New covenant

The turmoil over the past two years called into question some of the fundamental principles of asset management. Vanessa Drucker reports from New York on the 10 lessons to arise from the global market upheaval.

Trust broke down. “What struck me, on a personal note, was how people turned against one another,” recalls Michael Beattie, portfolio manager for Tradex Group in Greenwich, Connecticut. “Prime brokers turned against clients, clients turned against hedge funds, leaving the whole industry in broken disarray. A manager’s knowledge or sophistication or experience didn’t matter.” The panic had divorced emotion so far from reality that all banks were regarded as suspect. Then, in a final twist, in December 2008 the Madoff ­scandal erupted. “It became even harder to trust the person at the other end of the telephone,” Berman describes.

During the crisis, the school of behavioural finance attracted increasing interest, as investors lost their moorings in classical theories of value investing. John Maynard Keynes described stockmarkets as a kind of beauty contest, where the most sophisticated punter seeks not the prettiest face, but rather the one most likely to be chosen by other judges. Edesess, who holds a PhD in mathematics, has always been fascinated by Heisenberg’s Uncertainty Principle, which basically states that no observer can be entirely detached. George Soros explored a similar notion with his “reflexivity” concept. The market turmoil caused Edesess to pay more attention to how the idea functions in the investment world. “The bubbles changed my thinking about market efficiency,” Edesess says.

For example, CEOs and heads of companies must act with confidence, whether genuine or not. Otherwise they risk spooking investors. As another illustration of reflexivity, some of the subprime bankers might argue that, were it not for the naysayers, they would still be surviving and thriving.

5. Due diligence
Sometimes it takes an upheaval to refocus attention on governance and transparency. At RCN Genter, in Los Angeles, president and chief investment officer Dan Genter has spent hours in discussion with his department heads over what they do differently today. “We radically underestimated the degree of leverage, especially off balance sheet, among banks, insurance companies, municipalities, across the board,” he says. His teams perused ratios, coverage, and cash flow to debt service. Yet although they knew they could not understand all the cross covenants and cross collateralisations in depth, they finally downplayed and “turned a blind eye to the glimmers of smoke”.

”If you don’t understand it, don’t travel there”

The tell-tale signs were difficult or impossible to uncover for anyone but an inside auditor. At the time, Genter and his peers were complacent to pick up an extra 600 basis points, or more, to boost alpha and enhance return. All were driven by competitive relative performance, which demanded representation in large banks to avoid underperforming benchmarks. “What we know now is that you must dig and dig and dig some more, and if you don’t understand it, don’t travel there,” he says.

In similar vein, Berman no longer accepts 90% transparency from companies, and demands more disclosure on governance. He should have been even more rigorous in analysing AIG, for example. While he had always been circumspect about off balance sheet obligations, he used to say that, as long as they were properly disclosed and footnoted, adequate supervision was in place. Berman, moreover, ranks as one of the conscientious ones. “Most advisers and investors don’t read prospectuses,” Tran says.

“Everyone took hedge funds almost for granted until 2007,” says Beattie, who manages funds of funds. “We got complacent, thinking most managers who accumulated assets with a three-to-10-year track record would be bullet-proof in nearly any environment.” Now he is more apt to regard hedge funds with the same scepticism as private equity or long-only investments.

6. Mediocre managers exposed
According to one of Warren Buffett’s most popular witticisms, it is only when the tide goes out one discovers who is swimming naked. In 2008, the tide began receding mightily. In a normal environment, a standard manager might experience disasters half the time, but that would be offset by the other half, when investments performed favourably. Anything that could potentially go wrong in an environment of increased uncertainty and volatility, will do so. Beattie warns, “You don’t get a second chance.”

“The crisis offered a rare opportunity to look carefully to see who outperformed,” Weiss suggests. Several long-only managers, or even hedge funds, typically hide behind the indices. They might mimic the S&P 500, or the FTSE 100, and goose their results by taking an outside bet on one or two stocks or sectors. Where did their swimming suits go?

7. Liquidity matters
Institutional managers found themselves locked into illiquid positions, while individual investors and wealth managers suddenly experienced the trauma of cash crunches. Todd Schoenberger, a managing director at LandColt Trading in San Antonio, Texas, has drastically re-evaluated the percentage of cash he advises investors to hold.

Before 2007, he recommended 10% of an entire portfolio; now he says a minimum of 30%, as a cushion for dealing with expenses. “We are too close to the recession and the threat of a double-dip still remains intact.” He considers it would be irresponsible to reallocate off the cash position before a sustainable recovery emerges, marked by three consecutive quarters of GDP of at least 2%.

From the institutional side, Beattie came to realise how illiquid certain funds turned out to be, such as those holding convertible bonds, levered loans, small or midcap equities or emerging market securities. Hedge funds needed to “side pocket” many positions, that is, segregate the illiquid portions from the rest of a portfolio.

Beattie vows to be more conservative in making judgments regarding the liquidity of the underlying components of the funds he buys. What types of assets give him comfort? He highlights managed futures, large cap equities, volatility traded in listed plain vanilla options, agency mortgages and liquid convertibles. Meanwhile, he would shy away from any type of structured credit or less liquid over-the-counter derivatives.

8. Avoid noise/think long term
Blocking out the cacophony of news commentary and media pundits during market events is never easy. Herman receives many emails from clients who have been “bombarded by media that shapes their thinking,” as well as newsletters and magazines. He tries to boil the arguments down for them, presenting both sides. In the past couple of years, he sometimes found it helpful to bring out an old copy of Time magazine from October 1974, showing President Gerald Ford with a rolled up sleeve on the cover. The grim headline reads, “Trying to fight back (inflation, recession, oil).” He uses history as a starting point for framing discussions, rather than a means to discount concerns.

”Try to block out all the outside noise from the so-called experts”

“Try to block out all the outside noise from the so-called experts being quoted daily on TV,” agrees Scott Kahan, a New York-based principal at Financial Asset Management. He emphasises the importance of a long term perspective, after his own 30 years’ experience as a financial planner, and having ridden the wave of previous downturns. Kahan adds, “Learn from mistakes, something many don’t do.”

9. Develop a sell discipline
Imagine a day at the races. You have lost your allotted gambling money. Do you go to a cash machine, to withdraw some more, or do you call it quits when you reach your threshold?

Every investor knows that selling is much harder than going shopping for securities. “Our whole industry is predicated on buy, buy, buy!” sighs Matt Hudgins at Mosaic Wealth Management in Atlanta, Georgia. He likes to dollar cost average his way out of a position, just as he would dollar cost his way into one.

Clients claim they understand a sell discipline when it is explained to them in advance, but when the time comes to take a loss they may balk. Studies in Prospect theory, developed by Daniel Kahneman and Amos Tversky, showed that subjects felt the pain of a financial loss about twice as bitterly as they enjoyed the pleasure of gaining an equal profit. Last year, however, investors were more willing to unload their losers.

“That difficulty was overcome by fear of the market going to zero, irrational as it may be,” Hudgins explains.

Hudgins himself has learned to understand better his clients’ risk tolerances, and how much volatility they can take. “They are all brave souls before a crisis, but ­during a crisis it is a different story.”

10. Career risk
One more old Wall Street rule states that you never want to be wrong and alone, but it is permissible to be wrong if everyone else is as well. “That’s the pressure on the typical adviser, who is prone to do nothing,” says Ashburn. It is the practical challenge of the business that it is not enough to be right–you need to keep your clients too.

”Being dogmatic about valuation investing or buy and hold can destroy your business, and disrupt your clients’ goals”

Keynes warned that markets can stay irrational longer than you can stay solvent. If momentum drives equities to the moon, and you do not buy stocks, you could be wrong and alone. In the same spirit, “being dogmatic about valuation investing or buy and hold can destroy your business, and disrupt your clients’ goals,” says Kitces.

One can only deviate from the trend for so long. “Remember those hard core valuation guys who were pounding the table in 1997, that markets were overvalued and investors wouldn’t get good returns for 10 years?” Kitces asks. “They were right–and they probably also lost half their clients if they stuck to their guns.”

So wind the clock back to 1997, and make one simple decision to which you must adhere for the subsequent decade. You can choose the standard recommendation for a 60/40 equities/bonds allocation, to be rebalanced annually. Alternatively you can put the entire amount 100% into bonds and cash.

The latter approach produces an astronomically higher return for your clients, but you have probably destroyed your business. Even that loyal remaining crew who thought you were a genius by 2002 for avoiding that bear downturn, would have abandoned you by 2005, concluding you did not know how to get back into a bull market.

A glimpse back over the past 15 years reveals the hazards of clinging to an ideology. The moral is that it is impossible to be a pure valuation theorist and survive indefinitely. While that view may be cynical, those who are running investment management firms also must be realistic. “Welcome to the reality that we are in money management with other human beings,” Kitces says. “Ignore that to the peril of your business.”