A number of investment executives overseeing pension, endowment and foundation assets are feeling the brutal, unforgiving nature of the capital markets and the dangers of pioneering in them in the wake of the collapse of Askin Capital Management L.P.
They, and others, should not let the experience deter from new theories and investment concepts. If they and others like them are unwilling to take measured risks, investment progress will cease.
Executives at consultants such as Collins Associates and Evaluation Associates Inc., who ran manager-of-managers funds, and Rockefeller Foundation and others, reportedly had assets invested with Askin, a market-neutral and mortgage-backed derivatives manager.
Askin collapsed when interest rates rose and liquidity in the derivatives markets in which the firm specialized dried up. As a result, some apparently market-neutral portfolios fell out of balance, and when the firm could not meet brokers' margin calls, the brokers sold off the positions, effectively wiping out the firm.
As much as any other firm, Askin represented the new age of money management, the melding of high returns with supposedly little risk. Leverage was in part responsible for the promised high returns, and was in part responsible for the demise of the firm. But the still unfamiliar nature of the mortgage-backed derivatives market also contributed. There was little previous experience to indicate the liquidity of one side of the market neutral portfolios would dry up.
This was a hidden flaw. As Murphy's Law warns, "Nature always sides with the hidden flaw." It sided with the near-invisible fatigue cracks in the British Comet jetliner, causing some to explode in midair. Yet the disasters led to better understanding of metal fatigue, and tools to identify it early and methods to correct it.
Continued developments of new tools and techniques for investing in the capital markets, including those arising from the analyses of the causes of the Askin collapse, will bear equivalent benefits for the beneficiaries of large pools of invested capital. The events in the markets in recent weeks indicate three things:
The melding of derivatives with the risk-and-return measurement techniques of modern portfolio theory to produce high returns while cutting off the downside risk has not yet been perfected. Misjudgments still occur.
These derivative-based strategies are so new and complex that they challenge the analytical abilities of even the most experienced, sophisticated investors, making it very difficult in their due diligence for them to see flaws.
Imposing new government regulation, as some politicians advocate, would contribute nothing, and in fact might make things worse. Regulators know even less about these derivative-based investment strategies than investors. To their credit, commissioners like J. Carter Beese Jr., Securities and Exchange Commission, and Sheila C. Bair, Commodities Futures Trading Commission, speaking to Pensions & Investments on derivatives in general, see a harm a rush to inappropriate regulations could cause to the markets and investor strategies.
Those pioneers on the trail of cutting-edge strategies have to accept some losses on the trail, but they undoubtedly also will reap gains as they learn newer techniques to analyze their risks. In the process, everyone on the sidelines benefits, too, as they have with earlier theories that led to techniques like indexing.