The troubles with technical trends Professionals have lost sight of the risks but cannot blame day traders for the outcome, writes Barry Riley Financial Times, Oct 05 2001
For eight years I contributed a weekly Financial Times column - recently labelled Investment Watch - on developments in the fund management industry. I closed the series in August, but in the context of the stock market slump I would like to draw out some themes and explain how technical trends in the asset management industry, especially in equities, may have caused trouble. Too many professionals have lost sight of the risks being run. Instead, they have focused on a particular definition of active risk (also called tracking error). It is measured, using complex models, in terms of the standard deviation of expected investment returns compared with the benchmark index. It is precise, but it gave clients no inkling that the stock markets had become highly risky by the end of the 1990s. The atrocities of September 11 prompted a further slide in equities, but many stock markets had already tumbled from their peaks by September 10; the World Index was down 32 per cent in dollar terms. Those eight years took in a stock market bubble. This in part reflected favourable economic trends, and especially growth in corporate profits. But the scale of the price rise also reflected uprating. When I started writing the column, the S&P 500 offered a dividend yield of 2.7 per cent and a price/earnings ratio of 23, falling to 16 in 1995: at the market peak in March 2000 the yield was just 1.07 per cent and the p/e ratio had reached 35. This bubble was often presented at the time as being created by day-trading amateurs, but it can be better viewed as a collective mistake by investment professionals. How did it happen? Here are a number of the themes I discussed during the late 1990s: * Indexation and its "closet clone" benchmarking. * Distortions arising from capitalisation-weighted indices. * Risk control applied through "tracking error" estimates. * Increasing focus on investment "styles". * Prevalence of short-term performance measurement. To this list could usefully be added some characteristic failures of client protection. The managers' business risks were usually controlled more carefully than the clients' investment risks. The pay and bonuses of asset managers rose rapidly, and many cashed in through takeovers of their firms. Many asset management firms are now in disarray. Most have depended on a steadily rising stock market and have no strategy to cope with adverse circumstances. A new category of alternative asset managers has sprung up, hedge funds. These pose their own problems, especially through the generation of high volatility, which has recently caused problems for regulators. But they represent an important reorientation from relative risk towards absolute risk. The relative risk concept was a fundamental cause of the great bubble. Ironically, it has now even spread into bonds: a curious paper from JP Morgan's emerging markets research team a few weeks ago, entitled The Argentine Portfolio Dilemma, discussed why bond fund managers were being drawn into wildly risky Argentine paper because otherwise they would suffer high tracking errors against emerging market bond indices in which Argentina has a weighting of about 20 per cent. This has uncomfortable echoes of the stock market distortions of the late 1990s. In more normal conditions, overpriced stocks and sectors would be sold by value-oriented portfolio managers. Across continental Europe, the telecoms sector generated similar huge distortions, largely because of weighting technicalities related to low free floats. Through entirely artificial shortages of stock, both France Telecom and Deutsche Telekom achieved phenomenal prices, before the inevitable reversals. Now there is a global economic recession in the offing. It has become evident that herd behaviour caused by the risk reduction procedures of big institutions can be disruptive and lead to irrational valuations. There has also been a failure of the various agents who stand between the corporate sector and investors. Investment banks, for instance, fed the mania through initial public offerings of quite unsuitable companies, and promoted ill-conceived mergers. All the while, analysts, many employed by the same investment banks, were encouraged to publish what turned out to be quite unrealistic forecasts of earnings. None of this provides a decent excuse for asset managers. They are supposed to base their decisions on rational analysis, and should act in the interests of their clients. True, there can be variations on these themes. Running overtly speculative portfolios on a short-term basis in a bubble for mutual fund clients is a different matter from pursuing prudent long-term strategies for, say, pension funds. Unfortunately, the clients are rarely made fully aware of the risks being run on their behalf. It is worth pointing out that UK pension funds often used peer group benchmarks, rather than market index ones, in the 1990s. This enabled them, as a group, to back away from an increasingly overpriced Wall Street. But they remained highly exposed to equity risk through their core equity holdings in the UK and continental Europe. Defining risk as short-term volatility against an index has proved to be a trap. The index providers, including MSCI, FTSE and Dow Jones Stoxx, have brought in measures to correct the free float distortions. But there is a basic flaw in the use of capitalisation-weighted indices to define risk: it attracts fund managers towards expensive stocks and encourages them to maintain low exposures to cheap ones. The control of absolute risk, and the establishment of strategies in the light of very long-run historical returns on different asset classes, would help to avoid similar upsets in the future. But then, the rationality of financial markets in the short term has always been suspect, whatever the modern Nobel prize-winning generation of market theorists has postulated. Full article at: http://news.ft.com/ft/gx.cgi/ftc?pagename=View&c=Article&cid=FT34WZHVESC &live=true&useoverridetemplate=IXL8L4VRRBC&tagid=IXLUCLOJQBC Michael Keaney Mercuria Business School Martinlaaksontie 36 01620 Vantaa Finland [EMAIL PROTECTED]
