News Room
Fragile state
Nov. 10, 2008

By Vanessa Drucker

As the credit crisis has taken its toll, the financial landscape has metamorphosed. A decade ago, enthusiastic investors rushed to embrace a "new paradigm", to use a long discredited expression. Now, secular delevering has brought about a real and radical sea change, requiring a new set of investment principles.

The financial services industry has turned to government bail-outs to prop up private investment. The failure of Lehman Brothers demonstrated how both institutions and derivative instruments are linked like dominoes across the world. Banks are being nationalised, or hastily consolidated in shotgun marriages. Equity markets have plunged, with unprecedented volatility. Fast forward a year or two. How will the new normal look? Without doubt, battered faith will be slow to heal, as the supposed expertise of the mega financial institutions has been so badly undermined. The rating agencies have lost credibility, and mark-to-market accounting has come under fire with an almost theological fervor. Over-the-counter derivatives are likely to be standardised and exchange traded, as part of an overall move toward increased regulation.

"We have excess capacity in almost everything, especially homebuilding, retail stores, branch banking, auto manufacturing and restaurants," says Mike Martin, an adviser at Financial Advantage, in Maryland. "That will lead to a regression to the mean for corporate profit margins."

In the new order, clients and investors may no longer readily accept the old mantras, like buy and hold, buy the dips, or a blind faith in diversification across asset classes. This season, almost no strategy has worked and there has been nowhere safe to hide. Even the normally defensive refuges, such as healthcare, consumer staples and utilities, have cratered. "People predict the future by extrapolating from the past. In financial situations, that works as long as things are steady," says Randy Park, Toronto-based author of "The Prediction Trap". Today's conditions are anything but steady state, and not comparable to previous epochs.

Over a 10-year period, while both equities and fixed income have lost ground, only cash has been profitable. "People will think twice about remaining invested. All that data about the disadvantage of missing the 10 best market days fails to mention the pain of suffering through the 10 worst days," reminds Ron Rowland, of Capital Cities Asset Management in Austin, Texas.

History sends a stern warning. From September 1929 to June 1932, American investors lost 86.7% of the value of their equity portfolios. Worse, it took more than 25 years for them to recoup those losses. Subsequent American bear markets, albeit less virulent, have tested their patience. Losses from 1938 to 1942 took 6.4 years to make up, and from 1973 to 1974 needed 7.6 years to break even. More recently, the Japanese stock market has shed three-quarters of its value, retreating from its high near 40,000 in 1989, which it reached almost 30 years ago.

Modern portfolio theory (MPT) is under assault for failing to protect against today's unprecedented volatility. The theory, which encompasses such concepts as the efficient frontier, the capital asset pricing model and mean standard variation, no longer describes the optimal structure for balancing risk against return. "We need to revisit the underpinning of our assumptions on the quantitative side," suggests John Sawyer, the chief investment officer at Compass Bank, in Houston. The Gaussian world we have taken for granted depicts a bell curve-shaped distribution of risk. Yet supposedly improbable events, known as fat tails, black swans or 100-year floods, seem to be happening all too often.

Most advisers measure risk wrongly, leading them to allocate too much equity to their portfolios, says Todd Millay, managing director of Boston-based Choate Investment Advisors. Using oversimplified MPT tools, they develop a flawed picture of how asset classes behave. Millay measures a risk curve to take account of skewness (asymmetrical upside and downside risk), kurtosis (infrequent and extreme deviations), and fat tails (meaningful risk at the fringes that cannot be assumed away). Those risk measurements lead to more conservative and diversified portfolios, with increased emphasis on non-correlated assets. For example, Millay avoids geographic concentrations, since countries exhibit different demographics and growth cycles.

It is not easy, alas. In past weeks, equities in emerging marketshave been even more brutally punished than those in developed ones. Brics and other growth regions were meant to provide an element of non-correlation, offsetting losses and even decoupling altogether.

It did not work out. Brenda Wenning of Wenning Investments in Newton, Massachusetts puts it succinctly: "In today's global economy, markets around the world are in sync with the US stock market. When the US market tanks, other stock markets generally do as well."

In a crisis, everything correlates to one. Investors learned that bitter lesson in 1998, with the collapse of Long-Term Capital Management, and then all but forgot it over the intervening decade. That hedge fund, whose founders included Nobel prizewinners, held over 800 positions based on non market-directional trading strategies.

The same problem applies to the style boxes, such as large or small cap, growth or value. For a long time, Martin has observed and compared their performance, wondering whether it was derived from cause and effect or whether just random. "Recently, all those supposed diversifications didn't defend of equities, bonds, cash and real assets, such as property or commodities? When you think you are adding non-correlated alpha, you may be buying into a blind pool of assets, a black box run by a guru who has inspired your confidence. That guru will have limited room for error. It is difficult enough to obtain alpha with a fraction of a per cent for expenses, let alone when charging the standard two-and-twenty hedge fund fees. "The money management industry will see more alpha beta separation," Tuttle predicts. "The cream will rise to the top." Those who are not generating alpha, but are charging alpha prices for beta will be shown up.

So many of the old investment formulas have come a cropper, both the tried and true maxims and the sophisticated strategies. Against the chaotic background, financial advisers will need to offer novel and flexible approaches to preserve clients' capital and keep them from defecting.

With or without advisers' blessing, investors have been turning to cash. Some need it for psychological reassurance, some for short-term expenses and others in preparation for a more deflationary environment. According to the American Association of Individual Investors, as of September 30 - just before the global markets hurtled into freefall - a survey revealed an overall portfolio breakdown into 50% stocks, 14% bonds and 36% cash, including US treasuries. "Such a migration into cash and treasuries is unheard of," says Ezra Zask, director of LECG and finance professor at the Lally School of Management and Technology at the Rensselaer Polytechnic Institute.

Since fat-tailed events are happening with more frequency and severity than had been expected, it makes sense to review the standard asset allocations. In the past, investors would have curtailed their cash holdings to 5% or 10%, retaining a cushion to put to work during corrections. "Should they now manage cash more actively and hold onto it to take advantage of opportunities? " says Sawyer.

There are challenges to implementing such a strategy. Suppose that financial advisers advocate carrying a larger cash balance over a business cycle, perhaps as long as six or seven years. The disadvantage will be that clients will likely see it as dead money, which they are reluctant to hold when markets are doing well. They may indeed resent paying a manager a fee, while 30% or so of their assets are locked in cash and low return liquid instruments.

The key, says Sawyer, would be to obtain acceptance and agreement that the cash would be eventually allocated over a long horizon, with "observable and definable instances in which it could be deployed". Those instances would need to be spelled out and quantified, such as a market percentage drop. Most advisors shun the temptation of timing the market, so this bold approach represents a significant departure from generally accepted investing and planning.

Another simple way for advisers to take some risk off the table is by using better protective instruments, including stops, alerts, hedging and price targets. During bull days, many managers forget about stops, which are a straightforward way to let the market take them out, especially when it is reaching lower lows.

"The use of stops alone can prevent major, portfolio-draining losses, such as those experienced by investors in technology stocks in 2000 or financial stocks last year and this year," says Wenning, who first began to use Fibonacci retracements in 2004, setting her stops at about 7%. Her models generate pre-set alerts, which indicate when she should buy or sell specific investments. She also uses hedges, to offset her positions with options contracts.

A plethora of useful tools have become available since 2004. For example, the Direxion Funds offer leveraged index and other alternative class products to help manage risk in bull and bear markets. One such vehicle, the Direxion Commodity Trend Strategy Fund, allows managers to short grains and metals (although not energy), as a play on global demand destruction. As another example, Rydex provides a host of currency ETFs, such as the Strengthening Dollar 2X, which could be overlaid on a diverse international portfolio, to hedge against wrenching currency swings.

The merciless plunge in values has dragged down the good, the bad and the ugly together in one swoop. Yet, in terms of protective strategies, it is easier to deal with a systematic correction than with less correlated declines. "You can even just buy puts on Diamonds and Spyders," suggests Sawyer, referring to the options on the exchange traded funds that represent the Dow Jones and S&P averages.

Volatility, likewise, operates as a two-edged sword. Martin has been using the recent turbulence to his advantage, by implementing a strict rebalancing discipline. As soon as a position goes 20% in his favour - which has mainly happened on the short side as markets sold off - he rigorously sells it back to its original allocation as a percentage of the portfolio. In reverse, when a position goes 20% against him, he repurchases it up to its allocation targets, "making volatility our friend".

At the same time, Martin says the emphasis on index funds, which have been so popular during the bull years, is doomed to fade. A broad index inevitably includes both strong and weak components. He explains, "coming out of an era when the rising tide of credit-based consumption lifted all the corporate barges, despite their level of competence, now we'll see more intense competition to separate the men from the boys - if that's not too politically incorrect!"Hitherto, financial planners have had a relatively easy time of it, by building their practice on modern portfolio theory and style-box constrained index funds. Martin predicts, "Now they will be scrambling for a new business model, depending on active management, which of course requires more artistry than the old method that worked during the credit expansion."

There will no longer be any excuse to retreat to a mother country, home bias philosophy. The investment theatre has become truly global, as America relinquishes some of its predominance at the centre of the financial universe.

Wall Street traders grimly joke that it is Mumbai, Dubai, Shanghai or goodbye. It is true that emerging markets have not held up well during the sell-off, with most down steeply over 50%, and some, like Russia and Brazil, even forced to close their exchanges for hours or days. Yet there is no reason to imagine the economic surge among the Brics and other developing nations is permanently over. Their GDPs continue to trot ahead, albeit at a slower pace for now. Sovereign wealth funds still sit on huge hordes of cash, even after some of their investments in Western financial institutions earlier this year proved premature.

As the dust settles, managers must reposition for a changed world environment. "It's a no-brainer," says Zask. "This is a great time to structure a fresh portfolio in the international arena, for the longer-term haul over decades." Specifically, that means buying Asian markets and commodities now, if you buy the argument that demand will increase again, once we come out of recession. Mohamed El-Erian, co-chief executive of Pimco, made that point in his book, When Markets Collide, published in May. He describes, "a gradual hand-off to a set of countries that previously had little if any systemic influence."

El-Erian, who previously ran the Harvard Endowment, garnered kudos for his fund's performance and set the standards for a new model of investment thinking. He and his counterpart at Yale, David Swensen, were among the pioneers to rejig their allocations, channeling most into real assets and alternatives.

Other university endowments and high net worth family offices have replicated the model, sprinkling 10% in beta-linked equities. "It is harder to find the alternatives, since the aggregate tends to be smaller than global equity markets, but is still large enough to accommodate family offices that are managing a few billion," says Pierre Villeneuve of Mapleridge Capital, based in Toronto.

In When Markets Collide, El-Erian sketches out a possible allocation for long-term investors. Time horizons would be critical, since many of his recommended asset classes have been exceptionally badly buffeted. He divvies up the pie into 15% American equities, 15% stocks from other advanced economies and 12% from emerging markets; a 14% share for bonds; 6% for real assets account and 11% for commodities; and other classes, such as infrastructure and inflation-protected bonds make up the remainder.

Looking ahead, investors are still groping for an elusive market bottom. It may still be early for heroics. Until some of the confusion shakes out, advisers could do worse than to remind clients of some well-known Will Rogers humor. The early 20th century American cowboy comic once quipped that he was less concerned with the return on his money than the return of his money. Following Roger's warning, many will doubtless plump for the government insured bank accounts that offer reassurance in many countries. "They will convince themselves that making a couple of per cent return is much safer than the possibility of losing 20% in the stockmarket," Rowland says. "But they will ignore that this approach carries inflation risk."

There will be time for value investing once the recession bottoms out. Although bonds are delivering historically massive yields, 2009 is likely to bring a dramatic increase in default rates. Standard & Poor's predicts that default rates on speculative-grade issuances among non-financial firms could triple in the next 12 months, particularly in media, entertainment, consumer products and retail. Investment grade corporate bonds continue to shed value, as a sign of impending bankruptcies.

Financial memories are notoriously short. It took only one good year in 2003 for many to forget the hard lessons learned in the 2000-03 bear market, says Tuttle. "Investors will ultimately forget and move on and make the same mistakes," he adds.

"The media will play up the next time as the 100-year storm, and talk about how this never happens." It is sometimes said that, after a vicious bear, markets do not bottom until an entire generation of investors has sworn off stocks forever. Then, finally, dawn arrives. All the liquidity that has been pumped into global financial markets will play its role again, flowing towards the next asset bubble.

The hardest hit:

There is ample pain to go around, from mortgage foreclosures and job losses, to local budget deficits, which entail reduced social service provisions. As stock portfolios are battered, two groups of American investors are most likely to panic: retirees and soon-to-be retirees on fixed incomes, as well as parents facing university tuition costs.

In America, unlike in Britain, most secondary education is hugely expensive, with top-tier universities charging more than $40,000 (GBP 25,000) a year for each student. Some parents, who do not have available cash, may be forced to liquidate their portfolios at losses.

"The real heartbreak is the people whose core assets are being eaten," says Ezra Zask, the director of LECG securities practice, of those employees who are planning their retirements. American social security, the government sponsored pension system, is more generous than the British equivalent. However, the entire system has been moving since the 1990s from company-based plans to a 401(k) structure, shifting the risk from the company to the individual. Employees are allowed to put tax-deferred income to the 401(k) accounts, to which employers frequently make matching contributions. The stock market plunge has left the whole population of 401(k) holders shocked and aghast. After years of funneling their savings into equity-focused plans, workers suddenly face the prospect of either postponing retirement or making do less comfortably.