I've just finished Robert Finkel's "The Masters of Private Equity and Venture Capital", and thought it merited some quick thoughts. First off, it's an easy read that I recommend, and a good introduction for those not immersed in the worlds of PE and VC. The roster of characters interviewed will probably interest even those who know PE and VC well, with stalwarts like Joe Rice, Warren Hellman, John Canning, William Draper and Franklin "Pitch" Johnson making appearances. Some of the anecdotes are amazing, such as Canning breezily relating how banks like First Chicago used their PE arms to smooth earnings. This practice became harder with the advent of mark-to-market, leading to the spin-off of future titans like Madison Dearborn. Some of the less-known stories are just as interesting. Steven Lazarus describes the creation of ARCH Venture Partners, designed to commercialize and monetize research from the University of Chicago. This seems a natural outgrowth of research, but it had never crossed my mind that such entities existed. While I was left a little disappointed with the chapter on Jeffrey Walker, his work bringing a PE approach to the Millennium Villages will interest those who have followed the debate over Jeffrey Sachs' ambitious project (particularly if you have heard these EconTalk podcasts with Nina Munk and Jeff Sachs.)
No book on PE or VC would be complete with a reference to Georges Doriot, widely considered the founding father of these two fields. In his introduction, Finkel quotes Doriot: "The study of a company is not the study of a dead body. It is not similar to an autopsy. It is the study of things and relationships. It is the study of something very much alive which falls or breaks up unless constantly pushed ahead or improved. It is the study of men and men's work, of their hopes and aspirations. The study of the tools and methods they selected and built. It is the study of conceptions and creations - imagination - hopes and disillusions."
I thought Doriot's quote was an important one. Finkel's book, presumably meant for a popular audience, steers clear of arcane descriptions of valuation and financing. Yet this also reflects that financial wizardry is not the only ingredient for success in these businesses, or any branch of investing, for that matter. The venerable Pitch Johnson recounts his transition from the steel industry to VC, and counsels, "A person picks up a lot of lessons over time, and the person who pays attention, even in places as seemingly dissimilar as steel mills and biotech labs, has a good chance of backing the right people, with the right ideas, in the right markets." Being an "intellectual magpie", as my former English teacher would describe it, is exceptionally beneficial in the business of investing. Finkel concurs, pointing out that "Many of the major sources of competitive advantage for the private-investment asset class are qualitative in nature: picking the right companies, mentoring their managements, measuring their performance, and driving them toward success... Moving from deal to a successful long-term investment requires patience, a human touch, strategic insight, and ultimately a keen assessment of a company's market value and potential."
Another crucial element the book describes in PE, in particular, is operational excellence (and I mean genuine insight, not just having someone who did an internship at consulting firm once). David Swensen, who allocates billions to PE as head of Yale's phenomenally successful endowment, has very cutting words for most PE fund managers, describing them essentially as investment bankers with mid-life crises. He derides most PE funds as providing commoditized financing, and insists on only investing in those that can provide operational guidance to portfolio companies. Speaking about Russian PE, Patricia Cloherty reflects,"Private property is a new concept, so negotiations focus exhaustively on price with a wholly inadequate emphasis on the strategic development of the company." It seems to me that western PE firms who lack operational expertise will similarly be relegated to bidding for companies with insufficient interest from firms who can offer both operational and financial expertise. The results for LPs are unlikely to be satisfactory.
Much like the hedge fund industry, PE and VC seem to have become more professionalized, and perhaps less lucrative for LPs. As Pitch Johnson observes, "After the dot-come crash of 2000, when the venture market came back, it came back in a different form than previously. It became a big money management business." Carl Thoma explains just how difficult the game has become: "Information flows a lot faster than it once did, and there are about five times as many firms out there competing for deals compared to when we started out." He goes on to say, "It's just a different game, and the old investment process no longer works as effectively."
Given the exceptional suite of skills needed to be a top-tier PE or VC manager, and the increasingly competitive arena, it is therefore doubtful that most limited partners are getting what they pay for. Investment talent is scarce, and requires organizational frameworks that can nurture it. I am fairly skeptical that most "alternative assets" will prove worthwhile for limited partners - but I'm sure that many mediocre intermediaries will do fine off of management and incentive fees.
I'll end with some customary speculation. There has been a lot of interesting discussion among monetary policy commentators about whether today's central bankers are exceptionally averse to inflation given their coming of age in the mid to late 70s. I was intrigued by Patricia Cloherty's horrified observation that "In the early 1990s many young business people in Russia told me that they learned much of what they knew about business by watching films such as Wall Street with Michael Douglas." It struck me that someone who had "come of age" in the world of finance in 1987, when Wall Street came out, would have been about 45 in 2007 as various unseemly business practices in the world of finance became visible. One can only hope that this cohort of fairly senior people was not overly influenced by Gordon Gekko. It's an unfortunate indictment of a certain type of character drawn to finance that both Oliver Stone and Michael Lewis intended Wall Street and Liar's Poker to be cautionary tales about the noxious greed in the industry, but were both ultimately dismayed that their stories were instead seen as exemplars for ambitious young people.
Sunday, July 27, 2014
Wednesday, July 23, 2014
Scenario Analysis & The Depressing Fed
I was reading Brealey, Myers and Allen on scenario analysis today, and was struck with a depressing thought. Scenario analysis, to clarify, looks at a limited number of combination of variables, and examines the effects of these various combinations on the net present value of a project or on firm enterprise value. This is an essential tool for any analyst. Perhaps my favourite quote on de facto scenario analysis comes from Bruce Kovner, who said "One of the jobs of a good trader is to imagine alternative scenarios. I try to form many different mental pictures of what the world should be like and wait for one of them to be confirmed. You keep trying them on one at a time." Kovner believed this was one of his competitive advantages: "I have the ability to imagine configurations of the world different from today and really believe it can happen. I can imagine that soybean prices can double or that the dollar can fall to 100 yen."
I no doubt lack Kovner's creativity in imagining different macro scenarios, but I'm finding it desperately difficult to imagine a booming US economy. It seems very unlikely that the Fed wants to recover the lost NGDP gap from the Great Recession, and David Beckworth has highlighted evidence suggesting the Fed is targeting a corridor of 1-2% PCE growth. Expectations for growth, and to corporate earnings generally, must therefore be muted.
I'm not bearish by temperament, despite some cautious (some might say pessimistic) posts of late. I'm not predicting an imminent market correction, or suggesting that stocks are overvalued. I am inclined, however, to believe that a reasonable scenario analysis would assign a higher probability to a bear case than to a bull case.
Ryan Avent has also written an excellent post discussing the two-way interaction between Fed policy and the labour market, while Ambrose Evans-Pritchard believes Janet Yellen is less dovish than consensus perception. I'm reminded of the work of the sociologist Katherine Newman, which you can read in her books, or listen to on this superb EconTalk episode. Newman's ethnographic work recounts how marginal workers were brought into employment by the booming economy of the mid to late 1990s. As Marcus Nunes notes, this was the byproduct of the (accidental?) delivery of stable NGDP growth. Today, with low labour participation rates and the masses of the long-term unemployed growing, the Fed's determination to stave off any nascent inflation and secure financial stability (two separate, and possibly contradictory goals within the current framework) seems unnecessarily cautious. Try as I may to channel Kovner, it's hard to see anything but a negative skew to my scenario analysis.
I no doubt lack Kovner's creativity in imagining different macro scenarios, but I'm finding it desperately difficult to imagine a booming US economy. It seems very unlikely that the Fed wants to recover the lost NGDP gap from the Great Recession, and David Beckworth has highlighted evidence suggesting the Fed is targeting a corridor of 1-2% PCE growth. Expectations for growth, and to corporate earnings generally, must therefore be muted.
I'm not bearish by temperament, despite some cautious (some might say pessimistic) posts of late. I'm not predicting an imminent market correction, or suggesting that stocks are overvalued. I am inclined, however, to believe that a reasonable scenario analysis would assign a higher probability to a bear case than to a bull case.
Ryan Avent has also written an excellent post discussing the two-way interaction between Fed policy and the labour market, while Ambrose Evans-Pritchard believes Janet Yellen is less dovish than consensus perception. I'm reminded of the work of the sociologist Katherine Newman, which you can read in her books, or listen to on this superb EconTalk episode. Newman's ethnographic work recounts how marginal workers were brought into employment by the booming economy of the mid to late 1990s. As Marcus Nunes notes, this was the byproduct of the (accidental?) delivery of stable NGDP growth. Today, with low labour participation rates and the masses of the long-term unemployed growing, the Fed's determination to stave off any nascent inflation and secure financial stability (two separate, and possibly contradictory goals within the current framework) seems unnecessarily cautious. Try as I may to channel Kovner, it's hard to see anything but a negative skew to my scenario analysis.
Friday, July 18, 2014
To Panic or Not To Panic?
I'll keep this post short as I shake off the rust on my blog after a 2-month hiatus. It seems to be a day for serious geopolitical news with word coming that pro-Russian forces have mistakenly shot down a Malaysia Airlines passenger plane at the same time that Israel has launched a ground offensive in Gaza. Tren Griffin has wisely counselled investors to focus on their process and stay rational by tuning out noise, echoing the excellent advice Meb Faber offered 8 days ago.
I can't agree enough with that statement. Equanimity and the ability to step back from one's emotions are crucial parts of investing that aren't sufficiently cultivated. Yet this doesn't mean ignoring geopolitical news. Investors need to find a way to incorporate geopolitical shocks into a methodical framework. Frankly, this is easier said than done. Financial markets are complex adaptive systems, and one of the characteristics of such systems is non-linearity, i.e. the propensity for small inputs, physical interactions or stimuli to cause large effects or significant changes in output.
Another reason we have to wrestle with geopolitical news is that these events can be genuine shocks within an AD/AS framework. For example, Lars Christensen noted the aggregate supply shock resulting from the Russian invasion of Crimea. Aggregate demand shocks, too, are rampant. I recently saw "Five Years From The Brink", a documentary focusing on Hank Paulson's role as Treasury Secretary during the panic of 2008 (I wouldn't rush out to get it, although it does offer the benefit of hindsight). One thing that struck me was his point that each of the beleaguered financial institutions would have constituted a full-blown crisis on its own, and that policy-makers from Treasury and the Fed (to name a few) had multiple balls of crisis up in the air at the same time. This, undoubtedly, prevented the Fed from acting sooner in its role as monetary policy-setter as it went instead into crisis mode. The revival of geopolitical tensions requires the attention of policy-makers who may therefore neglect the importance of monetary policy (weakening AD) or investments in education and infrastructure (weakening AS). None of these things is good.
The reality is, therefore, that investors need to incorporate geopolitics into their frameworks, either by setting out various scenarios and assigning probabilities to them, or by demanding a buffer of safety in their investments. My suspicion is that the current bad news is not sufficient to derail the global economic recovery. Those who are bearish today, however, may turn out to be right for the wrong reasons. Ambrose Evans-Pritchard warns of a possible dollar squeeze in the offing, as Lars Christensen is rightly concerned about the Fed's stock-picking. I had to wonder today on Twitter if biotech and social media stocks will prove to be the magnets making the Fed's monetary compass malfunction, as oil did in 2008. I certainly hope not, for if so, the modest expectations for growth that I and other investors hold may still prove to be too optimistic. So, to answer the eternal question - to panic or not to panic? - I offer the measured, "It depends on your framework." But I hope you have one, because it may soon be challenged.
I can't agree enough with that statement. Equanimity and the ability to step back from one's emotions are crucial parts of investing that aren't sufficiently cultivated. Yet this doesn't mean ignoring geopolitical news. Investors need to find a way to incorporate geopolitical shocks into a methodical framework. Frankly, this is easier said than done. Financial markets are complex adaptive systems, and one of the characteristics of such systems is non-linearity, i.e. the propensity for small inputs, physical interactions or stimuli to cause large effects or significant changes in output.
Another reason we have to wrestle with geopolitical news is that these events can be genuine shocks within an AD/AS framework. For example, Lars Christensen noted the aggregate supply shock resulting from the Russian invasion of Crimea. Aggregate demand shocks, too, are rampant. I recently saw "Five Years From The Brink", a documentary focusing on Hank Paulson's role as Treasury Secretary during the panic of 2008 (I wouldn't rush out to get it, although it does offer the benefit of hindsight). One thing that struck me was his point that each of the beleaguered financial institutions would have constituted a full-blown crisis on its own, and that policy-makers from Treasury and the Fed (to name a few) had multiple balls of crisis up in the air at the same time. This, undoubtedly, prevented the Fed from acting sooner in its role as monetary policy-setter as it went instead into crisis mode. The revival of geopolitical tensions requires the attention of policy-makers who may therefore neglect the importance of monetary policy (weakening AD) or investments in education and infrastructure (weakening AS). None of these things is good.
The reality is, therefore, that investors need to incorporate geopolitics into their frameworks, either by setting out various scenarios and assigning probabilities to them, or by demanding a buffer of safety in their investments. My suspicion is that the current bad news is not sufficient to derail the global economic recovery. Those who are bearish today, however, may turn out to be right for the wrong reasons. Ambrose Evans-Pritchard warns of a possible dollar squeeze in the offing, as Lars Christensen is rightly concerned about the Fed's stock-picking. I had to wonder today on Twitter if biotech and social media stocks will prove to be the magnets making the Fed's monetary compass malfunction, as oil did in 2008. I certainly hope not, for if so, the modest expectations for growth that I and other investors hold may still prove to be too optimistic. So, to answer the eternal question - to panic or not to panic? - I offer the measured, "It depends on your framework." But I hope you have one, because it may soon be challenged.
Thursday, July 3, 2014
Sunday, May 18, 2014
The Quest For An Investing Moral Compass
I have cheekily (some may say unoriginally) adapted the title of a new book by Kenan Malik for the title of this post. Unlike Malik's book, this is by no means a treatise on an ethical approach to investing, but rather a collection of thoughts that will continue to be refined through experience and discourse. As Malik says in his introduction, "In the modern world, morality is inseparable from choice." Earlier this week, I finished Kurt Eichenwald's excellent Conspiracy of Fools, which narrates the rise and fall of Enron. Mercifully, scandals on the scale of Enron happen infrequently, but I was struck by how many people were complicit in its collapse through indifference to detail, fears for job security and subservience to presumed expertise (as opposed to those driven by outright greed & intent to defraud).
The world of investing, as we know from the likes of Bernie Madoff, is equally fraught with such moral decisions. More subtly, investors make implicit ethical choices by investing in companies or asset classes, or even by settling on different investing strategies. (If this sounds impossibly sanctimonious, I wish I had some folksy, homespun Buffet-isms to help, but they would probably sound pretty ridiculous coming from someone from Singapore). Bodies like the CFA Institute attempt to sketch out guidelines for financial professionals' "fiduciary duties", but these can never cover the complex interaction of real-world investors and clients. Fiduciary duty can only be described vaguely as "doing what's right for one's client". I list some examples below of possible areas of ethical conflict for those engaged in the purchase of securities or allocation to managers and strategies:
1) Is it ethical to invest a new dollar for a client if you believe a market is overvalued? Inflows from clients (particularly retail) are notoriously pro-cyclical, which suggests that you are very likely to be receiving new capital late in the game when valuations are stretched. Some PMs seem to take the view that investors have given them a mandate, and that they should then meet that mandate by investing in ideas that can outperform a benchmark, thereby achieving relative, if not absolute outperformance. Their clients, they argue, are not paying them to hold cash. I, on the other hand, think there are plenty of times when it's more appropriate to hold cash, and consider it another asset class. I understand well that the pressures of running a business often compel investors (particularly long-only funds) to be fully invested at all times, but this strategy seems doomed to the occasional (and possibly fatal) blow-up.
2) The recent decision by Stanford University's endowment to divest from coal-related investments has renewed (no pun intended) the debate on socially responsible investing. The investor's role is obviously to make the highest return possible for his client within a socially acceptable framework of risks and care for society and other stakeholders, but delineating that framework is tricky. Stanford has reportedly kept its stakes in oil & gas companies because of a lack of alternatives for those fuels. A cynic might plausibly suggest that given the growing prospects of natural gas and renewables, the likelihood of explicit or implicit carbon taxes in the future and the poor returns on coal-related equities, Stanford has simply decided to take its lumps on its coal holdings (ok, I meant that one). Arguably, a socially motivated owner could do more good by pushing his company to engage with regulators more keenly, rather than merely selling his stake.
3) This one might be the most controversial of the three. I've been listening to a lot of Michael Covel's podcasts lately on trend-following strategies (the longer interviews often feature interesting guests; the shorter ones seem less worthwhile). I recognize the potential for profitable trend-following/momentum strategies (right on cue, AQR has contributed its intellectual heft in defense of momentum investing), not to mention other technical strategies as laid out for popular consumption here by Andrew Lo and Jasmina Hasanhodzic. Mind you, an investor doesn't have to have an exclusively technical framework to be a momentum investor - as George Soros famously said, "When I see a bubble forming I rush in to buy, adding fuel to the fire." Yet one of the supposed benefits of a market is that it generates prices, which in turn provide information about the allocation of resources. I've seen it said that Soros used to say of his speculating, "I shouldn't be allowed to do what I do, but I'll do it as long as I'm allowed." That seems an amoral escape route, and one I suspect Soros himself has largely abjured in his later incarnation as global statesman. One can often make a good deal of money pushing up the price of an asset from fair value to overvalued levels before offloading to an unsuspecting patsy, but that hardly seems like a socially defensible form of investing, philosophically indistinct to me from other forms of legal but unethical business practices. But before I sound like I'm on my high horse and ready to break into canter, let me say that this somewhat ideological notion of contributing information to the market can be taken to extremes. Those dogmatically opposed to market exuberance would have been shorting Internet stocks in early 1999 and eventually cast in the sea of bankrupt investors in a shroud of ideological purity. Logotherapy is best saved for the therapist's couch, and shouldn't be bankrolled by one's clients. I'm sure there are some Herbalife investors out there who agree on that count. All told, it can be difficult discern whether and to what extent an investor owes a duty to society as a whole.
As I said, this is by no means an exhaustive survey of possible ground for ethical dilemmas in investing, but a recognition that these quandaries exist. I look forward to comments.
The world of investing, as we know from the likes of Bernie Madoff, is equally fraught with such moral decisions. More subtly, investors make implicit ethical choices by investing in companies or asset classes, or even by settling on different investing strategies. (If this sounds impossibly sanctimonious, I wish I had some folksy, homespun Buffet-isms to help, but they would probably sound pretty ridiculous coming from someone from Singapore). Bodies like the CFA Institute attempt to sketch out guidelines for financial professionals' "fiduciary duties", but these can never cover the complex interaction of real-world investors and clients. Fiduciary duty can only be described vaguely as "doing what's right for one's client". I list some examples below of possible areas of ethical conflict for those engaged in the purchase of securities or allocation to managers and strategies:
1) Is it ethical to invest a new dollar for a client if you believe a market is overvalued? Inflows from clients (particularly retail) are notoriously pro-cyclical, which suggests that you are very likely to be receiving new capital late in the game when valuations are stretched. Some PMs seem to take the view that investors have given them a mandate, and that they should then meet that mandate by investing in ideas that can outperform a benchmark, thereby achieving relative, if not absolute outperformance. Their clients, they argue, are not paying them to hold cash. I, on the other hand, think there are plenty of times when it's more appropriate to hold cash, and consider it another asset class. I understand well that the pressures of running a business often compel investors (particularly long-only funds) to be fully invested at all times, but this strategy seems doomed to the occasional (and possibly fatal) blow-up.
2) The recent decision by Stanford University's endowment to divest from coal-related investments has renewed (no pun intended) the debate on socially responsible investing. The investor's role is obviously to make the highest return possible for his client within a socially acceptable framework of risks and care for society and other stakeholders, but delineating that framework is tricky. Stanford has reportedly kept its stakes in oil & gas companies because of a lack of alternatives for those fuels. A cynic might plausibly suggest that given the growing prospects of natural gas and renewables, the likelihood of explicit or implicit carbon taxes in the future and the poor returns on coal-related equities, Stanford has simply decided to take its lumps on its coal holdings (ok, I meant that one). Arguably, a socially motivated owner could do more good by pushing his company to engage with regulators more keenly, rather than merely selling his stake.
3) This one might be the most controversial of the three. I've been listening to a lot of Michael Covel's podcasts lately on trend-following strategies (the longer interviews often feature interesting guests; the shorter ones seem less worthwhile). I recognize the potential for profitable trend-following/momentum strategies (right on cue, AQR has contributed its intellectual heft in defense of momentum investing), not to mention other technical strategies as laid out for popular consumption here by Andrew Lo and Jasmina Hasanhodzic. Mind you, an investor doesn't have to have an exclusively technical framework to be a momentum investor - as George Soros famously said, "When I see a bubble forming I rush in to buy, adding fuel to the fire." Yet one of the supposed benefits of a market is that it generates prices, which in turn provide information about the allocation of resources. I've seen it said that Soros used to say of his speculating, "I shouldn't be allowed to do what I do, but I'll do it as long as I'm allowed." That seems an amoral escape route, and one I suspect Soros himself has largely abjured in his later incarnation as global statesman. One can often make a good deal of money pushing up the price of an asset from fair value to overvalued levels before offloading to an unsuspecting patsy, but that hardly seems like a socially defensible form of investing, philosophically indistinct to me from other forms of legal but unethical business practices. But before I sound like I'm on my high horse and ready to break into canter, let me say that this somewhat ideological notion of contributing information to the market can be taken to extremes. Those dogmatically opposed to market exuberance would have been shorting Internet stocks in early 1999 and eventually cast in the sea of bankrupt investors in a shroud of ideological purity. Logotherapy is best saved for the therapist's couch, and shouldn't be bankrolled by one's clients. I'm sure there are some Herbalife investors out there who agree on that count. All told, it can be difficult discern whether and to what extent an investor owes a duty to society as a whole.
As I said, this is by no means an exhaustive survey of possible ground for ethical dilemmas in investing, but a recognition that these quandaries exist. I look forward to comments.
Tuesday, May 6, 2014
Risk: Its Wildness Lies In Wait
G.K. Chesterton wrote that "[life] is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait." I'm often reminded of this when I hear sophisticated investors describe their risk management processes. For many investors, particularly if they are institutions or cater to institutions, it seems to be a prerequisite that a rigorous risk management system is by definition highly quantitative. There are three possibilities where the use of these models is concerned:
(1) Their risk models actually drive portfolio construction.
(2) Their risk models are presented to investors to give the veneer of rigour, but are basically ignored.
(3) Risk models are used to augment commonsense approaches, but are not the final arbiter of portfolio construction.
I suspect (2) and (3) are significantly more common than (1). While (2) is unethical, it may have the benefit of shielding investors from blind submission to a model. The version of risk (i.e. volatility) taught in introductory investments textbooks can be a dangerous tool. It's particularly problematic when investors don't understand the math and statistics that underlie these quantitative risk models, and are therefore unable to fully grasp their limitations. For example, it seems like a lot of people are willing to say, "Yes, we understand that asset prices don't follow a normal distribution, but let's use it as a tool anyway." Obviously, one doesn't need to be an automotive engineer in order to drive a car, but I think being unclear about the limitations of one's vehicle creates the need for humility, and caution.
The quintessential definition of risk comes from Frank Knight in Uncertainty and Profit. "The practical difference between the two categories, risk and uncertainty, is that in the former the distribution of the outcome in a group of instances is known (either through calculation a priori or from statistics), while in the case of uncertainty this is not true, the reason being in general that it is impossible to form a group of instances, because the situation dealt with is in a high degree unique."
Critics like Taleb waste no time in attacking Knight's classification. Taleb writes, "Had [Knight] taken economic or financial risks he would have realized that these "computable" risks are largely absent from real life! They are laboratory contraptions!" Indeed, those who take Knightian risk to excessive lengths (and I don't think Knight himself intended this) are guilty of reifying risk. Berger & Luckmann, in their classic The Social Construction of Reality describe reification as "the apprehension of the products of human acitvity as if they were something else than human products - such as facts as nature, results of cosmic laws, or manifestations of divine will. Reification implies that man is capable of forgetting his own authorship of the human world... The reified world is, by definition, a dehumanized world." This is how simplistic models treat risk - as historical volatility which is indicative of future volatility because of some inherent feature, rather than as the product of economic fundamentals and economic agent action.
One reason this thinking is dangerous is because of what economists have termed endogenous risk. This is just a fancy phrase for something that other social scientists are well aware of. For example, the sociologist Kathleen Tierney notes that, "Risks associated with social and physical systems are not inherent in those systems, nor are they fixed; rather they are the outcome of interactions among those social and physical units, social structure, and human (usually organizational) decisions." Translating this into economics jargon, Danielsson and Shin define endogenous risk as "the risk from shocks that are generated and amplified within the system." Woody Brock cautions that, "In episodes of market turmoil, the relevant endogenous risks have probability distributions that cannot be known. This, in turn, means that those "market risks" we prattle on about cannot be properly assessed and thus cannot be correctly priced and thus cannot be optimally "managed" by individuals or institutions - despite widespread beliefs by today's risk managers that they can. Ironically, just when optimal risk assessment and risk management tend to be most needed - in periods of crisis - we learn that they cannot exist." No doubt there are very clever folks out there with complicated models that can simulate the effects of the economy and financial markets as complex adaptive systems (the Danielsson and Shin paper suggests competitive equilibrium and game theoretic models), but since I don't understand their workings, I have no way of commenting whether these models will actually work for investors.
The backward-looking nature of many of these models is also widely recognized, but considered by many to be a necessary evil. But it is worth considering, for example, whether low historical correlation between certain assets will hold as large institutional investors become ever more creative in allocating funds.
I'm not suggesting that we should give up on thinking about risk, merely that quantifying it may not be helpful for everyone. But I also reject the notion of risk as the "permanent loss of capital". In a terrific article on his Top 10 Peeves, AQR's Cliff Asness very effectively defends the use of volatility in an investing framework. He clarifies first, "Volatility isn't how much the security is likely to move; it's how much it's likely to move versus the forecast of expected return." More importantly, he explains, "Risk is the chance you are wrong. Saying that your risk control is to buy cheap stocks and hold them... is another way of saying that your risk control is not being wrong. That's nice work if you can get it. Trying not to be wrong is great and something we all strive for, but it's not risk control. Risk control is limiting how bad it could be if you are wrong."
That's a great description of risk management, and I appreciate the fact that Asness is able to convey it in straightforward language. Highly quantitative risk models are not appropriate for many investors, but that doesn't mean they need to eschew risk management altogether, or feel insecure about the lack of precision in their attempts. As Danielsson and Shin note, "an effective risk manager should be able to make an intelligent distinction between those cases where those cases where the standard "roulette wheel" approach view of uncertainty is sufficient, and to distinguish those cases from instances where endogeneity of risk is important. Common sense and a feel for the underlying pressures dormant in a market are essential complements to any quantitative risk management tool that merely looks back at the recent past." In a future post, I'll attempt to lay out a commonsense approach to thinking about risk and its management.
(1) Their risk models actually drive portfolio construction.
(2) Their risk models are presented to investors to give the veneer of rigour, but are basically ignored.
(3) Risk models are used to augment commonsense approaches, but are not the final arbiter of portfolio construction.
I suspect (2) and (3) are significantly more common than (1). While (2) is unethical, it may have the benefit of shielding investors from blind submission to a model. The version of risk (i.e. volatility) taught in introductory investments textbooks can be a dangerous tool. It's particularly problematic when investors don't understand the math and statistics that underlie these quantitative risk models, and are therefore unable to fully grasp their limitations. For example, it seems like a lot of people are willing to say, "Yes, we understand that asset prices don't follow a normal distribution, but let's use it as a tool anyway." Obviously, one doesn't need to be an automotive engineer in order to drive a car, but I think being unclear about the limitations of one's vehicle creates the need for humility, and caution.
The quintessential definition of risk comes from Frank Knight in Uncertainty and Profit. "The practical difference between the two categories, risk and uncertainty, is that in the former the distribution of the outcome in a group of instances is known (either through calculation a priori or from statistics), while in the case of uncertainty this is not true, the reason being in general that it is impossible to form a group of instances, because the situation dealt with is in a high degree unique."
Critics like Taleb waste no time in attacking Knight's classification. Taleb writes, "Had [Knight] taken economic or financial risks he would have realized that these "computable" risks are largely absent from real life! They are laboratory contraptions!" Indeed, those who take Knightian risk to excessive lengths (and I don't think Knight himself intended this) are guilty of reifying risk. Berger & Luckmann, in their classic The Social Construction of Reality describe reification as "the apprehension of the products of human acitvity as if they were something else than human products - such as facts as nature, results of cosmic laws, or manifestations of divine will. Reification implies that man is capable of forgetting his own authorship of the human world... The reified world is, by definition, a dehumanized world." This is how simplistic models treat risk - as historical volatility which is indicative of future volatility because of some inherent feature, rather than as the product of economic fundamentals and economic agent action.
One reason this thinking is dangerous is because of what economists have termed endogenous risk. This is just a fancy phrase for something that other social scientists are well aware of. For example, the sociologist Kathleen Tierney notes that, "Risks associated with social and physical systems are not inherent in those systems, nor are they fixed; rather they are the outcome of interactions among those social and physical units, social structure, and human (usually organizational) decisions." Translating this into economics jargon, Danielsson and Shin define endogenous risk as "the risk from shocks that are generated and amplified within the system." Woody Brock cautions that, "In episodes of market turmoil, the relevant endogenous risks have probability distributions that cannot be known. This, in turn, means that those "market risks" we prattle on about cannot be properly assessed and thus cannot be correctly priced and thus cannot be optimally "managed" by individuals or institutions - despite widespread beliefs by today's risk managers that they can. Ironically, just when optimal risk assessment and risk management tend to be most needed - in periods of crisis - we learn that they cannot exist." No doubt there are very clever folks out there with complicated models that can simulate the effects of the economy and financial markets as complex adaptive systems (the Danielsson and Shin paper suggests competitive equilibrium and game theoretic models), but since I don't understand their workings, I have no way of commenting whether these models will actually work for investors.
The backward-looking nature of many of these models is also widely recognized, but considered by many to be a necessary evil. But it is worth considering, for example, whether low historical correlation between certain assets will hold as large institutional investors become ever more creative in allocating funds.
I'm not suggesting that we should give up on thinking about risk, merely that quantifying it may not be helpful for everyone. But I also reject the notion of risk as the "permanent loss of capital". In a terrific article on his Top 10 Peeves, AQR's Cliff Asness very effectively defends the use of volatility in an investing framework. He clarifies first, "Volatility isn't how much the security is likely to move; it's how much it's likely to move versus the forecast of expected return." More importantly, he explains, "Risk is the chance you are wrong. Saying that your risk control is to buy cheap stocks and hold them... is another way of saying that your risk control is not being wrong. That's nice work if you can get it. Trying not to be wrong is great and something we all strive for, but it's not risk control. Risk control is limiting how bad it could be if you are wrong."
That's a great description of risk management, and I appreciate the fact that Asness is able to convey it in straightforward language. Highly quantitative risk models are not appropriate for many investors, but that doesn't mean they need to eschew risk management altogether, or feel insecure about the lack of precision in their attempts. As Danielsson and Shin note, "an effective risk manager should be able to make an intelligent distinction between those cases where those cases where the standard "roulette wheel" approach view of uncertainty is sufficient, and to distinguish those cases from instances where endogeneity of risk is important. Common sense and a feel for the underlying pressures dormant in a market are essential complements to any quantitative risk management tool that merely looks back at the recent past." In a future post, I'll attempt to lay out a commonsense approach to thinking about risk and its management.
Sunday, April 20, 2014
The Rotten Heart of Europe
Posts have been light lately because, in addition to a flurry of school-related activity, I was working my way through Bernard Connolly's excellent "The Rotten Heart of Europe". I'm fairly certain I first heard of this book through Lars Christensen over a year ago (sometimes I forget the source of reading recommendations, but thanks, Lars!). I had read certain parts of the book before this but never really found myself with the time to plow through the entire thing. I'm glad I finally got round to doing it. It's not the easiest read in some ways because it deals in great detail with the political decisions driving the bizarre economics of the Exchange Rate Mechanism, and it can sometimes be challenging for an outsider to try and understand the perverse choices politicians make. But despite - or maybe because of - the challenging nature of the material, it deserves to be read, and re-read. At many points, I marvelled at Connolly's erudition and prescience, and his ability to write with such insight about both politics and economics. Over and over, I thought to myself "well, that assertion is a little overblown" - and then realized that many things that would've been considered unlikely at the time have already come to pass. I highly recommend it, and rather than trying to summarize it, I just wanted to make a few points that the book revealed to me.
1) The Eurozone is a political construction. That seems obvious, but comes across over and over through this book. Understanding the politics of the Eurozone is absolutely critical to understanding its economics. Lars and I have often lamented that it seems like the political and legal news keeps slipping into the financial section. After reading this book, I realize there simply cannot be any other way. As Connolly notes, "the emergence of 'central bank watchers' implies that markets do not know what decision rules are being used by the central banks and have to try to deduce these uncertain rules from their actions and, perhaps even more important, their pronouncements." Unfortunately, this also means that investors have to make bets on political outcomes that aren't always clear.
2) We don't sufficiently understand the politics of the Eurozone. Following on from (1), the task of investors and economic actors is significantly complicated by trying to understand political mechanisms that aren't necessarily clear. Despite the surfeit of digital and literal newsprint devoted to the area's politics, I'm still left with the uneasy feeling that there's much of importance bubbling beneath the surface that I and other outsiders will simply never be privy to. Specifically:
- It's clear that there is a tremendous amount of political will from elites to keep the Eurozone together. I didn't understand this point well enough two years ago when I thought the Euro could well break up, and having read this book, I understand its origins better. At times, this political will is all the more baffling when you read just how painful the ERM experience was - and yet politicians decided to take it a step further. Of course, the Russian threat is making clear why some smaller nations desire broader integration with Europe (not to mention what Connolly calls "the Golden Calf of Structural Funds"). But now that everyone understands the political will to keep the Eurozone together, there are two new threats: (a) complacency from top-level officials to (b) the possibility of backsliding from structural reform. Of course, some of this backsliding is a response to the Euro's shortcomings. Connolly notes numerous instances of governments offsetting tight monetary policy with fiscal profligacy and harmful supply-side policies.
- Central bank politics. Connolly quotes an unnamed Bundesbank staffer who quips that "in every central bank, politics is king." Rotten Heart lays bare the unusual political role of the Bundesbank, and the internal struggles between Schlesinger and Tietmeyer. I'm as guilty as anyone of referring to "the ECB", but of course, this supposedly monolithic beast is made up of lots of individuals representing the (often divergent) interests of their own nations and institutions. I was reminded of a quote from James March: "We know more about abstract agents dealing with abstract principals than we do about real bureaucrats dealing with real politicians." Furthermore, Connolly notes that "the biggest problem for the Bundesbank in explicit inflation-targeting was precisely its explicitness...'Price stability' could mean anything it suited the Bundesbank to have it mean." While many commentators have raged at the ECB for failing its mandate, that mandate is actually unacceptably vague, as Jurgen Stark recently reminded us.
3) Never underestimate the importance of luck. Or to be more precise in this instance, the importance of geopolitics (i.e. the interaction of geography and politics). The terrible insecurity France and Belgium seem to feel is in some ways an artifact of history and geography. Similarly, Ireland's willingness to submit itself to boom-bust cycles is driven by its desire to be out of the UK's political sphere of influence. UK citizens can thank their lucky stars (from an economic perspective) that their physical separation from continental Europe has contributed to their avoiding the pull of the Euro.
4) Never underestimate the importance of insecurity. Similar to the above, and understanding "real bureaucrats dealing with real politicians", one must be sensitive to the blinding insecurity that drives so many important decisions. Insecurity towards Germany, the US and the "Anglo-Saxon" model of capitalism seem to have driven France into this unhappy marriage. Connolly is particularly (and rightfully) harsh towards British politicians who fear that Britain will be "left out". Nick Clegg is peddling that line today. In hilarious fashion, Connolly refers to these people as "behaving like the 'Fat Boy' in Pickwick by telling tales to make the flesh creep." Perhaps unkindly, I cannot get away from the image of two drunks clinging to each other feebly for security. The solution is probably to stop drinking, rather than clinging ever more desperately. Equally, the concept of a "Latin Monetary Union" was raised in the past (as it is today), and nothing is more insulting to the insecure as being seen as part of an unwanted club.
5) The Eurozone crisis remains unresolved. Earlier this week, I listened to a nuanced debate on the crisis. That debate and reading Rotten Heart have strengthened my belief that there are, sadly, many ways this could go wrong. I tend to think of myself as an optimistic person, and I don't want to be a perma-bear on Europe (see my earlier post on the conundrum of investing in the Eurozone). It seems, however, that we are in one of those momentary periods of calm that should not be underestimated (or should at least built into one's financial models). Rightfully, there has been much talk about the effects of deflation and low NGDP on prolonging the crisis. However, at least the ECB's task is made easier by generalized low inflation throughout the Eurozone. As I mentioned earlier, it is far from a monolithic creature, and there may actually be greater danger in recovery. Many of the periods of ERM crisis that Connolly outlines are sparked by divergence between the German economy and other ERM members. Trichet's attempt to raise rates in this iteration of the crisis shows the recurrence of this issue. Proponents of the Euro must hope that all its constituent economies recover in tandem. Unlike in Rotten Heart, politicians and central bankers seem to have done a better job of coordinating their rhetoric this time round. Fewer people seem to playing the role of Schlesinger, if you will. But it's a step too far to hope that economic recovery will be synchronous, despite the efforts towards banking union and structural reform. The remaining disparities between Eastern and Western Germany are a warning as to the pace at which convergence can occur (compare the GDP per capita of Hamburg or Bremen to Brandenburg or Berlin). Continued divergence between France and Germany will be particularly dangerous. While sympathetic to the economic views of many Euroskeptic parties, I cannot abide the unabashed racism and xenophobia. There are, however, many who have no such compunction, and their numbers are growing, even in traditionally Europhile France. With remarkable foresight, Connolly warns, "Either [a future ECB] will act in French interests or it will not. If it does, then Germany will destroy it, putting an end to fifty years of a 'European Germany'. If it does not, then it might well destroy France." One cannot help but worry that we'll reach a turning point in this incessant crisis, and sigh, as Connolly's unnamed French official, "Alors, c'est bien foutu, le systeme."
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