have been on the rise. Banks all over Europe have been reducing their loan books with small and medium sized companies suffering the most as a result.
This has given rise to a new industry where pension funds and other long term investors provide capital to facilitate lending outside the traditional banking system. Given what is around the corner for the banks in terms of new and tighter capital requirements, this industry will grow to be much larger over the next decade.

However, new data from the ECB suggest that European banks’ balance sheets are actually larger than ever (chart 5) so, on the whole, banks have merely shifted the balance sheet composition away from lending towards speculative investments funded cheaply through the ECB.

In other words, the European banking industry has become one massive hedge fund taking a punt on the ability of European sovereigns to service their debt. All of this will have to be unwound at some stage, suggesting that the deleveraging process in Europe’s banking sector is far from over.

Assuming that European banks eventually must bring the leverage down to U.S. levels or thereabouts, total assets in the European banking industry must be reduced from around $45 trillion today to less than half that number. Not only will that be painful but it could also cause the illiquidity premium to rise further.

The savvy investor will seek to take advantage of these inefficiencies and allocate his capital where others don’t go. In the long run, that is likely to be a winning strategy.
Indeed, as I already commented, savvy investors, including many Canadian pension funds, are piling into European distressed debt, but the opportunities have yet to materialize because banks are not in a hurry to sell assets.

Jensen also examines some analytical work from SocGen on value vs. growth:
Our friends at SocGen have recently published the result of some extensive work they have conducted on the subject which suggests that investors should focus neither on growth nor on value but on quality instead. Quality is obviously a subjective term but so is value or, for that matter, growth. The approach taken by SocGen emphasizes the quality of the balance sheet and, in particular, the company’s ability to sustain its dividend policy. After all, dividends have been the main source of equity returns over time (chart 8). We just happily forgot about that during the happy bull days of 1982-2000.
Beware of the old 'dividend trap'. I can show you a few companies with high dividends and deteriorating balance sheets. What you want is to find companies with quality balance sheets which will sustain their dividends during a sluggish economy.

Jensen ends his monthly letter by looking at dynamic asset allocation:
There is actually one approach to asset allocation I have not yet mentioned. In an environment such as this, where the mood swings can be sudden and quite violent, one can build a strong case for a much more dynamic approach to asset allocation.

Internally we operate with two layers of asset allocation – one for the long term (strategic asset allocation) and one for the short term (tactical asset allocation). The regular changes in sentiment do not affect our strategic asset allocation decisions but they certainly influence our tactical decisions. We use a mix of sentiment indicators and technical indicators to drive these decisions.

I agree with this approach, separating strategic asset allocation from tactical asset allocation, but in practice in can be fraught with implementation issues. For example, if senior managers at a pension fund cannot take tactical decisions quick enough, best to forget short-term tactical decisions.

Below, leave you with a couple of excellent reports from last night's 60 Minutes. One is on Huawei. The  Chinese telecom's pursuit of building the next generation of digital networks in the U.S. is prompting an outcry in Washington. The second is on the Italian firm Luxottica, which controls a huge chunk of the global eyewear business.