Sovereign Wealth Funds; A Potential Force from Within For Emerging Nations

By Erik L. van Dijk

 

Introduction

A lot has been written in recent years about the so-called Sovereign Wealth Funds(SWF’s). Wealth Funds are large pools of money, created by governments or governmental institutions. The Western world is not totally unfamiliar with huge government pools of investments, but normally we associate them with state pension funds. Some wealth funds, like the Norwegian one for instance, do indeed have this form. In other cases the wealth funds resemble long-term investments funds or stabilization funds, used to ensure that one or a few dominant sources of income with volatile prices (e.g. oil and gas) don’t disrupt a country’s national income trends through spectacular ups and downs in GDP caused by large price and / or demand-supply fluctuations.

As so often with new trends, market analysts, journalists and governments have expressed fear that the SWF’s might become too big a force in the market. Are these concentrated portfolios really invested with pure investment motives in mind? Or are strategical and political factors incorporated in the investment philosophy as well? Quite a few pundits have expressed doubts concerning the pure investment activities and skills of SWF’s. They rather stressed the political danger of these institutions.

As if Western goverments do always apply pure investment motives when spending their budgets! SWF’s are extremely large and do invest a substantial percentage of their wealth abroad. Now, if they would have been political entities, investing abroad and going against the rules and regulations of the recipient country is risky. Recipient countries could take nasty countermeasures ranging all the way from court cases and penalties to nationalizations.

SWF’s; a powerful but relatively new phenomenon

In this blog entry we study the pool of existing wealth funds a bit more deeply using the database of the SWF Institute. The database contains some 55 wealth funds from developed and developing countries. The SWF’s from developing economies form the majority (41 out of 55, or 74.5%). This might seem strange, but it is not. When income distributions are relatively unequal, it is not uncommon that governments try to get a piece of the action. And especially the goverments of resource-rich nations have a nice opportunity to do so. However, the structuring of those investment pools into wealth funds implies a professionalization that is rather new. The average year of establishment of the 55 funds in our empirical study was 1995, albeit it that one of the most famous wealth funds – the Kuwait Investment Authority  with USD 202.8 billion under management- was founded in 1953.  And the Foreign Holdings portfolio of the Saudi Arabian Monetary Authority (SAMA)– with USD 431 billion assets under management – was created in 1952. But some of the real big ones aren’t old at all. Here are some of the most remarkable entries since 2005: China Investment Corporation (2007;AUM USD 207 billion), Libyan Investment Authority (2006;AUM USD 65 billion), the Russian National Welfare Fund  aka National Wealth Fund (2008;AUM USD 83.6 billion), and the Investment Corporation of Dubai (2006;AUM USD 82 billion)

The SWFs are an enormous force now and we should not underestimate their impact and influence. Total assets under management for the 55 SWFs in the database continue to show an upward long-term trend and the current level of AUM is USD 3,585 billion. When looking at the amounts needed to repair our financial industry and cope with the credit crisis, this implies that Wealth Funds might be able to play an important role in any recovery plan. It is therefore quite remarkable that Western leaders so far seemed to focus on a strategy based on ‘look to each other, and solve together’. Didn’t we basically make the SWFs in the Middle East and Asia richer by buying their oil and  gas or cheap products, thereby creating a moneyflow from West to East? Only Gordon Brown and Barack Obama seemed to be willing to concentrate efforts on the Middle East (Saudi Arabia and Gulf States). The opening up to Iran in recent periods can also be seen as an important step. Iran is probably one of the most secretive nations as far as its wealth fund(s) are concerned. The Oil Stabilization fund is well-known, but too small to be the whole story. Currently the US and its Western allies on the one hand, and Iran on the other are going through a serious political chess game with probably just one goal. To find some kind of common ground to get Iran back in the league of ”’acceptable” nations. The Roxana Saberi case illustrates how tensions are orchestrated and reduced in a purely political rhythm. In normal situations it would be unheard to see Ahmedinejad suggest things like this to judges within the Iranian judiciary system.

In terms of goals, we see that the bulk of SWFs start of as stabilization fund, and gradually but slowly moved to a role as state investment funds with long-term investment horizon. A next step is the transition into full-fledge pension system, at least with a substantial part of the assets involved. A growing number of nations understand that the creation of a pension system provides countries with a tremendous source of savings and investment potential that can help stabilize the political situation in a country and fight extremist tendencies while at the same time helping to stabilize the economy.

SWF’s; The New Capitalism?

When comparing the SWFs with other large institutional investors, there are some structural differences. One of the most important ones according to us, and that holds especially for the SWFs that are based on energy- and commodity-related wealth, is their ability to concentrate on (ultra) long-term growth. This will enable them to capture higher returns by locking in the higher risk premiums on riskier investments while working with an asset mix that is more tilted towards riskier asset classes. Obviously, with this type of SWFs often being from countries that did not establish themselves as major financial powerhouses yet, we need to place a caveat. The level of knowledge within the SWFs might be a constraint. In recent years we did indeed see some indications of suboptimal asset management in the SWFs. Some tended to link this to strategic motives, but a closer look at the asset allocation, holdings acquired et cetera indicated that this was not the whole story. Lousy ‘picking’ at the bottom-up level has played a far more important role. The sad investment story of Chinese insurer Ping An that bought a stake in Dutch-Belgian financial conglomerate Fortis at about the worst moment possible is indicative. This is not to say that there aren’t any ultra-professional, well-managed SWFs. But the difference in investment expertise is still striking and far bigger than it is within the institutional investor community in Europe or the US.

Now, with their long-term focus, enormous wealth, and huge size compared to the local economy (which automatically implies that the focus has to be to quite a large extent ‘international’) and top-down, hierarchical decision structure SWFs are definitely not pension plans like the ones we know in Western Europe or the US. Their relative lack of transparency concerning decision taking, performance analysis, compliance et cetera further strengthens the case that this is really a new category of investors entering the stage.

Sure, when looking at total assets under management Western institutional investors are – as a group – still far more important. However, also more fragmented with smaller average sizes and with a much larger focus on low risk, fixed income assets. The impact of SWFs on global stock markets will therefore most likely increase tremendously in the years that lie ahead of us. First of all, because the economic growth rates in the nation mix of SWFs are higher than those in nonSWF-dominated economies. Second, most of the traditional Western institutional investors don’t really grow that fast anymore with the inflow of pension premiums more or less offset by payments to pensioners, with demographic trends making it almost impossible that this will really change.

This implies that we need to take a closer look to what could happen in the future when taking these trends into account.

China will win, but energy-related SWF’s should not be underestimated in the next 10-15 years

Although the Asian SWF’s are gaining in importance, led by the Chinese Wealth Funds that benefit from the country’s growth record, the oil-related wealth funds will be a dominant force to reckon with for quite some time to come.

The energy-related wealth funds represent a bit more than half of the group of 55 when we look at the number of funds (31), and in terms of assets under management their total of USD 2259 billion represents 63 percent of total AUMs of the wealth funds.

So, unless the growth rates in China and some other Asian nations reach record highs, with oil prices remaining sluggish, the Middle Eastern SWFs – actually the group that most people fear because of their lack of transparency – will remain a very important category to take into account. We at Lodewijk Meijer believe that it is not just for this reason important to ensure a dialogue with this group of wealth funds. Also when looking at the political situation in the Middle East and the problems with global terrorism, an open and fair communication, trade and investment relationship with the countries in the Middle East will certainly be beneficial in these areas as well. The West should recognize that quite a bit of the tensions are directly related to flawed drawing of country borders in the Middle East by Western occupiers in the past in combination with giving Western oil companies too large a stake vis-a-vis the revenues left for the energy-rich countries itself. Add to that the fact that quite a few nations were or are led by leaders that do not have the support of the population to the same extent as they have Western support and an important part of  the terrorist story is explained.

Development and growth in general have always worked against terrorism. Terrorists thrive in climates with inequality, lack of chances, and poverty. The SWFs and their growth stories will definitely make it less likely that MENA countries themselves – as a group – will witness increased terrorist activity. Skepticists will add that they will have more funds available then to support terrorist activities elsewhere, but we tend to believe that this risk is far more greater when not allowing these nations a dialogue and place within the family world nations, while at the same time helping their SWFs to further professionalize and internationalize their portfolios. This is a win-win situation for all.

SWF’s and the local economy; catalysts for growth….

but local growth can only thrive when economies develop further and governance improves:

The Trinidad Case

SWFs are huge. Often too huge compared to the size of their local economy. They do therefore have to diversify internationally. This implies that their wealth that was often created through Western imports of oil, gas and relatively cheap products will in the end – to quite some extent – flow back to us and other nations via financial market transactions.

That is not to say that SWFs cannot play a fantastic role when developing the local economy of countries. Their potential to be a catalyst of growth is huge. A nice example is the situation in Trinidad and Tobago.In an earlier entry to this blogwe told a bit more about the country, one of the least know oil states in the world. Most people outside the region still believe that the whole Caribbean is about tourism and tropical products, but Trinidad and Tobago is definitely an important exception with attractive growth potential that makes it an interesting Frontier Market.

The country’s Heritage Fund has assets under management of USD 2.9 billion or about 12 percent of GDP. And that percentage will be growing assuming that oil and gas prices will at least stabilize. Trinidad wants to establish itself as a regional financial center and we believe that this strategy could work when undergoing a structured transformation of the economy and upgrading of the financial market system. When taking into account that Cuba will probably be an interesting new entry to CARICOM any time soon (we at Lodewijk Meijer think that it could take approximately 3-5 years for this to happen), that regional financial role could really be of tremendous importance. The ongoing growth in the trust/offshore business in the CARICOM region could also further improve things, with Port-of-Spain then becoming a logical on-shore financial center for the off-shore islands of the region.

When talking to local leaders and international investors, we believe that the opportunities are there.

However, one thing that worries us – and an area where change is needed – is the relatively low country score (3.6 on a scale of 1 to 10 with 10 being the highest) on the Transparency International Corruption Index (CPI). Activities undertaken by institutions like the Caribbean Procurement Institute, Trinidad and Tobago’s chapter of Transparency International and by politicians with large popular support and a willingness to change things could all help. Currently, developments in the ongoing proceedings of the Uff Commission of Enquiry into the Construction Sector of Trinidad and Tobago seem to indicate that – as so often in many nations, even developed ones, – construction and real estate are the areas where lacking corporate governance and fraud have led to a situation in which public funds were misused for personal gain by corrupt politicians/bureaucrats and/or entrepreneurs (e.g. within the construction industry)  and/or lost through incompetency, with a political chess game being played in the background. When analyzing the corruption proceedings, we believe that the nepotists seem to have decided to make former minister of Housing Dr Keith Rowley (one of the most popular politicians in the country, with a tremendous track record as far as new housing activity is concerned while he was in charge of that ministry, and one of the architects of the Vision 2020 report in which the transition into a more diversified economy was first introduced) their scapegoat over a negligble malperforming housing project after he left office. And not just that, too much decision power was and still is not in the hands of ministers in the first place, but is concentrated within UDECOTT;  the Urban Development Corporation of Trinidad that seems to act like a kind of state within the state.

 The Commission will present its final report in September 2009 and we are optimistic that it will unravel a smelly truth about what is a standard nepotism case so often seen in developing economies. Local newspapers help set the stage for a climate in which nepotists are forced into defensive positions. This is a tendency quite often seen in developing nations. When the country develops and corruption fighting grows into a serious countervailing power, the growing independence of the media is not just an important sign of this, but a tremendous catalyst as well. The country’s growth story and transition into a more diversified economy with expanded financial sector will further improve things. Smaller local nepotists will lose out when ‘big finance’ discovers the region. Huge financial institutions will – through the investment opportunities they provide andthrough their larger focus on procurement and ESG strategies (they have too much at stake to be caught in local scandals!)- basically provide the final blow to the nepotists even when the Uff Commission verdict doesn’t already do so in a legal setting.

Along the way the role of the Heritage Fundwill become more important; a) as the largest local investor; and b) as entity attracting the professional skillset of international investors, litigation lawyers, investment bankers, asset managers, investment analysts et cetera. Either directly (to work for the Fund) or indirectly (through provision of services by parties wanting to establish a position for themselves in the country).

This Trinidad example is illustrative for developments in many Emerging economies. And the trends we see developing here have so far shown that in successful growth stories external money and expertise went hand-in-hand with a local willingness to fight corruption from within. And from an investment point of view: it is actually this group of Emerging and Frontier markets where both components are visible, that actually have showed the most attractive return-risk profile.

SWF’s and the international economy; a growing role to play

With total assets under management of USD 3585 billion, it is clear that SWFs can be an important force when leading us out of the current credit crisis. The combined assets of the big Western institutional investors are still far larger, but SWFs are quickly catching up.

We foresee that their role and positive contribution will substantially increase during the next 6 to 12 months, with the beginning of a positive change already under way. Part of the 30+ percent stock market return generated during the first 5 months of 2009 was directly related to SWFs stepping in (finally!) looking for bargains.

Evaluation

SWFs are a relatively new phenomenon. Their large pools of funds are of tremendous importance to the domestic economy and are a great support for the world economic situation as well, because most of the SWFs are too big to concentrate on a home-alone policy. They have to diversify internationally to a larger extent than most other institutional investors a) because the local economy is not big enough; and b) because it is often not diversified enough.

Western nations have often complained that investment behavior by SWFs was to a large extent guided by strategic instead of economic principles. So far evidence in this direction has not been convincing at all. Sure sometimes strategic motives might have player a role, but wasn’t that the same for Western investments in our past?

The attraction that economic development and wealth funds have to international financial instutions that might want to provide services to them will trigger a climate of financial sector dynamics and growth. What could hurt the positive potential effect of this is often a local climate in which nepotism and corruption thrive. Once that threat is neutralized, the upside potential will be tremendous.

The Value of Virtue

By Erik L. van Dijk Introduction They are already working on it since 2002, but it is a fine academic paper on a topic that is getting an increasing amount of attention in recent years: corruption and fraud. Cornell scholars Charles Lee and David Ng studied corruption levels in 44 countries, using the Transparency International database. There have been numerous studies using this and other databases over the last decades, probably starting with work by Anne Krueger (later Chief Economist at the World Bank, together with the IMF and OECD also very active in this area)  in the 1970s. What makes the Lee-Ng study special is according to us at Lodewijk Meijer first of all the translation of country corruption scores into analyses of the impact of corruption at the firm level. By doing so, the authors are capable of answering the question if there is any ‘Value in Virtue’. This is a very important topic, because we see that the literature so far defended two positions. Up until 2003 we have seen various – mostly theoretical and deductive – studies that defended the view that corruption, defined as the misuse of public office for private gain, might actually be a kind of ‘bonus’ system in countries in which salary schemes and other remuneration for talented labour are inefficient. Empirical research presented over the years has indicated that this position is probably totally wrong. Theoretically fine, but the empirical evidence is overwhelming and contrarian. Various studies performed between 1995 (Mauro) and 2006 (Lee and Ng) led to the following conclusions: The Negative Impact of Corruption at the Macro Level, as presented in various academic studies

1. A higher level of corruption translates into lower domestic investments and economic growth
2. Higher levels of corruption hinder Foreign Direct Investments
3. Higher corruption leads to lower tax revenues
4. More corrupt environments stimulate negligence with respect to operations and maintenance in both firms and government institutions
5. And point 4 even extends to health care: more corruption leads to higher infant mortality rates
6. Higher corruption leads to higher student dropout levels in universities and high schools
7. Higher corruption levels go hand in hand with a larger size of the grey economy, which is of course directly related to point 3

Jain (2007) analyzed what corruption actually is. When stating that corruption is about the misuse of public power for private gain, we basically translate it into an economic act. Why? Well, the cost-benefit analysis of corrupt persons involve three aspects:

1. Someone must have the discretionary power to take decisions and consider a corrupt or fraudulent act
2. There must be some kind of economic merit associated with that power
3. The existing legal system provides a sufficiently low probability of detection and/or low penalty for the corrupt wrongdoing

Although it is clear that the legal part of the anti-corruption policy should play a leading role in fighting these crimes, it is also clear that social, cultural and economic aspects play an important role as well. Reason: in the end, corrupt acts are a cost-benefit decision case in which a probably talented individual or a group of talented individuals undertakes activities that are counterproductive from a macro- and microeconomic point of view. It would therefore be fantastic when it can be proven that economically, corruption destroys value at the micro- and firm level. If that can be shown, the likelihood that a well-defined remuneration system (positive stimulus) can help the negative stimulus derived from the improvements in the legal system will ensure a more effective anti-corruption policy. We are pleased to see that this philosophy of our firm, Lodewijk Meijer, has been translated into action by an Emerging Markets anti-corruption initiative: the CARICOM’s Caribbean Procurement Institute. Lodewijk Meijer managing director Erik van Dijk was appointed facutly member for ESG Finance and Investments. The abbreviation ESG was defined in the United Nations Principles for Responsible Investment, with E standing for Environmental, S for Socially-responsible and G for Governance. The idea is that a good ESG policy will help governments, firms and other economic actors in attracting capital and better conditions while at the same time ensuring better profitability and growth in the long-run at both the macro- and micro-level. In other words: we believe that there is Value in Virtue. With this being the case,  officials with the potential power to be corrupt might – when of course being confronted with a legal environment that makes fraudulous/corrupt freerider behavior too risky (i.e. the probability of getting caught and the negative incentive related to the penalty that follows make it more interesting to go for realization of a positive reward) – concentrate on realization of positive social and economic results. The Agency Theory work by Jensen and Meckling has of course indicated that this optimistic view is indeed only warranted when the legal and regulatory framework is sufficiently corruption-proof. This being said, initiatives like the Caribbean Procurement Institute are of the utmost importance in many countries. The latest ranking list of Transparency International indicates that the bulk of nations in the world still suffers from far too high – and therefore value-reducing – corruption levels. The list of countries which have a reasonable score is limited to about 22 with a score in excess of 7.0 on a scale from 10 (lowest or no corruption perceived by people surveyed) to 1 (highest level). This is approximately 15 percent of the number of nations in the world. So a lot needs to be done. The Transparency International 2008 Corruption Perception Index ranking The top (score in excess of 7.0) The top-22 consists of only two non-developed nations, namely Saint Lucia and Barbados. Both actually part of the CARICOM for which the Caribbean Procurement Institute defines its policy. The other 20 are mainly from Europe (13) with 3 Asian representatives (Singapore, Hong Kong and Japan), 2 from North-America (Canada and the USA) and 2 from Oceania (Australia and New Zealand).  Denmark, New Zealand and Sweden have the highest score (9.3) and my own country, The Netherlands, shows a good score (8.9) as well. The rest of the list The rest of the list is mainly filled with Emerging Markets nations, although there are certain developed nations were corruption levels have remained remarkably high. To some extent low places in the list are directly correlated with flaws in the legal system. But we do have the impression that ‘social’ and ‘cultural’ factors play a role as well, including religious factors. Treisman (2000) has done some interesting research in this area. He found that low corruption levels are positively correlated with the following factors:

• Protestantism;
• Former British Colonies;
• Higher GDP;
• Common Law versus Civil Law-based legal systems;
• Higher ratios of imports to GDP (i.e. openness/integration of a country in the world economy);
• Longer exposure to democracy;
• Unitary forms of government.

Remarkably, Treisman’s study showed that the following factors are not significant.

• Relative salaries in the public sector;
• Degree of political stability in a country;
• Endowment with natural resources;
• Degree of state intervention in the economy;
• Level of ethnical diversity.

The need for a multi-factor approach at the micro level As you can see, the bulk of these analyses is focused on the macro level. However, acts of corruption are undertaken by individuals or groups of individuals at various levels of society with the bulk of course being at the lower levels (simply because of the law of large numbers). Sure, at the lower levels the relative amounts at stake are often smaller or marginal, but added up they have just as much of a disruptive impact on society as the few occasions of big fraud and corruption that catch the attention of the media. We do believe however that it is important that procurement lawyers keep a good balance between the bulk of smaller cases with in the end the largest aggregated impact and the few media cases that catch the public eye. The latter play an important role in showing people that the high level hot shots are not getting away with their fraud. This has an extremely important effect on the cost-benefit analysis at the lower levels. At the lower levels, it is not just corruption that is at stake. Corrupt acts can easily be examples for employees working in firms. The recently published report on fraud by PriceWaterhouseCoopers under some 5400 firms in 40 countries shows the following results:

• Men are responsible for 85 percent of fraudulous acts. To some extent this is related to their dominance in the labour force, especially in emerging markets, but it is also directly related to what we already indicated in our blog entry on investment styles. Basically, the cost-benefit analysis that is at stake when commiting fraud or corruption is an investment decision. The risk to get caught is probably seen as less of a barrier for men – who normally opt for higher risk strategies – than for women. Machoism in cultures is also important. A men who gets away a few times with fraud and then gets caught might be considered a ‘tough, cool guy’, contrary to the sissy whimp that just listens to his superior. Women are not so sensitive to this kind of reasoning.
• About 70 percent of fraud cases is commited by men in the age class 35-55. In other words, the age class in which men get a bit more confident concerning their societal status, with their built-up experience giving them the feeling that even after being caught they might find employment elsewhere. Younger men suffer more from machoism, but probably tend to translate that into other acts (harrassment; or fighting in bars in the weekend etc.) than their older gender colleagues.
• Social control – also in the work place – is important. The PwC study indicates that 68 percent of frauds worked as a loner.
• Contrary to standard beliefs the main frauds were not temporary workers that switch from one employer to the other quickly. One third of frauds worked 2-5 years for the firm, with the bulk of the others working longer for a specific firm!
• And just like what we see in the government corruption case, it is definitely not true that it is about peanut crimes at the lower levels only: about 25 percent of fraud cases was directly related to top management, with industries known for their complex valuation and risk management structures like real estate, construction and banking/insurance/investments being well-known for large fraud cases in recent years.

It is impossible to create a corruption- and fraud-free world. Everybody makes his or her own cost-benefit analysis. Moral decay is a reality and so is the deterioration of social control structures. This implies that there is a growing need for strong procurement initiatives and improvements in law, just as much as there is a need for attractive, smart salary and wage structures that reward acts of good-doing. In both areas a lot needs to be done. Recent discussions in the financial industry about excessive greed and horrible bonuses for top managers were just as much indicative of the moral decay and mentality of the people accepting these bonuses as they were of incapable human resource professionals and corporate lawyers helping top management and their controlling bodies (governments, labour unions, board of directors) to create smart bonus structures that award tremendous performance and penalize bad performance. When analyzing the Value of Virtue, it is important to check things at the micro level as well. Firms are still the economic drivers of most developed and developing societies. It would be fantastic if we can prove that firms acting in a more corrupt environment (and therefore probably being direcly or indirectly part of this system) are actually valued lower than their less corrupt counterparts. That is exactly what Lee and Ng tried to achieve in their study. There are a few problems when translating the macro results into micro-level conclusions. First, the available ratings are often at the country level. It is only recently that specialist ESG asset managers have started to use analysts or special bureaus to rank and rate individual firms. And unfortunately – due to a lack of data and maybe even interest (after all Emerging Markets investments are still just 5-10 percent of the institutional equity portfolios of institutional investors in developed nations) – they have started this trend in the developed nations. I.e. in the group of nations where the need for firm-level analysis is probably a bit smaller due to good control and legal systems. This is another reason why Lodewijk Meijer supported the Caribbean Procurement Institute initiative. It is a) from a mainly Emerging Markets region (CARICOM) and b) a region that has shown the willingness to act; with c) the presence of 2 CARICOM nations (Saint Lucia and Barbados) in the world top-22 indicating that it is not just willingness, but also actual success that can be shown. When analyzing the valuation effect of corruption at the firm level, we have to deal with a few problems. Firm valuation is dependent on a large number of variables, not just corruption. We do therefore have to create multi-factor models that unravel the valuation of individual firms in various nations while at the same time ensuring that differences in industry distribution between countries are taken into account. Lee and Ng regressed two valuation variables, the Price / Book ratio in which the market price of a stock is divided by the book value of common equity, and Tobin’s Q, defined as the market value of debt plus equity divided by the book value of debt plus equity, on a set of firm and country variables. The firm variables that they looked at where:

• Return on Equity (for the P/B analysis)
• Return on Assets (for the Tobin’s Q analysis)
• Profit Margin (net)
• Research and Development Expense / Sales
• Dividend Payout
• Beta (systemic risk factor measuring the firm’s stock market return sensitivity to changes in the MSCI World index)
• Currency Beta (measuring the sensitivity of the stock market return of the firm to changes in the value of the US Dollar vis-a-vis a basked of major currencies)
• Earnings growth (5 years)
• Credit Rating of the firm from Institutional Investor Magazine

At the country level, the researchers looked at:

• Country level average Return on Equity (for the P/B regression)
• Country level average Return on Assets (for the Tobin’s Q regression)
• Inflation
• GDP growth
• And of course, the Transparency International Corruption Perception Index

For a 10 year research period (1994-2003) the researchers were left with almost 60,000 valid observations. More than enough for a good statistical analysis. If Virtue would add Value, the result should be that in both the P/B and Tobin’s Q regressions higher levels of corruption would translate into lower valuations. I.e. Corruption should have a negative and significant sign in the regressions. This was indeed the case. The Cornell scholars found that – ceteris paribus (all other things being equal) – firms in the high corruption tertile had a 15-20 percent lower valuation than firms in the low corruption tertile. There was not much difference when looking at P/B compared to Tobin’s Q, with the latter being a firm-level analysis and the former looking more at the equity level. Value in Virtue: where does the value loss for firms in a corrupt system come from? When looking at the theoretical discount models, value loss could come from reduction in expected future cash flow and dividend levels, reduction in earnings growth or increases in the required rate of return that a firm would have to offer its shareholders and debt providers. Common belief was that the increase in the required rate of return is the dominant factor. However, Ng and Lee show that this is not true. In a corrupt system firms suffer mainly because the expected future cash flow levels will be lower. Partly because of the corruption (extraction of cash via bribes etc.) itself and partly because of loosing customers and/or translation of the corrupt climate into direct internal fraud (people at all levels in society start to believe that if greed and immoral theft is the standard, then let’s do it ourselves as well). Especially international clients and/or investors might be very weary to do business. The tremendous growth of ESG Investing in recent years is indicative of this trend. Both employers and employees (via their labour unions) on the one hand, and the government on the other, stimulate this trend. Good examples are the large Swedish state pension plans AP1 to AP7, who have a combined ESG investment policy, and the Dutch mega investor ABP, one of the largest pension plans in the world. However, ESG is growing but not so big yet as to guide investment decisions of institutional investors completely. But it is indicative that even private investors are getting more enthousiastic about the idea. Not surprisingly as our analysis shows. There is Value in Virtue for long term investors and firms following an ESG policy. We believe that this can be of special importance in Emerging Markets. It will increase value and enable firms and countries following a good ESG policy to attract more foreign capital which in turn can lead to further growth. CLICK THE LINK BELOW FOR THE FULL NG-LEE STUDY corruption-virtue

2009; The Year to add More Convertibles to your Portfolio?

By Erik L. van Dijk

The credit crisis was the period of disasters with structured products. Even the normally relatively quiet convertible  bond market ended up being bashed in the illiquid, panicky arena that financial markets seemed to be all through 2008 and especially since Sep/Oct 2008. Convertibles are basically hybrid securities with a risk profile somewhere between that of straight bonds and equities. On average, their expected return will lie between that of bonds and equities as well. Convertibles are hybrid in that they contain a debt component and a call or warrant component directly linked to the underlying price movement of equity. This implies that the holder can benefit from the upside potential of stocks, while at the same time having the debt value as a cushion.

Contrary to the situation in 2002, convertibles didn’t seem to provide investors the relatively soft-landing scenario they expected. On February 11, 2008 DJ Financial News Online stated that it would be an interesting year for convertibles, ”because they should benefit from the increased volatility”. Yes, it is true – and we know that from option models like Black and Scholes – that the call option or warrant component of this hybrid security will benefit from an increase in volatility. However, and that is the difference with regular options, the cushion component provided by the underlying bond might get hurt in that a period of increased volatility can often go hand-in-hand with economic debacle. When this became reality in 2008, the high correlation between volatility increases on the one hand and increased probabilities of default on the other led to a higher credit spread. This in turn triggered an increase in the relevant discount rate for the calculation of the net present value of the bond component of the convertible as a result of which the positive option valuation impact caused by volatility increases was more than offset.

And that is why convertibles are difficult securities. Only the true champions like for instance Nick Calamos of  Calamos Investments or Kris Deblander of Ed Rotschild Asset Management know how to add up the various valuation components that play a role in convertible pricing in the right way. In and of itself the pricing of convertibles is straightforward when looking at the individual variables that play a role in their valuation. Unfortunately adding them up is difficult because the relative importance of the various individual factors changes not just over time, but also when comparing one issue with another.

Emmanuel Derman’s 1994 note on Convertible Valuation, written with some colleagues at Goldman Sachs Asset Management provides a nice overview of the important valuation components. Not surprisingly, the model presented is an elaboration of work by the late Fisher Black (together with Huang). For the full note of Derman, click on the link below:

gs-valuing_convertibles

But to summarize the note, the important valuation factors are:

Convertible-related Factors

1. Principal / Redemption Value of the Bond (+); quite obvious, the higher the amount the investor will receive at maturity for the bond component, the more valuable the convertible
2. Coupon (+); a higher coupon improves the value of the debt cushion, which also translates into a more valuable convertible
3. Coupon Frequency (+); also logical, if I get 2 times a coupon of $10, I am happier than when I receive that same coupon just one time per year
4. Conversion Ratio (+); this measures how many stocks I will receive in exchange for giving up my convertible debt instrument. Obviously, the more the better.
5. Conversion Price (-); the conversion price = Principal/Conversion Ratio. The negative relationship is logical: the lower the conversion price, the quicker the call option component of the convertible will end up being in the money.
6. Parity / Conversion Value (+); is equal to the conversation ratio multiplied by the current stock price. The higher the stock price, the more valuable the convertible is (see also Market-related factor number 1 below).
7. First Conversion Date (-); the longer the period during which I can convert, the more valuable the conversion right is. Longer periods imply earlier first conversion dates.
8. Call Provision for Issuer (-); in quite a few cases, issuers give themselves a call right. It is clear that issuers will use this right once the call option for the investor becomes too valuable. The call for the issuer is therefore a negative value component for the investor.
9. Call Price of the Call Provision (+); the higher the call price at which the issuer can use his/her call right, the less bad it is for the investor.
10. Put Provisions for Investor (+); this type of provision is like an extra cushion for the investor. It gives hem the right to demand a certain amount of cash through early redemption (before maturity date) of the convertible bond.

So there are quite a few convertible-related valuation factors that in-and-of-themselves aren’t rocket science in terms of finding the right sign for the relationship between factor and convertible market price.

There are also a couple of market-related factors that should be taken into account:

Market-related Factors

1. Current Stock Price (+); the higher the current stock price, the higher the value of the option
2. Volatility of the Stock (+/-); see link with 5 below as well; volatility is one of the most complicating factors in convertible valuation. When looking at the option component, it has a positive relationship with valuation. The upside potential is infinite when looking at stock prices, whereas the minimum price is 0. But this positive ‘vega‘ can be offset by the negative impact on default risk (see 5 below) with in some cases a negative vega as end result.
3. Dividend Yield (-); since the convertible holder is not holding the underlying stock, but the bond plus call option high dividend payments by the firm are not to his advantage. On the contrary, they will reduce the potential for share price increases. The convertible bond holder would rather see the firm opt for reinvestment of realized profits so as to trigger further growth and increases in share price.
4. Riskless Rate (-); Convertible bonds are entitling the holder to a potential stream of future cash flows, either directly (coupons plus principal), or indirectly (to the underlying cash flows related to the stock via the option component). Net present value calculation is based on a discount rate, with the riskless rate being the basic component of this rate. The higher the discount rate, the lower the net present value.
5. Issuer’s Credit Spread (-); convertibles are hybrid instruments in which the default risk of the issuing firm is of importance as well. The debt cushion is just as strong as the credit rating of the underlying firm. The larger the likelihood of the firm going into default, the less valuable the cushion. Default risk levels can be measured through the credit spread, i.e. the additional interest rate premium on top of the risk-free rate that has to be added to the cost of capital/discount rate by the firm. High default risk firms have higher net discount rates, because of the increased credit spread. Therefore this negative linkage.

Factor 5 and its linkage with the earlier mentioned volatility factor (market-related factor number 2) is one of the most complicating aspects of convertible valuation. Markets go through trends as far as volatility is concerned. However, when in periods of fear or panic, this is often directly related to the underlying fundamentals be it at the firm level (high volatility for the firm, with normal volatility for the rest of the market) or at the economy level (high volatility across the board). In both cases the increased default risk – be it real or sensed – translates into a lower valuation of the debt cushion. And that reduces the convertible value that is normally positively related to volatility (via the option component).

2009; THE YEAR OF CONVERTIBLES?

The year 2008 was terrible for convertibles, because the cushion value of the debt component seemed to work less well than investors and their advisors expected. The UBS Global Focus Convertible Bond Index lost 31.7 percent in Euro’s over 2008, a disastrous performance that was only hardly better than the -46% lost by the MSCI World index. There are four reasons for the lousy 2008 performance:

1. Forced sales by hedge fund managers. Hedge funds were holding 70 percent of the convertible market in 2008. A huge number, that can be asigned mainly to so-called convertible arbitrage hedge fund managers. Excess leverage led to problems for these managers. As a result, they had to delever and sell their assets. This translated into an increased supply of convertibles to the market.
2. Low number of buyers due to flight into quality/safe-havens. The excess supply could not be sold to buyers, because they were less active or even left the market due to a flight for quality in 2008. Cash was king. The convertible market suffered from the same problems as equity markets did, with liquidity drying up.
3. The highly pressurized market environment, that hurt all asset classes (credit crisis). The period of the credit crisis was equally stressful for investors in many different asset classes and that was not different in the convertible market. There was fear, and buying and selling behavior was often irrational. This has led to a situation in which – compared to models like the one presented in the Derman/GSAM note presented above – undervaluation went as high as 10-15 percent. Investors simply did not want to step in and this was a unique feature in the normally not that volatile convertible market.
4. The collapse of Lehman Brothers. Lehman was a big player on the convertible market, both as an investor as well as market maker. Its collapse in October 2008 has hurt the market substantially.

Now, what does that mean for the outlook of Convertible Markets in 2009? We believe that convertible bonds have good potential. First, the average bond yields of convertibles are quite attractive. Yield levels of 9-10 percent are common and that is of course amazing during a period in which yields on regular fixed income instruments have fallen to relatively low levels due to the coordinated actions by Bernanke, Trichet and other central bank presidents. If we add to this the existing undervaluation of convertibles (see above) which normally will be traded away relatively quickly, we do believe that the underlying return related to the debt component of the convertible is actually quite high already. We do not really believe in a quick and sudden increase in risk-free interest rates and even if that would happen due to inflationary pressures, the current credit spreads are full of overreaction by investors in fear-torn 2008. So with a potential reduction in credit spreads, we have some cushion in case interest rates creep up. Added to this, we know that stock prices at the moment are relatively low. With March already showing the first signs of mean-reversion (it was so-far actually one of the best stock market months since 1974), the option component of the convertible has high potential.

Rothschild’s Kris Deblander tells a bit more about how he would construct his convertible portfolio at the moment in this interview:

interviewshconvertiblesfevrier2009anglais574

His Saint-Honore Convertibles Fund won the Lipper Fund Award in his category for the years 2005, 2006, 2007 and 2008. So this guy surely knows what he is talking about. Lodewijk Meijer’s manager selection unit considers this fund one of the best to go for if you want to exploit the potential for a stock price rebound without taking all the risk that comes with stock market investments. Deblander suggests a normal weight of 10 percent convertibles in your portfolio, with probably even an overweight of 5-10 percent right now. We do subscribe to a larger convertible component in the portfolio, albeit that the non-specialist can better outsource the decisions to a specialized fund manager. As we showed above, convertibles look simpler than they actually are. It is a hybrid security with a lot of valuation factors within it and their relative weight is not always clear.

Therefore, if you believe that 2008 was not indicative of the end-of-the-world being there, shares will rebound. Now, the rebound could come quickly or still take some time because we have to go through a period of uncertainty in the economy first. The insurance aspect of the debt component of a convertible is then ideal. We do therefore recommend investors to take a closer look and buy convertibles. US investors are referred to firms like Calamos, Europeans can opt for Deblander’s Saint Honore Convertible Fund.

The World is Changing: Also in Asset Management

By Erik L. van Dijk

The world is changing. On the one hand, we see that the relative importance of Emerging Markets is growing. When looking at the relative market value of stock markets of these nations, we see that the percentage went up to some 10-15 percent in 2006-07. True, due to the credit crisis this percentage dropped back to about 7-8 percent recently. And although that number is more or less in line with percentages seen in the decade before, one thing is totally different since 2003. Market values of stocks represent the price of economic activity in a country (albeit as a rude proxy). But the gross domestic product (GDP) of a country is an indicator of the underlying asset base / fair value of that economy. Robert Shiller’s excellent book on Market Volatility contains a few papers that clearly indicate that prices are far more volatile than fair value. Result: we move from periods in which prices are far too high to periods when they are more or less in line with fair value to periods when prices are way too low, et cetera. With the GDP weight of the Emerging Markets now being close to 30-35 percent of world GDP, it is obvious that the market value weight underestimates their current importance. More than ever so. We do therefore believe that the bulk of conclusions drawn by Jim O’Neil and his Goldman Sachs economic research team in their book ‘Brics and Beyond’ do still hold. This is going to be the era of Emerging Markets. Sooner or later China and maybe India will be bigger economies than the US one.

But it is not just the economic world that is changing geographically. A similar phenomenon is going on in the asset management world. As an asset manager selection specialist, I would say that up until the beginning of this century the bulk of real best-of-breed asset managers was Anglo-Saxon. Within that group, the US asset managers got the lion’s share. This was especially true when looking at so-called quantitative asset managers. In the fundamental zone there were some good British asset managers active as well. Local parties in other nations were mainly of interest to local end-investors to the extent that the local factors were of importance. Be it legally, or because of the local presence. In terms of performance track record they couldn’t keep up with the best-of-breed specialists from the UK and US.

Now, with the world getting smaller due to globalization, the number of products growing and international complexities increasing, something has happened. The dominance of the Anglo-Saxons in the best-of-breed major league is far less prominent than it used to be. In the case of the Americans part of this is understandable. The Americans were always best in domestic products, and I would still be more than surprised to see a top-notch US equities or bonds manager not being from the States. It can be done, but it is hard. But their attitude to label products elsewhere as ‘International’ and put them alltogether in one mandate/fund was illustrative of how the US saw the world: us, the US, versus the rest. In terms of a world divided by market cap this was actually quite understandable. The US’s relative weight in terms of market cap was indeed about 40-50 percent for many years. If you add to that the fact that the Wall Street stock markets were the best-regulated and most-liquid ones, this approach was more than OK.

But with the shift in economic activity, and with the world becoming a more equally-weighted place with the US now being approximately 30-35 percent of the total pie, Europe and other developed nations (JAP, CAN, AUS, NZL, SING, HKG) representing a similar percentage and the Emerging Markets also, things are changing. And not just that, it is also clear that with this shift in economic power two important trends have helped to change the balance of power in asset management:

1. The increasing role of London as center for international asset management. With Americans being less internationally-oriented than the Brits, major banks, insurance firms and asset managers from all over the world realized that London was an excellent alternative as world hub for international mandates. Not just in terms of available knowledge, but also in terms of time zone, being neatly placed between Asian time zones and the US time zones. The UK also followed an active strategy to grow the London Stock Exchange and attract as much as it could this type of new business. And with it came the shift of knowledge to this market. Even big American institutional investors and financial services firms accepted it and the growth in the City of London was to a large extent caused by American institutions understanding that ‘London was the place to be’ for non-US asset management. It was not surprising that the brightest talents in the asset management community followed this trend. Sure, when thinking in terms of academic study in Finance or Investments the US was still the hottest place to be, although levels in European schools like the London Business School, London School of Economics, INSEAD or even Asian ones like the Indian Institutes of Technology, top universities in Israel, Hong Kong and Singapore are definitely not considered much lower by recruiters anymore.
2. And not just that. With the economic balance of power shifting, it became clear that there were areas of the market in which foreigners could do at least as good a job as their American colleagues. The ‘investment game’ is not the same in every asset class. Equities, Fixed Income, Hedge Funds are different games. And that is definitely true when looking at running portfolios of securities in these markets in different countries. This has led to the rise of excellent asset managers in other nations as well, also on a performance basis.

Examples: the top-level French asset managers are true specialists in Fixed Income. Somehow the French specialists, often relatively quant-oriented play a ‘game’ in Fixed Income that makes it very hard for the big Americans to compete. Germans also are strong in Fixed Income. Good quantitative managers are now also not a rare thing in the UK anymore, albeit that it is mainly in boutiques (with the exception of large powerhouse Barclays Global Investors, albeit that BGI is especially strong in index products). Average knowledge levels in the Netherlands and Scandinavia have gone up spectacularly.

This increased competition between a growing number of international players with far more knowledge dissemination than before has led to:

a) growing numbers of strong asset management boutiques, that exploit a specific, specialized skill set on a relatively narrow market segment;

b) finally (!), some downward price pressure on asset management fees, with unfortunately brokerage fees still not following quickly enough

c) the demise of parties that didn’t really add value, but simply leveraged their ‘brand name’ image / ‘size’

d) a growing interest in manager selection, because – with the non-existence of reliable ratings similar to what we described about rating systems in the Chess World in a previous entry – a larger number of providers in a growing number of sub-categories of asset management made things less overseeable for the average investor.

That is where we stand. An industry getting more mature at a time when the financial world seems to be burning. Investors do not just have to analyze carefully which asset manager has products in a specific category that are truly outperforming on the basis of skill, no, he/she also has to make sure that the provider itself will be there one year from now. Especially asset managers that are part of large banks or insurance firms have to be analyzed carefully. Before you know the asset management operation is sold as part of the restructuring operation, with all the turmoil that goes with it. What will that do to the team of specialists that you think you are hiring when opting for a specific product that you like? Will they stay with the entity? Leave to another one? Start their own?

Asset management in a grown-up financial world is more important than ever, but separating the good guys from the bad ones will itself prove to be a new, specialized quality as well. A quality that can make or break overall portfolio results. Those of you that were hurt by investments in the Madoffs of this world, or in asset management products that underperformed indices by 100s of basis points know what I talk about.

The end result of this new development is of course good: they are all signs of maturing. But as long as end-investors do not realize what is going on and think that the old world is still there, it will take quite some time before end-users – be they pension plans or private investors – will be provided with a full opportunity set of good products, with bad products having no chance at all. In the mean time the grey zone will continue to make victims, because penny-wise, pound-foolish market participants might continue to follow a DIY strategy of selection without realizing that it is really true that results in the past are not necessarily in-and-of-itself indicators of success in the future.

Fund Manager Selection Part 2; The Institutional Investor

By Erik L. van Dijk

During the last few days we discussed topics related to the behavior of Private Investors. We analyzed how they choose their fund managers, individual stocks, how their decision processes work and even addressed differences in style between the genders. Now, for analyzing the behavior of Institutional Investors we first had to study the Private Investor. In the end, decision processes of investing institutions are always processes in which individuals act together. In other words:

Whatever we derive for private investors, will – one way or another – have an impact on decision taking in institutions, because in the end every professional working in an institution is a private person as well.

We can add a bit more detail. Professional investors are often mainly involved with fulfilling their tasks on portfolios of third-party money. This implies two things:

1. The existence of agency-related problems. Unlike the situation that we discussed a few days earlier when analyzing the investment behavior within investment clubs, we are dealing here with group processes similar to the ones studied by Jensen and Meckling. The bottomline was and is that agents – when not controlled in a sufficient manner – can and will incorporate their own goal variables in the decsision process. This could lead to ‘style differences’ (see also below) with respect to the investments done, or even to outright acting against the interests of the principal. See our entry on the behavior of investment clubs for more details.
2. Group psychology plays an important role on the decisions taken. Group size and composition are therefore  important variables.

From these 2 points we can therefore derive 4 important elements to study:

• Investment style differences (Agency element nr 1)
• Agent-related goals (Agency element nr 2)
• Group size
• Group composition

But we have to add two others:

A) Management and control structure within the institution

B) Type of institution.

With respect to A) and B), investment decisions are just one part of the overall activity set of institutional investors and its relative role is not the same in banks, insurance firms, investment banks or pension funds. Management boards in banks and insurance firms are often filled with non-investment-specialists who – as a controlling body – work together with ”respected colleagues” from other firms filling the ranks of the board of directors. The higher ranks in investment banks are often filled with the most successful and toughest guys with investment knowledge. They used to do what the specialists are doing now, but moved to management plus the bigger deals. In a pension plan the governance structure often implies a controlling body with a lot of non-specialists, be they representatives of the sponsor, employees or government. A very complex control structure that is far more sensitive to public opinion and daily news gathering and information dissemination than the others. And to make things even more complicated, there is also the difference between so-called ‘Defined Benefit’ (DB) schemes and ”Defined Contribution” (DC) plans.

Defined Benefit (DB) versus Defined Contribution (DC); a sub-categorization within the institutional investor category Pension Plans

In a Defined Benefit structure pools are created in which one investment style / portfolio applies to the whole group of members, be they young or old, men or women, high-income or low-income. Obviously, this middle-of-the-road investment style might be sub-optimal for many, but the social aspect of it (”we all stick together”) has certain benefits as well. As we saw in our earlier contributions, investment success is not something easy and since in the end a pension plan is about making sure that you have enough money when reaching old age, this kind of pooled structure ensures that no one can be the victim of his/her individual mistakes caused by non-professional bad investment decisions.

For more information about Defined Benefit (DB) plans CLICK HERE.

It is probably no surprise that the ideas behind DB were quite popular in nations with a culture of social cohesion. European nations like the UK, the Netherlands and Scandinavia are good examples of markets with large DB plans. Actually, a relatively small country like the Netherlands with just 16 million inhabitants is the fourth largest pension market in the world. And this is directly related to the creation of big DB plans that has been started in the 1950-60s.

The social aspect of DB plans is strong and attractive, and it is therefore not surprising that Emerging Markets that have achieved a certain wealth status are contemplating the introduction of similar structures. E.g. the IR Iran is working on a pension structure similar to what has been created by the Dutch in the 1950s or the Norwegians during the last 10-20 years. The existence of gas and/or oil reserves in both these countries and in Iran is not coincidental of course.

Now, the big problem with DB is exactly that: DB. Defined benefit….you know upfront what the end-result is supposed to be. However, there are uncertainties in the world. The end result is a function of: a) investment results; b) demographic factors and c) economic factors, with the premium inflow being covered in the economic category. With demographic factors working against pension plans by definition in the West (people get older and a smaller relative number of people is working), obviously pressure on the structure will be huge whenever economic and or investment factors work against it. And that is what is going on at the moment. Social cohesion is under huge pressure in DB countries simply because of that. In all these nations, younger generations are pressing for either full-scale DC alternatives or DC components as an add-on next to a minimum-level DB structure.

In a pure Defined Contribution (DC) plan, the pension fund is nothing more but a provider of various investment opportunities, be they funds or pools, in which members can invest according to their own belief (what mix to choose?) with or without guidance by the pension plan. The minimum achieved is cost advantages, since the DC plan uses its scale to get the funds chosen against some kind of fee rate not available to members individually. But hopefully, the DC plan did also use its knowledge about fund manager selection when pre-selecting the funds in its choice portfolio for the members.

The DC structure is most popular in countries in which some kind of individualism was and is strongly developed. The US market is of course the most important one. The main certainty is that you save for your own old age. But, with the contribution being sure, the uncertainties now are the economic and investment ones. Whenever you invested the wrong way, your end result will be disappointing. Maybe even insufficient to avoid poverty!

For more information on DC plans CLICK HERE.

Investment and selection style by Type of Institutional Investor‘

In the remainder of this blog entry we will now analyze the various components mentioned above for the three different groups of institutional investors that we can distinguish.

I) The aggressive guys; Investment Banks and Hedge Funds

Investment bankers and hedge funds that also use substantial parts of their own money are the real risk takers. You can classify their styles based on what we told you in our blog entry on differences between men and women (see here) as typical ”macho”. They are in there for the quick buck, fast deal, and aren’t afraid to take big risks. High, often excessively so, leverage is a typical characteristic of the style of these guys. When successful they think that they are the best and can get away with everything. Yes, to a certain extent you could say that they are the guys that caused maybe not the whole credit crisis, but definitely the momentum and exuberrance that in the end made the system explode. As long as they do it with their own money, or with that of investors that do understand some investment basics, that is all fine. However, when they label themselves ‘investment magicians” and attract money by others while at the same time not being controlled carefully enough, because the regulatory authorities do not understand the difference between a ”miracle investor” or ”magician” or ”someone just having plain luck” this can be very harmful. And that is what happened. Even smart people seemed to have forgotten how long it takes before guys with casino strategies are not part of the alleged magician group anymore.

Example: Assume that there are 100 investment bankers/hedge funds out there that do only one stupid thing. They flip a coin and when it says heads they go long with all their money in dangerous stock investments. When it is tails they go long with all their money in some kind of fixed income, gold or other defensive investment. After one year there are still 50 coin flippers labeled good investors. After 2 years 25, After 3 years 12, after 4 years 6, after 5 years 3, after 6 years 1.5 /2 and after 7 years there is one of our 100 guys who can say that he outperformed the whole 7-year business cycle. And believe me, he will attract a lot of money when capable of doing business with people that don’t ask him too many nasty questions about his investment ”strategy”. And yep….you do immediately see now why Madoff could happen!! Admiration without checking results.

With respect to investment style and manager selection, these guys are not afraid of anything. They will actually love the most risky deals. They like frontier markets more than defensive solid investments in fixed income in established nations. They prefer distressed firms over mature solid ones. Et cetera. It is good to go with them up to a certain extent, because they often use their own money. But, to the extent that they might be sensitive to overconfidence (the macho thing), always make sure that they hold the best-possible, diversified portfolios. In our case, we would require them to be Markowitz-van Dijk compliant, i.e. true champions in diversification. To the extent that they have invested in talented small managers, they are good for the system in that they are not afraid to give money to these talents. But only to the extent that the talents are really talents of course, and – as shown by the previous example – that is difficult enough when you don’t know how to ask the right questions and perform the right performance analyses.

II) Banks and Insurance Firms; Non-specialists with Investments not being the main activity

They earn their main money with other products, be they banking/savings related or insurance products. But because of developments in the financial industry, all of these products got a larger linkage with the investment world. In the end you will have to invest money – be it your own, or that of your clients – somewhere. After the collapse of the pure savings banks back in the 1980s and the transition from pure insurers into bankassurance in the 1990s we did indeed see some indications of diversification understanding. So, being non-specialist, the decision takers here – who have probably the relatively largest amounts to invest due to their scalable product offering to the economy at large – do diversify. But it is definitely not the top-level, diversification and risk management activity that can be labeled Markowitz-van Dijk compliant. It is amateur diversification and risk management as a result of which disasters like the investment in securitized mortgage portfolios in the US could happen. They really believed that having a portfolio of large amounts of mortgages from all over the US would be diversification. That there are more dimensions to this thing than just plain geography and that correaltions between Seattle and Florida are pretty high in a time of crisis and economic malfunctioning was totally forgotten. They have never seen the work of French top professor and diversification specialist Bruno Solnik on the relationship between crises and correlations. Or they saw it and didn’t believe it was important, because they sticked with the big names. Non-specialsts always overesimate themselves not to the extend of taking too much risk knowingly, but to the extend of thinking they know what to do and how to do it. Result: huge investments in investment vehicles and structred products created by well-known, allegedly successful institutions. Be they large asset managers, investment banks or hedge funds.

Or: they translate their alleged knowledge into the belief that they should have their own asset management branches to develop these products internally! And to some extent you could say that this ”strategy” might also partly explain why – on average – good boutiques outperform large houses. Too often do large houses start things when not being a specialist. The ”macho” overconfidence of a bad boutique is replaced by ”breadth” overconfidence!

So in a way, using money from external clients and with a mind set that focuses first and foremost on risk reduction, these institutions should have invested like women do. Study information thoroughly, dig into the details, take not too much risk, diversify and avoid overconfidence. Unfortuately, women decision takers are a very small percentage of the boards of these instituions. Therefore, we cannot be too surprised that the big failures happened in this group of institutional investors during the 2007-now credit crisis. Out of synch with their own style and goals, and not capable of distinguishing between sharks and frauds on the one hand and true specialists on the other. It is not a surprise that it is especially true that investment affiliates of these entities invested a lot in Madoff!

III) Pension plans

As a group, the true specialist pension plans that basically act as a kind of end investor (definitely so in the DB case, and to some extent in the DC case) or his direct advisor through pre-screening (DC plans) are normally when looking at the return-risk profile the best institutional investors. Logically so, because they do have all the information available, they do have armies of specialists working for them and they do work structurally with consultants.

So when we concluded that on average institutional investors have better returns than private investors, see our earlier entries, we should at the same time add that the difference is shockingly small. When investments are at the same time art and science, the specialists should outperform the non-specialists by a wider margin. That this is not the case, is the result of overconfidence on the one hand, and lack of honest, sincere performance measurement and analysis on the other. The difference between true investment professionals and their performance on the one hand, and the amateurs on the other, should not be as small as to make funny stories about King Kong throwing darts and beating the specialst possible. Definitely not when analyzing diversified portfolios created by true specialists.

Now, how come things can go so terribly wrong, also when we look at the pension plan investors? To one extent this is directly related to the agency argument. Pension plan investors are not using their own funds (like the co-investing investment bankers and hedge fund managers) and that could probably lead to some agency aspects playing a bigger role than they should. It is good that new governance structures and control- and regulatory mechanisms are being created that will further mitigate this problem. But it is still there.

On the one hand this leads a lot of pension plans to investment styles similar to that of banks: overweighting of established ”big names” with middle-of-the-road products (the ”you never get fired for hiring IBM” argument), whereas actually they do know enough about investing to go for a best-of-breed approach with more bold products on an individual basis linked together into a well-diversified overall portfolio.

And also: although they are the true specialists, their boards do also contain large components of non-specialists with quite an impact. Be they government-related or labor-union related. Amidst fear and panic, the relative importance of these groups within the decision structure grows bigger. As a result of this, there might be a tendency to sell the most risky investments at exactly the wrong moment. And that was happening in 2008! Instead of buying low and using the crisis as a once-in-a-life-time opportunity, these investors were actually in Q3 and Q4 of 2008 selling in many nations where we have good information about the buying and selling of DB investors. And obviously, the same pattern was even more prominent in DC plans, because there the end investors (individual members) were panicking themselves.

The whole system of calculation of how DB pension plans in this structure are doing, through the use of so-called coverage ratios makes things even more compicated. The average time to maturity of liabilities of pension plans (measured by the duration) is higher than that of its assets. That leads to the weird paradox that – when interest rates decline to bottom levels, like right now – the net present value of the liabilities goes up to such an extent that the coverage ratio will probably decline to levels not acceptable for regulators or boards.

That leads to tension and increased relative importance of the non-specialists within the board exactly at the time when the true specialists should take the lead. Result: what is sold is NOT the parts of the fixed income portfolio that made above-average returns during the period just finished (e.g. investment grade bonds that went up in value due to interest rates moving to zero), but actually stock components of the portfolio are being sold in a period of total sell-off of stocks in the first place. And even worse: within the stock component of the portfolio stocks from markets that are fundamentally strong in the long run (emerging markets) are sold first and foremost before selling-off the stocks of firms in your own country. Reason: ”we cannot – often for political reasons – start with a sell-off of our own stocks, because this might hurt local firms and therefore also employement and the economy.

Conclusion

Institutional investors, and that holds especially for those that are willing to co-invest with their own money or the ones that are true professionals, should generate above-average returns at a far better scale than they actually do. King Kong and individual investors / investment clubs shouldn’t be competition when looking at their results. It is a disgrace that they often seem almost as good. Amateur base ball clubs from let’s say a high school in Anchorage, Alaska are just a ridicule when trying to compete with the Florida Marlins and that is how it should be in investments as well.

Credit Crisis: Post-scriptum

What does this mean for the credit crisis? It means that it is not so clear that institutional investors as a group will get us out of this mess soon. True, some of the bold investment bankers that survive the current liquidity squeeze and de-leveraging will be among the first to try to use the (almost)zero interest rate situation to buy into deal portfolios with above average prospects. But are they big enough to move the market? We at Lodewijk Meijer believe they are not. Only when the so-called Sovereign Wealth Funds will join them, will the system switch back into optimistic gear. In a next entry we will therefore have to pay separate attention to this new phenomenon that became important during the last 10 years.

Men versus Women; The Impact of Gender on Differences in Investment Style and Results

By Erik L. van Dijk

In our last two blog posts we analyzed how private investors take their decisions. With our without the help of financial planners, the non-professionals seem to struggle in the financial market place. Before concentrating ourselves on the institutional side of the industry in later blog entries, we would like to ask the question: but what about gender? When looking at the TV, or reading a newspaper, it seems clear that the financial world is (still?) mainly male-dominated. This is especially true when it comes to the main executive and ‘content’-related positions in the industry. In marketing and sales things are slightly different, for obvious reasons: when the industry is male-dominated, and not just that, but even dominated by alpha males that exert some macho characteristics, then don’t be surprised that it pays off to overweight the percentage of good-looking, eloquent, nicely-dressed and -heeled women in your marketing/sales staff.

But is this gender pattern in line with investment qualities? During the last 10-15 years there has been quite a bit of behavioral research into this question. And now, with the group of Wall Street, London or elsewhere-based crooks (be they big bankers or frauds) that have or should apologize for the Credit Crisis being male-only, it is interesting to summarize the results. A remarkable, but clear pattern evolves:

i) Gender and Investment Confidence

It will not come as a big surprise that all research seems to indicate that one important difference between the sexes is that men tend to believe that they understand investments, whereas women have less difficulty explaining that they are not so sure about their abilities. And in and of itself this lower ego is not a wrong thing: investment analysis and portfolio management is a complicated thing. A far larger number of disasters were the result from overconfidence than from lack of confidence. The result of this difference in confidence is first and foremost that less women trust themselves to start investing (as amateur) or even consider a career in investments. But what remains to be seen is if the confidence differential translates into quality differences between those men and women that start to invest.

ii) From confidence differential to style differential: women care more about the details

The lower confidence levels in women translate into an approach in which women want to know far more about their potential investment than men. Men ‘think’ that they understand things much quicker than women do. Result: women will dig deeper when it comes to the information-gathering phase before deciding if they buy/sell an investment.

iii) Women: the careful investors. From less confidence and more detail to lower-risk strategies

And even when studying a larger information set, women don’t get rid of their initial negative confidence level gap. They remain prudent and translate knowing more into a larger interest in investments in asset classes with lower risk. I.e. fixed income securities, real estate et cetera. Men like to go for higher beta (more systematic risk) and higher volatility securities. This implies that – if we will find a return differential between men and women in favor of portfolios created by men – we will have to make sure that portfolio returns are corrected for differences in risk, before making our final judgment.

iv) How the lower ego of women translates into a larger willingness to incorporate mutual funds in

the portfolio

When your personal SWOT indicates – after careful revision of the available data – that you don’t know enough, then it is far better to outsource the decision to a professional with proven track record than to gamble. Women do therefore use a larger percentage mutual funds than men do. Sometimes up to 40 percent larger allocations to mutual funds. This does translate into a larger diversification of women portfolios and it adds to the risk differential between female and male portfolios, even when looking within a specific asset class.

v) Style drift: women are more style consistent

One of the problems with investing is that you will go through periods of success and lesser periods. When doing so, investors will also be exposed to external information from news media, so-called experts et cetera indicating where the real profits were. This will create an innate tendency to shift your style bets away from the original plans into new territory that might seem to generate better results. Men are far more sensitive to this style drift than women are. To some extent this is caused by the fact that women in general won’t embark so quickly on a new path. They are less afraid to miss out on that so-called ‘unique opportunity’. They have a longer-term investment approach and understand that a new chance will always follow.

vi) Men are better for their brokers: excess trading

The overconfidence of men and the eagerness to follow the quick buck leads them into strategies that involve a larger amount of trading. Studies seem to indicate that the average annual turnover of male portfolios is some 25-50 percent higher than that of female portfolios. This larger trading activity in male portfolios is the result of overconfidence (‘I understand the market and feel that this is the right time for a timing-related switch!’) and to another extend to the shorter-term focus of men. It will obviously lead to higher trading costs, that will eat away part of the gross return on the male portfolio. Note that the male portfolio should – based on what we found so far – outperform the female portfolio on a gross basis, because of the excess risk taken. If you have a larger tilt towards higher risk instruments, you should earn a higher gross return. And net return as well, unless the trading wasn’t smart in the first place. Interestingly, some studies seem to indicate that this was indeed the case: the net results of the male and female portfolios would have been higher had they refrained from intra-year trading and concentrate on an annual buy-and-hold strategy instead!

vii) The Return Analysis, who wins: men or women?

One of the most important studies analyzing the return differential on female and male portfolios was the 2001 Barber & Odean paper Boys will be boys: Gender, Overconfidence and Common Stock Investment as published in the Quarterly Journal of Economics. Barber and Odean were also (together with Heath) writers of the paper that we used in yesterday’s blog on ‘Good Reasons’ investing. It is quite likely that women – fed by a larger information base with more details – use more complicated decision models that are to a lesser extent prone to the ‘good reasons’ fallacy. And indeed, studying the investment behavior of more than 35,000 households over the 1991-1997 period the authors conclude that single women score portfolio returns on a risk-adjusted basis that exceed those of single men by 3.0% annually. In marriage couples that decided to have men and women invest separately the differnence is still there, but to a lesser extent: in that case the women outperform by 1.4%. And this is not a pure US result. A 2005 study in the UK corroborated these findings. Actually, UK blokes are relatively lousier investors than their US counterparts were, or, UK women were better than US ones, or a combination of both. But more research is needed, since the Barber-Odean study was more rigorous and robust than the UK one.

Another study by Kuenzi and Riessen (University of Cologne, Germany, 2006) came to the conclusion that the differential net return did not exist when looking at mutual funds that were either led by a woman investor as leading portfolio manager or a man. In other words: the overconfidence of men leads to disasters when it is not based on some kind of background knowledge. Male amateurs seem to forget that they are just that: amateurs. But when taking a closer look at the Kuenzi-Riessen paper the result is still surprising. First, we should not forget that there are far more mutual funds led by men than there are by women, and the funds that men manage are much bigger too. As if there was an innate tendency in the professional community to mistrust women that didn’t want to focus on selling and looking good, but on fund returns instead. Now, Kuenzi and Riessen show that on a gross basis male mutual funds do indeed outperform. However, the outperformance was to a large extent directly related to the fact that they take more risks. So part of the excess return was eaten away after a proper risk-adjustment. There was still a bit of outperformance left though, but that gross outperformance was consecutively eaten away by excess trading. Final result therefore: equal net returns, but the women got there with excellent style consistency. Knowing that style consistency is in and of itself also important in asset management (because you should always assume that you are not running the whole portfolio of the client, so that if you don’t stick to your job his/her overall portfolio risk-return profile might start to be hurt), the conclusion should again be that – if anything – women win.

viii) Give women more space and investment responsibilities

So women should feel a bit more confident about their investment qualities (as long as they don’t become overconfident!), and the men that dominate the investment community or their married amateur counterparts that still believe that they are best-equipped to do the finances at home should give women more credit for their hidden investment qualities and give them more space.

In a slightly different setting, Harvard professor Boris Groysberg corroborates these findings. In the August 2008 Harvard Business Review he gives a nice interview to reporter Martha Lagace, explaining that based on his research ‘star’ women (be they financial analysts, lawyers, investment managers, accountants, investment bankers et cetera) are more successful than men when changing their job. The ‘star’ women that are hired by a new employer who wants to pay more or offer other fringe benefits for the new divas are far less disappointed than employers who hire male ‘stars’ from another company. Groysberg explains that there are two reasons for this:

a) Portable Relationships

Women are good in having both internal and external relationships and this phenomenon is part of the same process that made them look for more details when it comes to taking investment decisions (see above). Never wrong to know more (be it about things or be it people). Result: they can easily adjust to new circumstances, with their external network helping them cope with it. Men on the other hand are more inward-looking (either alone or with their smaller group of buddies), and do therefore struggle when switching to a new, unknown situation.

b) Smarter Evaluation

Women use ‘multi-factor’ approaches in which they probably are not totally aware of the exact weights of factors in that decision process (they are not necessarily more quantitative than men, on the contrary!), but they know damn well that it is wrong in complicated situations to use an oversimplified decision procedure. In other words: they are less senstive to Barber, Heath and Odean’s ‘Good Reason’s Fallacy’ that we explained in yesterday’s entry. This implies that women take better decisions about when to switch jobs and to what employer to go.

ix) It was a man’s world. Will James Brown’s song become past tense in the credit crisis and the years ahead of us?

I think that it is impossible to believe that the gender divide will continue in its current form. Especially so after the credit crisis in which the male species played such a dominating role. Coming from a family of strong women, where men were never inclined to think that they were the dominant species and blessed with a sister that is indeed a savvy, smart investor who – based on qualitative reasoning – was always capable of challenging my ‘quant’-based work and making sure that I didn’t forget to incorporate qualitative factors in our decision processes at Lodewijk Meijer, I don’t find this shocking. However, I cannot exclude the rise of some kind of countermovement that wants to maintain the existing glass ceiling that is hindering upwardly mobile women in society in general and in investing in particular.

On a global scale the sign of times is that women will  become more important in our industry and based on what we just mentioned, that is a good thing.  Last month, the Financial Times published a nice article about female Japanese investors. Contrary to what many Western outsiders might think, women in this Asian country do already play a far stronger role when it comes to managing the household budget and savings than their western counterparts do. Actually, Kyoto professor Noriko Hama believes that Japanese women have played a significant role in recent arbitrage trends in the fixed income and currency markets. During the last 10 years interest rates in Japan were almost zero, a situation similar to the one the Western nations are now facing due to the credit crisis. In the Japanese case it was directly related to the multi-year Japanese recession. Now, with interest rates so low, the women were afraid that they could not balance their household budgets. Different investments were needed. Knowing that interest rates in favorite countries (for holiday and shopping) like Australia, the UK, Singapore or even Turkey were much higher than in Japan they steered money out of Japan into those countries. Of course, the Yen is normally a stronger currency, but with international investments almost being non-existent the combined acts of Japanese women (and men) led to a money outflow that created a self-fulfilling prophecy. It generated downward pressure on the value of the Yen, which in fact made this strategy less risky. The strategies were solely coupon/interest rate driven, without too much worries about the principal and with this positive surprise and – in the end – always the possibility to ask for payout in the foreign country where it can then be spend on a nice holiday or some shopping, it is already a clear indication that women are here to stay in investing. Be it in the Western world or in Asia.

Best of both worlds; smart gender diversification within the investment team

It is surprising to see that this plea for more women in investing is NOT the same as saying that women dominate men to such an extent that we should get rid of the overconfident, alpha-male investors alltogether. Research does also indicate that the best solution is a mixed team with both men and women. Men are good in the high risk zones of the market that require alertness, speedy trading and strong nerves. Women are better in the low-risk zones of the portfolio and when acting combined one group can be a useful control set for the other. It is in the end all in the mix!

Conclusion: MEN SHOULD LEARN TO LIVE WITH THE FACT THAT WOMEN ARE MUCH BETTER WITH INVESTMENTS THAN MOST OF US ARE WITH HEELS. MIXED TEAMS WILL TAKE THE BEST DECISIONS BECAUSE THEY COMBINE THE STRENGHTS OF BOTH GENDERS.

How do people invest? The difference between group and individual decision taking – with a small side-step to the credit crisis

By Erik L. van Dijk

In our previous entry on Fund Manager Selection we noticed what the typical flaws of private investors and their advisors are. Now, before turning to decision taking by the so-called specialists in part 2 of the series on Fund Manager Selection, it is good to take into account resulst from a great paper by Barber, Heath and Odean from the Haas Business School at the University of California Berkeley. In their paper Good Reasons Sell; Barber, Heath and Odean, published in Management Science in 2003 they point out that individual investors take different decisions when being part of an investment club. 

A lot of the research focusing on differences between private and institutional investors incorporates agency-related factors in one form or another. The Agency Theory, going back to the original work of Mike Jensen and Bill Meckling in the mid-70s, indicates that situations in which a principal / decision taker is working in his own self-interest can lead to different outcomes when – for example because of the decision framework or company structure getting too large – he/she outsources part of the decision taking to an agent. Supposedly the agent is required to act totally in the interest of the principal / decision taker, but one can never exclude that the agent will incorporate his/her own agenda with goals/targets in the overall decision framework. Consequence: the end result can easily be less good than what the principal expected.

Before turning to investment decisions by institutions in a future post on Fund Manager Selection (part 2 of the series started yesterday), it is good to re-analyze the Barber et al. paper. In their paper they publish results from tests in which they distinguished between individual investors who took their investment decisions alone, and those who worked together in a group. Now with investors in an investment group still being the sole owner of their share of the overall group portfolio, the agency aspects don’t apply. Any difference in investment style of people in groups versus people on their own is therefore the sole result of behavioral factors.

The results are astonishing. People do decide differently when in groups. And not just that: people in general use decision processes in which ”good reasons” are guiding them more than conscious cost-benefit-analysis-based decision taking! Both the individual investors and the clubs in the Barber et al. study underperformed the benchmark, both on a net and gross basis. In other words: professional investors as a group do outperform. And that implies that the fun, anecdotes about King Kong beating the specialists with stocks picked by throwing darts are demagogic. The tests of monkey versus specialist do always incorporate 5 or less stocks and one ot the key characteristics of a good specialist portfolio is diversification. Taking away the diversification from the specialist, is like taking away bananas from the monkey. If you don’t give him his yellow, curvy food, he won’t be able to pick any stocks, let alone outperform.  

But the differences between the good, bad and ugly in both investor categories can be substantial. And that holds for both the professionals and the amateurs.

One standard mistake made by private investors is that they forget to diversify. Research has indicated that it is best to diversify a portfolio over 15-20 different, if possible not too-correlated holdings. In case your portfolio is too small: stick to funds and avoid individual stocks or other securities. The average investor club or individual diversified his/her portfolio over 5-10 holdings. The excess risk that results from this is one reason for the relatively meagre performance. Diversification was a bit better in the groups, but there diversification did not follow the lines of correlation reduction. It was more a way to ensure that everyone in the group had something funny and interesting to do, with others being able to mingle in the discussions. I.e. we diversify the research, but please make sure that the group discussions in the meetings that decide on portfolio changes are ‘fun’ with all respected members being able to show how knowledgeable they are.

This phenomenon can explain why securitized portfolios that were so instrumental in explaining the credit crisis were not diversified enough. A good group process would be one in which bottom-up specialists prepare things, bring their research into a meeting with eachother and with top-down specialists, with the latter than deciding ultimately about allocations. That is not what is happening in the case of investment clubs I am afraid. Actually, it is not even true for most institutional decision processes either. As top-down specialists, we believe that our cooperation with Noble Prize laureate dr Harry Markowitz (mr Diversification if you like) has helped us to take an objective stand by using a helicopter view in which we give credit to the bottom-up specialists that we categorized as best-of-breed.

No, decision taking in investment clubs follows a different path. Barber et al. show that ‘good reasons’ are the dominating factors explaining buy decisions. ‘Good reasons’ are labels and categorizations providing a seal of approval / quality stamp to individual stocks, albeit that the same could apply to mutual funds. Factors that fall under the ‘good reason’ definition could be; i) incorporation in a most-admired list (e.g. the one by Fortune); ii) strong sales growth of a firm over the last 5 years; or iii) strong stock returns over the last 3 years. With respect to the incorporation in most-admired lists: compare what we wrote in our previous contribution about advertising by mutual funds! And the 3-year return track record is of course one-on-one in line with what we wrote about raw returns in our previous post. ‘Good reasons’ are useful quality stamps, but not necessarily so for achieving above-average investment results: you have to pay for them. ‘Good reasons’ firms are more expensive, so that net results on ‘good reasons’ portfolios can be lower than on a contrarian one. That is how markets work: if something is more desirable, more people want it. And this higher demand translates into a higher price.

The fascinating thing is that people in an investment club are not agents, but principals! So, why do they decide the way they do? In our contribution on Fund Manager Selection by institutional investors we will show that the old adage ‘No one ever got fired for buying IBM’ is an important explanation in an agency setting. But the Barber et al. research indicates that there is more at stake. Group decision taking incorporates innate behavioral problems that can lead to sub-optimal investment decisions with or without agency complications. Investment portfolios should – in the end – lead to diversified mixes of individual holdings or mutual funds that are sufficiently different. Selection of different things involves different qualities. Different qualities require different type of people/specialists. Group processes with different people might lack the ‘social fun’ or a group process in which all like each other, respect each other, have fun working together. And that is where things go wrong. It is most likely that this problem plays a bigger role, the bigger the organization is. Investment clubs are normally limited to just 10-15 people, and already with those small numbers, the problems are tantamount.

Interestingly enough, it is not true that this problem arises solely in groups. Be they institutional (with agency problems included) or private (principal-only). Barber et al. show that the ‘good reasons’ problem is also bothering most individuals on a stand-alone basis when selecting stocks, albeit to a lesser extent. We can extrapolate this behavioral finding into another plea for making sure that boutique, smaller asset management firms in which a charismatic set of key personnel plays a leading role are not forgotten within a diversified portfolio of funds.

Bottom line: taking the right investment decisions – be they the selection of fund managers or the buying or selling of individual stocks, bonds or other securities – is a complicated thing. Too often, do we show weakness to quality-related factors, or non-investment-related agency factors, or do we fall prey to naive extrapolation of historical results. The ‘good reasons’ work by Barber et al. confirms this.

Conclusion: good investing requires a complicated skill set, that is unfortunately less readily availabe than we would like. It is not very helpful that the average marketing or business development executive of big financial institutions tries to make us believe that they are big because they are the best in everything they provide. The same holds for investor relations personnel (or the CFO or even CEO) of stock-market-listed firms trying to convince investors to buy their shares and hold them longer. The difference between ‘the good’, ‘the bad’ and ‘the ugly’ is complicated when it comes to finding the best investment portfolio. Avoiding ‘bads’ and ‘uglies’ alltogether will lead to underpermance. Buying the bads is not an option either. The best strategy should lead to a diversified mix of ‘goods’ (‘quality’) and ‘uglies’ (contrarian strategy components), but as a decision taker you need a strong stomache to defend the latter category, especially in harsh times.

POSTSCRIPTUM

Application example 1; Emerging Markets 2008

The fact that Emerging Markets – even the ones with strong fundamentals – lost more in the credit crisis than struggling but bigger (‘good reasons’) developed markets gives you an idea about what we mean here.

We at Lodewijk Meijer continue to believe that only a robust, cost-benefit-based approach in which all pluses and minuses are made transparant to the final decision taker (‘principal’) can lead to structural outperformance. That is why we combine ‘best-of-breed’ specialist products of a mix of large firms and boutiques in a framework in which we only play the top-down, objective outsider role based on a framework that we developed together with Noble Prize laureate dr Markowitz. Humble when necessary, bold when based on something and boring when it comes to risk: that is the right way to go for investors in this new era. Unfortunately too many decision takers didn’t come to that conclusion yet.

Application example 2; Will our leader be capable of getting us out of the current crisis?

And that does also seem to hold for the ones that are trying to lead us out of this credit crisis. Initially the G7 leaders and ministers of Finance tried to do it themselves. With the smaller developed nations playing copy-cat in their own country. But hey guys, if you let liquidity first flow towards the Chinese and Arabs through the acquisition of products, oil or direct investments, don’t be surprised that – when suffering a problem – liquidity is somewhere else. The receivers of liquidity in the aforementioned nations did not automatically send it back to Wall Street or London. Sure, sooner or later it will come, but at their convenience. Only now, months down the road do we see markets slightly improve and leaders change talk from G7 to G20. Finally! The initial money spent was printed money of future tax payers. If we want it or not, cost-benefit-based thinking would imply direct talks with the Chinese, the Arabs and other sovereign wealth investors. Our leaders have to be bold and humble at the same time when doing so. Difficult, but possible.

The Social Face of Banking

By Paul van Oyen and Erik L. van Dijk

 

The world has been roughly shaken up by the rather un-social behavior of the Western banking system, especially in the U.S. and in Europe. As a result, the banking world is shaking on its very fundament of trust and stability. It sounds unbelievable that the greater part of the banking system in the USA and in Europe has fallen prey to the entanglements of greed and self-interest. The push for shareholder-value has driven the banking system into products that were so complicated that they could cover up the real risks as long as the markets kept on moving upwards. Banks have engaged in all kinds of complicated financial deals based on property investment, on life insurance policies and option schemes backed up by guarantees issued by other respectable banks in the West. These, and their derivates, are euphemistically called structured loans. On top of this there are many more forms of securitization of debt which have, as yet, not attracted the attention of the public eye.[1] In short, the western banking system is gravely sick and it looks as if the tax payer will have to face the bill if the banking system is to survive. There is no other option in present day circumstances. Here are some causes of our predicament:

 

·      Over a long period the system has been flushed with liquidity from the Central Banks, notably the Federal Reserve Bank. There was no lack of money for many years. Banks were like a cornucopia.

·      Low interest rates invited lenders and borrowers to increase lending and borrowing, creating an atmosphere of ‘manageable credit’ without looking at the facts. Rising property prices were considered a sound basis for repayment schemes. This turned out to be a major error of judgment.

·      Twenty-five years of being focused on ‘shareholder-value’ rather than on the interests of all involved as would be fitting for prudent leadership. The take-over of Dutch ABN-AMRO Bank for 80 billion Euros marked the limit of this seemingly endless sky.

·      Selling bad loans under the guise of triple A ratings is almost tantamount to telling lies. Supervision of banks failed. Accountants were condoning.

·      The remuneration of the top and its executives by means of a bonus system that had gone completely ‘out of measure’.

 

When, finally, the world woke up to these facts the global banking community was no longer ready to allow the interbank market to function properly. This attitude of mutual lack of trust only aggravated the situation immensely. Every bank(er) mistrusts the other bank(er) because they know how much ‘junk’ everyone has taken on their books. With taxpayers’ money ‘bad banks’ are now created to harbor all those bad loans. For the time being the interbank market is only partially available for funding the outstanding loans of the banking system. Governments have to step in with taxpayers’ money to fill the gaps left by the banking system. The result is a banking crisis of – as yet – unseen proportions and a number of banks have had to be taken over by various governments by way of a bailout. No wonder that in these circumstances new credit lines are not easily available for business and industry although they are highly needed.

 

As a further crisis measure banks in the Netherlands are actively closing down on the ‘underside’ of the market and refusing basic banking services to a number of enterprises on the grounds that they may be prone to the white washing of cash payments, even if these enterprises have obtained every form of ‘good conduct’ certificate from the local authorities and from the tax authorities. In short, using a Dutch saying: banks are more Roman than the Pope in Rome himself. For a public function, like banking, this is an unacceptable attitude and a number of businessmen are suing the banks, successfully, in this respect. Even if they are successful the attitude of the banks is fundamentally unsocial and it is important that this arrogance should be redressed. Such a ‘retuning’ of activities may be achieved from the inside and with the help of the government and the central bank, but it could also be achieved by setting up a new banking entity that would be willing to act, once more (as 100 years ago), as a Volksbank (people’s bank). The origin of the now respectable (triple A rating) Rabobank comes from this background.

 

Paul van Oyen: In my opinion the market is ready for such an initiative. In 1986 I had the unique opportunity of starting a small merchant bank in Amsterdam funded by investors from the Middle East (Bahrain and Kuwait) and from the UK. Unfortunately, the bank was converted into a savings bank. In its short time of existence as a merchant bank the bank was able to prove its useful function as a source of trade finance based on the bill of exchange.

 

Although the world’s outlook has dramatically changed over the past 30 years, the fundamentals are still the same. It is those fundamentals that are now under threat to remain neglected. This should not happen and it opens, therefore, a good opportunity for a new vision in banking: its public function as a service institute to the community based on the wellbeing of all involved. The function of a bank is to facilitate prosperity for all and not the excessive incomes of its executives. The duty of a bank is to get the facts and state the truth. Only the truth will vouchsafe credit, not lies or manipulated stories and dreams. Nobody has ever been able to actually eat an illusory apple.

---

[1] Renowned scholars like Noble Prize laureate Dr Harry Markowitz did however warn people for the innate risks of secured products. Already back in 1999 van Dijk and Markowitz gave a lecture at Nyenrode University at a securitization seminar in which they stressed that diversification is an even more important risk management tool for this kind of products than it is for traditional products. Many of the securitized mortgage portfolios that were an important cause of the crisis were not properly diversified: they consisted of mortgages only, to the same class of buyers and from one country.