Jill Fredston is a nationally recognized avalanche expert from Alaska. She knows how to identify risky terrain, predict avalanches and lead rescue efforts. Jill knows about complacency and overconfidence. She knows about a kind of moral hazard risk, where better safety gear can entice climbers to take more risk making them in fact less safe. She knows about our culture, which glorifies those who dare, and win. You cant help but listen to her talk on managing risks when the stakes are high and think about the current state of the investment world.
Around the world, credit has been available and dirt cheap. Perhaps you cant blame the borrowers, but where is the discipline on the lending side? Yield-hungry investors have thrown caution to the wind and willingly dole out oodles of cash in return for a little extra yield or expected return via some newfangled strategy.
Many institutional investors appear hell-bent on emulating David Swensen of Yale University endowment fame. They are grasping for yield and return to show alumni or to beat those actuarial assumptions that have led to deficits on the pension fund side. The better mousetrap includes commodities, emerging markets, private equity, junk bonds and, of course, hedge funds anything but those stodgy stocks and investment-grade bonds.
But remember, Mr. Swensen, chief investment officer of Yales endowment fund, got in early and he now opines that the current cohort of hedge funds and private equity firms are unlikely to outperform. The low-hanging fruit has been picked, folks. And a lot of those other asset classes have been bid up in price. Besides, Yale has developed an expertise in this area that most probably cant replicate.
Before running out to hire the new breed of managers and consultants, investors would be well served to heed the advice of Warren Buffett. In his 2006 annual letter, he bemoaned the spread of hedge funds and other managers taking a 2% fee and 20% of the profits. And of course if they screw up, its your dime, not theirs.
A common thread across many of these strategies is leverage, often achieved via derivatives. How much leverage is out there? The honest answer is God only knows and He aint telling. We do know that it is a two-edged sword.
Give me a lever long enough and I can move the world said Archimedes. Long Term Capital Management just about did that back in 1998. Their strategy of picking up nickels (in front of a steamroller, as it turned out) failed and brought the financial markets to their knees. Alan Greenspan said that was about as close to a complete market failure as he had ever seen.
The world is much more complicated and interconnected compared to a decade ago. The numbers and positions are much bigger now. You can run all the models and stress testing that you like to quantify risk. But there is a difference between risk and uncertainty. Some things are unknowable and common sense and conservatism are about the only defense against this eventuality.
The new world of credit default swaps is a case in point. These allow investors to sell risk (buy protection) or buy risk (sell protection). It is estimated that there are seven times as many credit derivatives outstanding as there are underlying bonds. You have to ask the question: is risk been transferred or created? Are the new gladiators hedging with derivatives or just leveraging up? The Federal Reserve sets margin requirements (currently 50%) to prevent excessive borrowing. Yet, derivatives and other structured products allow these rules to be circumvented.
The regulators are worried but seem unable to do anything. We arent very good at taking the proverbial punch bowl away when the party is getting good. In fact, we live in a world where just the opposite is contemplated. That is, dont worry and enjoy the party because the Fed will be your designated driver. Lets hope Ben Bernanke rids the market of the moral hazards created by the so-called Greenspan put.
Sports writer Blackie Sherrod once wrote: If you bet on a horse, thats gambling. If you bet you can make three spades, thats entertainment. If you bet cotton will go up three points, thats business. See the difference?
The difference between investing and gambling is indeed getting blurry. Its my view that some institutional investors are allowing some managers to gamble with their money. Actually, its not their money, but rather the money of hard-working men and women who expect a diversified portfolio across mainstream asset classes and reasonable returns close to the market. That portfolio you can promise and deliver.
Jeff Pantages is chief investment officer of Alaska Permanent Capital Management Co., Anchorage.