“We need more transparency!” is the clarion call in politics, banking and investments. The word “transparency” is used so frequently one would think it could be the cure for budget earmarks, bad loans and future investment losses. If it really is that good, we should insist on having it.
Individual investors tend to have a manageable number of investments and therefore a reasonable sense of what markets are doing to their brokerage accounts. But large institutional investors such as pensions, endowments and foundations tend to hire multiple investment managers. These managers are usually spread over a number of asset classes and investment strategies to achieve diversification of investment risk and return. Some fund sponsors believe given line-by-line transparency they will be able to avoid taking too much risk, being cheated by scoundrels or losing money if they simply know what is going on with their investments.
Really?
In most cases, the majority of fund sponsors demanding “full transparency” from their investment managers, custodians and administrators would be overwhelmed if they suddenly received their full position reports. Transparency by itself has little value. The risk of knowing the exact nature of the investments simply means sharing the downside liability with whoever is looking over the shoulder. Not a desirable legal exposure for a consultant or adviser.
Transparency helps only to ensure investment managers' compliance with permitted investments. It is the conversion of information into insight that gives the investor a useful handle on the market factors that will affect portfolio value the most, and the range of likely outcomes the investor should be willing to live with. Insight means identifying what some call factors and others refer to as “key drivers” that translate thousands of portfolio positions into a handful of instruments that most closely replicate all the underlying position risks. Paying close attention to these factors/drivers, and the relative levels of portfolio diversification, gives a risk manager the tools to control portfolio exposure in all market environments.
To complete the process, the insight must be turned into action. “Managing” the portfolio risks is about controlling the downside and allocating to the best sources of risk-adjusted returns. Using transparency, insight and risk management is a powerful business model for any institution that has benefits or bills to pay and actuarial expectations for portfolio growth.
Let’s review the impact of what would have happened over the past year’s market environment using this process. I will assume that a prudent investor had a globally diversified portfolio managed to a target standard deviation equivalent to the 10-year S&P 500 average, around 12% to 15%. When market volatility increased in the spring, equity positions in all major and emerging markets would have been taken down by selling long positions. By summer, virtually all exposure to emerging markets would have been removed. Then two things happened that would make a risk manager’s computer smoke. The Chicago Board Options Exchange volatility index soared to 80 and the volatility of intramarket and intermarket correlations became completely unstable. (The volatility index measures the amount of price fluctuation in the S&P 500.) Hedges did not work, even in hedge fund strategies, and diversification was not reliable. The target volatility would have required wholesale liquidation of investment positions and the accumulation of cash and Treasury securities. Losses would have been minimized by the small capital commitment to the hemorrhaging and illiquid markets. By the fourth quarter, almost all risk would have been off the table, and the portfolio value would have been protected from all but minor losses. This approach would have kept investors whole and happy to be on the sidelines.
Carrying large cash positions into the new year would make re-entry to the market possible as the velocity of money increases and market volatilities stabilize. But risk management is not about making market calls. It is a discipline that limits both downside and sometimes upside, while always trying to maintain a favorable relationship between risk and reward. The risk of knowing too much is the risk of shared transparency without the rest of the translation into insight and commitment to action.
Today is, in many regards, a far more open environment than even six months ago, with managers understanding investors’ desire for transparency. Investment managers in alternative as well as traditional investments are aware of the need to make full disclosure user-friendly. Custodians and administrators have sufficient transparency to kill an army of green eyeshades. Let’s hope that those who get what they wish for know what to do with it.
