(The original version of this story ran on pionline.com on Feb. 2.)
Institutional investors can't afford to be passive — not when trying to mitigate the effects of any future financial crisis on their investment portfolios, according to three Nobel Prize laureates who spoke at the European Colloquia Series in London.
“There's an implicit view out there that (the crisis) was regulatory failure. I don't think anybody would argue that regulatory failure was a component, but it was also an investor failure,” said Michael Spence, senior fellow at the Hoover Institution and the Philip H. Knight Professor Emeritus of Management in the Graduate School of Business at Stanford University. “I don't think regulatory reforms will eliminate periodic systemic risks. If that's true, then investment strategies should reflect that.”
Eric Maskin, Albert O. Hirsch-man Professor of Social Science at the Institute for Advanced Study, Princeton, said: “There is no realistic hope for stopping (another) crisis altogether.” However, well-designed government regulations might reduce the probability of a crisis and (help investors) better cope with one when it occurs. For example, placing limits on leverage and higher capital requirements for investment banks “is potentially one of the more effective proposals out there,” Mr. Maskin said. Furthermore, imposing a minimum standard for loans could help limit credit risks that banks can take.
Earlier in January, President Barack Obama announced several proposals to limit banks from engaging in certain risky activities, including proprietary trading. U.S. investment banks could further be restricted from owning, investing in or sponsoring hedge funds and private equity.
Details have not been finalized, but the aim is to better safeguard the economy from a similar financial crisis, according to the announcement.
“However each crisis is at least somewhat different from its predecessor,” said Mr. Maskin, who won the 2007 Nobel Memorial Prize in Economic Sciences for his work on mechanism design theory. “Even if we fix the originator problem, the next time, the originator problem will likely occur some place else.”
Mr. Spence said the framework that institutional investors have in place to monitor risk/return profiles needs to evolve to account for these periodic systemic risks. While concepts such as regular asset allocation reviews and sensible diversification are not invalid, they are not enough.
“In addition, periodically, systemic risk arises and you have a sudden rocketing up of correlation, big changes in asset prices, liquidity problems and so on,” Mr. Spence said at the conference on Jan. 28. Mr. Spence won the 2001 Nobel in economics for his part in the analysis of markets with asymmetric information.
“I think that a good investor strategy has to include a regular, disciplined, inclusive process for monitoring and evaluating periodic systemic risk,” he added.
For example, liquidity needs to be revisited on several fronts:
c Do the illiquid investments within a portfolio hinder asset allocation flexibility?
c What are the risks of distressed selling?
c What opportunities are available because of forced distressed selling by other investors?
A better understanding of beta and alpha sources is another key in preventing investment catastrophe. Robert Merton, John and Natty McArthur University Professor at Harvard Business School, Boston, emphasized the need to isolate the different types of alpha in measuring performance, particularly within the risk/return profile of any particular asset classes.
For example, he lists three types of alpha that becomes specialized beta: performance improvements over a benchmark that can be replicated passively; hedging strategies that address risks such as interest rate, volatility and liquidity; and liquidity-event risk, which takes into account uncertainties on the part of investors in episodic events, usually resulting in a "flight to quality.'
Incorporating risk factors into performance analysis for each asset classes is crucial, Mr. Merton said in a separate interview at the conference.
“It's not just a matter of safety, it's a matter of performance,” said Mr. Merton, who won the 1997 Nobel in economics for his part in determining a new method to value derivatives. “If you mismeasure risk, that will no doubt impact performance.”
The European Colloquia Series is an annual forum on economic issues sponsored by Pioneer Investments.
