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«1. Scene setting Content: 1. Scene setting 1 The 300 Club believes that modern portfolio theory and practice are failing institutional 2. How it all ...»

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10 | The 300 Club | The Death of Common Sense | April 2012 Sub-prime loans became a ready outlet, once they were sliced, diced and repackaged to create the magic dust. Authorities believed that the efficiency of the markets would ensure their fair valuation and attract willing buyers around the world for these freshly minted securitised products – many with (bogus) triple-A rating. Also by spreading their risks across the global investment community, their use of derivatives would pre-empt any systemic risks. Alan

Greenspan, no less, was emphatic on the merits of this financial engineering [1997]:

“The use of a growing array of derivatives and the related application of more sophisticated methods of measuring and managing risk are key factors underpinning the enhanced resilience of our largest financial institutions. … As a result, not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more stable.” The rest is history. No wonder, today’s investors fall into two camps: the shocked and the dismayed. Indiscriminately, like a tsunami, the 2008 sub-prime crisis wiped out some $15 trillion in asset values, hitting every asset class, every market, every geography and every client segment: 15 years of capital gains were wiped out in 15 months.

Yet, in May 2007, barely three months before the crisis unfolded, Ben Bernanke couldn’t see

a phenomenon of this magnitude coming, when he stated in a public speech in May 2007:

“We do not expect significant spill-over from the sub-prime market to the rest of the economy or to the financial system.”

Nor did Gordon Brown, for that matter. In his June 2007 Mansion House speech he said:

“Everyone needs to follow the City’s great example and emulate this high value-added talentdriven industry. Thanks to its remarkable achievement, we have the huge privilege to live in an era that history will record as the beginning of a Golden Age.” Of the 20 biggest daily upswings in the S&P 500 since 1980, 10 have occurred in the last five years. Likewise, of the 20 biggest downswings, 13 have taken place in the last 5 years.

Rarely have the stock markets been so wild and moved so little, until early 2012. With too many wild variables, investing has become a loser’s game.

This is a far cry from the heady days of the 1990s when the unrelenting chase for relative returns delivered double digit performance year after year until the ensuing crash in March

2000. It was a defining moment. Investors discovered that index hugging could not buy groceries in a bear market; nor could it prevent an unprecedented funding shortfall in defined benefit pension plans worldwide. Thus, uncorrelated absolute returns became the new mantra.

Some 30 new product sets, asset allocation tools and hedging techniques were duly adopted [Rajan, 2011]. They aimed to control risk and boost returns irrespective of market conditions – only to be overwhelmed by the crash of 2008.

That episode showed that the world of investing can be a hall of mirrors: what you see is not as it is. Securitised mortgages in the US are just one example. The other is a raft of structured products that were subsequently hammered by the collateral damage from the collapse of Lehman Brothers and AIG. But that is not all.

–  –  –

They are hard to model in a world where technology has amplified investor mood swings and compressed decision spans from calendar time to real-time. Nearly 65% of daily movements in key market indices are now driven by ‘noise’ rather than ‘signal’. Politics, not economics, drives the markets. Also, high frequency trading reinforces the periodic bouts of risk-on/risk-off that are unconnected to corporate fundamentals, a far cry from the selfcorrecting mechanisms of the efficient markets.

In hindsight, investors have learnt that they were not managing risk, they were managing uncertainty. One relies on known probabilities of expected returns, the second on pure guesswork. As one large pension plan participating in the 2011 CREATE-Research survey observed, “We’ve lost money in every asset class we were advised to follow in the last decade”.

Few policy makers and their economists saw the bear markets coming; few detected the time bomb concealed in cheap money; few understood the unintended consequences of the mark-to-market rules; few expected the asset class correlation to go through the roof: few challenged the validity of the bar belling model. Long conditioned to viewing the investment landscape through the prism of EMH, they failed to see that investing had become ever more nuanced in the face of systemic forces akin to the Black Swan [Taleb, 2007].

In retrospect, the 2000-02 equity crash was a defining moment in global fund management.

It set off a chain reaction whose cumulative impacts were hard to foresee. As millions lost billions, the old ways of investing fell into dispute. Nor could the hype of equity risk premium or benchmark hugging stop a severe shortfall in defined benefit pension plans worldwide.

So, they switched from relative to absolute returns, in what promised to be an era of low nominal returns. This decisive shift coincided with the most benign conditions in credit markets in living memory. These conditions served to perpetuate the myth that absolute returns were not only desirable but also deliverable, thanks to the arrival of the ‘new masters of universe’ who had suddenly rediscovered the skills that lay fallow in the bygone era of relative returns, when chasing alpha was like looking for a needle in a haystack.

In the brave new world of absolute returns, this new breed of managers overly relied on the use of leverage, shorting and derivatives in their freshly minted ‘go anywhere’ type strategies.

Risk was stacked up like a wedding cake. Like alchemy and quack medicine, the prevailing risk models thrived on the investors’ wish to believe in impossible things. The advice from a

leading thinker of the day was largely ignored [Scholes, 2005]:

“We make models to


reality. But there is a meta-model beyond the model that assures us that the model will eventually fail. Models fail because they fail to incorporate the interrelationships that exist in the real world.”

6. What’s all this got to do with efficient markets?

First, it helped to cultivate the belief that markets are always right and mean reversion towards fundamental values is the norm. A new lingo was created which, in hindsight, used clever words to conceal longstanding problems. Policy makers, especially in the UK and the US, were seduced into believing either that bubbles never happened, or if they did there was no hope that central banks could spot them and intervene. Evidently, they believed that markets have their own self-correcting fair-value dynamic. The only thing that central banks can do is to mop up the periodic mess afterwards. That thinking lay behind 12 | The 300 Club | The Death of Common Sense | April 2012 the two savage bear markets of the last decade. It also lay behind the whole mark-to-market accounting edifice introduced in 2004 that rests on the view that only markets can provide ‘fair’ valuations at all times. Arguably, that edifice turned the US sub-prime crisis into a global disaster, when the value of all securitised assets dropped like a stone, irrespective of their intrinsic worth.

Second, it also turned investing from art to science; from craft to industrialisation; from judgment calls to mechanical formulas. Much of the innovations – e.g. derivatives, shorting, leverage, portable alpha, high frequency trading – were justified on the grounds that the only way to beat the markets was to create ever more clever mouse traps. More often than not, they have aimed to extract value where there is none. Systemic risks, product complexity and higher charges have been the main outcomes.

Third, the EMH fostered complacency amongst policy makers and investors alike. Most of them did not realise that, under the froth of the booming markets in the period 2002serious fault lines were developing in the investment landscape in response to mega forces like the globalisation of markets, the impact of revolutionary technologies, and the unintended consequences of regulatory changes – to name but a few. Via mounting anomalies, caused by periodic bouts of dislocations, these forces were progressively eroding the twin pillars of asset allocation: equity risk premium and asset class diversification.

The anomalies in question arose due to: the ad hoc manner in which markets react to information; the unstructured means by which markets price a given asset; and the behavioural biases of investors who continue to use the old heuristics for new situations.

The anomalies have multiplied as markets have gone from: local to global; calendar time to real time; clear ‘signal’ to loud ‘noise’; buy-and-hold investing to opportunistic investing;

and asset management to liability optimisation.

Last, but not least, the ‘industrialisation’ of investing has, in turn, depersonalised relations between investors and their asset managers. Unlike their physical counterparts, like cars and computers, investment products do not have a definable shelf life, they do not deliver predictable outcomes, they cannot be pre-tested in a lab, and they do not carry a fit-for-purpose certificate. For good returns, what matters most are timing and market environment. These require a far higher degree of engagement between investors and their managers than has been the case over the past 20 years where dis-intermediation has become ever more pronounced [Rajan 2012].

For asset managers, it is essential to:

• Understand their clients’ dreams and nightmares • Solicit new ideas by tapping into clients’ investment expertise • Manage expectations in what can and can’t be delivered • Minimise ‘wrong time’ risks in buying and selling • Communicate bespoke research that addresses unique issues to clients • Highlight proactive buying opportunities in periods of big price dislocations.

–  –  –

7. What next?

Our main conclusion is that neither the CAPM nor the EMH have much empirical support. They work until they don’t work. Both have undergone significant refinements to the point where their much-publicised inferences – that markets are efficient and active management does not work – are no longer tenable.

Yet, they have reigned supreme for the best part of half a century, having a profound influence on the psyche of financial investors, policy makers and the investment industry.

It is probably too far-fetched to single them out as the key culprits in the current crisis.

They are merely ingredients in a rich stew of financial irresponsibility, political ineptitude, lax regulation and perverse incentives. Besides, the world of investing is too complex for a few naïve ideas to bring it to its knees.

It is equally hard to underestimate their influence on the forces that have brought us to where we are today. They promoted a world view detached from the on-the-ground reality.

For a long time, they rode on the back of the strong pro-market anti-regulation sentiment unleashed by the Thatcher-Reagan era in which faith mattered more than facts.

Either way, this paper has had the limited goal to describe how modern financial theory has evolved and how it has been linked to the current crisis. As such, its tone and content have been deliberately retrospective.

Subsequent papers in the 300 Club series will focus on some of the challenges highlighted in the last two sections and the responses they require from governments, investors and asset managers. Areas that will receive special attention are dynamic asset allocation, manager selection, principal-agency relationship and client engagement.

14 | The 300 Club | The Death of Common Sense | April 2012

–  –  –

Current economic and investment trends will change the investing landscape over the next two decades and we are at a crisis point which presents huge risks to investors, according to the 300 Club. Moreover, the 300 Club believes that current financial and investment theory and practice run the risk of failing investors at their time of greatest need.

Contact us

For further information about the 300 Club contact our Media Team:

Asmita Kapadia +44 (0) 20 7680 2120 asmita.kapadia@the300club.org Jean Dumas +44 (0) 20 7680 2152 jean.dumas@the300club.org The views and opinions contained herein are individual views held by those of the 300 Club.

The information herein is believed to be reliable but the 300 Club does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments.

Although the 300 Club believes that its expectations and the information in this document were based upon reasonable assumptions at the time when they were made, it can give no assurance that those expectations will be achieved or that the actual results will be as set out in this document.

The 300 Club undertakes no obligation to publicly update or revise any forward-looking information or statements.

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