Archive for Credit Crisis

Smaller Frontier Markets: Hidden Opportunity or Totally Uninteresting? The Trinidad Case

Posted in Asset Allocation, Emerging Markets, Portfolio Optimization, Risk Management, Uncategorized with tags , , , , , , , , , , , on April 2, 2009 by evd101

By Erik L. van Dijk


In the first entry to this blog we presented one of Goldman Sachs’s Next-11 countries, Iran, as an interesting ‘neglected country’ for speculative investors. On the one hand, we saw an economy built on huge oil and gas reserves (which provide a kind of collateral or put option to your investment strategy in the country) and on the other we saw growing signs of structural talks between the US and other Western nations with Iran in the political arena. The fact that Frontier economies like Iran and others (Kazakhstan, Vietnam, Saudi Arabia are also well-known representatives in this category) have a relatively low correlation with the MSCI World index and even with the MSCI Emerging Markets index are of interest to large investors that want to diversify their portfolio. But we also know that smaller economies are more sensitive to the potential risk of growing protectionism in a world that is struggling with the credit crisis. We did therefore decide that it might be good to look at a smaller Frontier Market as well, to see how things are going there.

Our Emerging Markets unit decided on Trinidad and Tobago. On the one hand (see also below) the country is not a tourism-dominated, one-dimensional banana republic, but one of the richest Caribbean nations with an economy built on strong oil and gas reserves. On the other, we see a relatively stable political situation, a leading role within the CARICOM (the regional cooperative entity between some 15 Caribbean states) and an English-speaking population. When we add to that a legal system that has tight links with British rules, it makes for a Frontier market that is definitely ‘unknown’ and ‘neglected’, but also not ”scary” like so many other exotic nations in this group.

In our databases we have daily stock market information about Trinidad and Tobago (TT) starting from May 2005. Almost 4 years of data split up in a good period for world exchanges (2005-2006-beginning 2007) and a disastrous one (second half 2007 and especially 2008-09). A relatively short period, but definitely an interesting one when trying to get a feel for Frontier Market investing, its opportunities and its dangers.

When we look at the index information (in USD) over this period, it is not surprising that the net result for the period is not a good one for global equities. The effect of the credit crisis is clearly visible in the numbers. The MSCI World index generated an annualized return of minus 7.82% for the period. When we compare that with the plus 8-10% positive return normally expected for global equities, it is clear that we are dealing with a dramatic  outlier here. Everybody states that when the rich, developed world is sneezing, smaller Emerging nations are catching a cold. Now, when we look at the annualized return over the period for the MSCI Emerging Markets index we derive a figure of 2.58% positive (!). So notwithstanding the fact that Emerging Markets did indeed drop a bit more than developed ones in the  2008-09 (until March 27)  period (-58.87% compared to -51.81%), their positive net result indicates that the value gain in the May 2005 – Dec 2007 period compensated for that. It was the period when the BRIC nations gave the leading Emerging Markets economies their new catalyst role. Obviously, some (e.g. Russia) suffered more than others, but all in all the correlation with developed nations was quite high, and return differentials not that big and there wasn’t really a big cold. When we look at the MSCI Frontier Markets index we see where the old adage about sneezing and catching a cold comes from: the smaller developing economies in this index were the ones struggling. The MSCI Frontier Markets index lost on average minus 14.65% on an annualized basis during the period May 2005 – End of March 2009! Trinidad and Tobago (TT in the remainder of the entry) was actually a big outperformer with an annualized return of minus 7.65% for their equally-weighted First tier stock market index and minus 8.03% for the marketvalue-weighted one. Lodewijk Meijer decided to look at both equal-weighting and value-weighting due to the fact that the TT stock market index is to quite some extent bank/other financials-dominated. But analysis made clear that although the banks and other financials did indeed suffer quite a bit, their story wasn’t as bad as that of many of their huge US and European colleagues that ended up at the brink of bankruptcy.

So, in and of itself the performance of the TT exchange wasn’t good. Relatively speaking the7 percent outperformance compared to the Frontier index was interesting, and so was the countries solid oil- and gas-based economic basis. If we add to that government initiatives to play a larger role within CARICOM on the one hand and ideas about setting up a regional International Financial Centre (IFC) on the other, we found it interesting enough to present TT as our representative small frontier market. And besides: don’t forget that the main stock market wisdom says that you have to buy low and sell high. So one could also present the bad performance of the Frontier Markets as an opportunity to step in if you believe with us that mean-reversion of global markets will indeed set in in 2009 (6-12 months before seeing the first signs of the economic recovery that normally follows the stock markets).

But it is not just that: we also looked at volatility (measured as the standard deviation of return) as absolute risk indicator and beta (indicator of systematic risk, measured as percentage average return when the world index changes 1%). High volatilities and high betas are then indicative of risky markets and low volatilities and betas of less risky markets. Since we compare things with the MSCI World index when calculating betas, the MSCI World has – by definition – a beta of 1. The MSCI World had a volatility of 20.53% annualized for the whole period and 32.76% for the 2008-09 period. That is a huge number. The 32.76% translates into an almost 35 percent likelihood that the actual realized return will fall outside an interval ranging from -22.76% to +42.76% when you expect a 10% return on stocks. I am sure that none of us will mind a more than +42.76% return with a probability of almost 17.5%, but there is a similar chance of ending up with another terrible year of more than a 22.76% loss! This is indicative of the turbulence in the global economy, with especially larger countries now being very nervous due to enormous tension of their financial systems, the unwinding of struggling hedge funds et cetera. In normal situations the Emerging Markets would have both higher betas and higher volatilities. But the beta for the period was actually 0.972, i.e. the Emerging Markets reacted more or less the same to bad or good news as the developed ones. Their normal excess country and firm risk  (in general) was compensated by the fact that our financial system in the West was under enormous pressure. The volatility was still higher in Emerging Markets, but actually not that much: 26.60% in EMs for the overall 2005(May)-2009(March) period (versus 20.53% for the MSCI World). And in the 2008-09(March) period the EMs went up to a volatility of 39.27% versus 32.76% for the MSCI World. It is indicative of a changing world in which the New World Order (with bigger role for China, India, Brazil and Russia) is gradually but slowly happening. And that will make Frontier investing more interesting as well. The BRIC nations are known to be more active with investments in the Frontier markets, see for instance how the Chinese and some Sovereign Wealth Funds are increasing their influence in Africa.

Frontier Markets are amazing when looking at their risk profile. They are the least risky ones when taking a first look at volatility and beta. The beta was relatively stable for the period (0.178 for the overall period and 0.188 for 2008-09). Far lower than the beta for Emerging Markets or the MSCI World. And the volatility was only 17.74% and 24.15% respectively!

How is that possible? Where is the investment risk when opting for a Frontier Markets strategy? Are they really less risky? Yes and no. They are less risky in that these numbers are correct. They do move less when analyzing day-to-day or week-to-week price movements. But what is going on here is to quite some extent related to illiquidity and thin trading. You can compare investing in Frontier Market public equities quite a bit with private equity in Western nations. Share trading is thin and that suggests a peacefulness that is only there as long as new news items aren’t too big or investor-induced portfolio trades (for non-firm or non-country related factors) not too dramatic.

Lesson 1 for the investors:

Never forget about illiquidity of Frontier Markets

When you go there, be sure to have a longer-term strategy based on fundamental (i.e. not speculative, trading-oriented) factors, especially when you are big.

When you are too big: forget about it.

And that brings us automatically to lesson 1 for the frontier country.

Lesson 1 for the country:

Make sure you create trust in your exchange.

And also ensure sufficient liquidity!

 And that is where TT has its main problem. Volatility levels during the period for the average firm in the market were so low that you might almost think that TT stocks were bonds. When looking to daily data the volatility was 4.78% over the period as a whole and 5.47% for the 2008-09 period. Academics have written tons of papers about the adjustments that are necessary to correct for thin trading, with the work of Scholes and Williams in the second half of the 1970s basically being the start. Without going into detail in this direction, we would like to compare the low volatility and systematic risk with what you could see in private equity strategies. In private equity we do not have daily price quotes as a result of which annualized return and risk levels are based on far less data points with a larger interval between them. To some extent the situation here is similar. Abou 3-3.5% is the turnover (as percentage of market capitalization of stocks) at the TT stock exchange. Compare that to the 50-100% rate seen on most Western developed exchanges! It is much closer to the 0 percent liquidity of private equity.

Question then: is the ultra-low liquidity enough reason to forget about a country? The answer is no. Frontier Market investors should know that the characteristics of investments in these markets do have quite some similarity with private equity. In and of itself that is not necessarily bad. Especially now, low correlations and low betas (TT has a beta of about 0 with the MSCI World) are qualities that can be of interest when creating diversfied portfolios. However, the investor should at all times be aware of this aspect of Frontier Market investing. Don’t do it when you don’t have the time to wait and/or the advisor with fundamental knowledge of the markets to support you.

Trinidad: The Country

Columbus arrived in Trinidad in 1498. The Island state has an overall size of just 2000 square miles, neatly situated outside the famous Caribbean hurricane belt. Initially the Spaniards occupied the country, but they never took the colonization very serious. In 1797 the territory became a British colony, a situation that lasted until its independence in 1962. Ever since the linkage with the UK has been prominent, with the British Privy Council for instance being the highest Court of Appeal, with the Caribbean Court of Justice (2005) – an institution of the regional cooperative body CARICOM – now being prepared to replace it. Politically this strong linkage with the UK has ensured relative stability in a democratic system in which not more than 2-3 political parties seemed to play an important role. It was only in 1990 that a Muslim movement led by Yasin Abu Bakr (Lennox Phillips) created some turmoil through a 6 day coup effort. But even in this case, the TT definition of turmoil turned out to be nothing like what we have seen elsewhere in Emerging and Frontier economies. Helped by large oil and gas reserves, the increase in oil prices in the 1970s and again in the period 2003-2007 has led to a tremendous increase in average wealth with now an income per capita in USD of $ 18,600. As is normally the case, political stability and wealth increase were highly correlated.

The small Island state (1.2 million people, of which 96 percent lives at Trinidad and only 4 percent at Tobago) has a remarkably mixed population, with 80% being of Indo-TT or Afro-TT descent. The Indian group is the larger of the two by a small margin. The other 20 percent is made up of Europeans (whites), Chinese, Syrians and Lebanese and mixed people. With political parties to some extent catering to the needs of ethnical and to some extent also religious groups, it is quite remarkable that the political situation is as stable as it is. And there isn’t really any reason to believe that this will not continue.

The only worry seems to be that the population is not growing at all with the relatively small (for Frontier Markets standards) net population growth rate due to births minus deaths being compensated by net emigration to (mainly) the UK, US and Canada. That could create problems for an economy with ambitious growth targets.

Trinidad: The Economy

TT has a GDP of US $ 24.2 billion. The GDP growth rate dropped recently from 8% to 5% and we foresee a further drop to about 3-3.5% due to the strong linkage with oil and gas. But it is still a growth rate and that is something that a lot of countries cannot show anymore in this period of crisis and turmoil that we are in. Governnment debt is low at 28% of GDP. The proven oil reserves are some 728.3 million barrel and gas reserves are at 481.3 billion cu m. Nothing like the huge reserve numbers we showed earlier for Iran, but still in general with a bit fantasy you could say that it is like a smaller version of Iran. Neglected, but with a nice collateral and in this case (to compensate for the smaller collateral) a situation where no one in the world has any problem with this sympathetic Island of steel drums, soca, calypso and limbo (contrary to what people think about the Islamic Republic).

Gas is recently getting more important than oil, with the country now being responsible for some 70% of the US imports of LNG. Oil and gas are responsible for 40% of GDP and 80% of total exports. But only 5 percent of employment is related to these industries and that helps explain the emigration trends.

But the government is trying to create a diversified economy, which looks like anything but a tropical island resort. Sure, Tobago is to a large extent tourism-oriented, but Trinidad has expanded in the following sectors: petrochemicals and plastics, manufacturing (steel, aluminum), cement and food and beverages. And even the old agricultural sector (a very important part of the economy before oil and gas prices started to rise in the 1970s) is not insignificant, with citrus, coffee, cocoa, rice and poultry being important crops.

The country posted a US $ 5.7 billion current account surplus over 2008, which is about 22.5% of GDP with the US being the most important trading partner (57.5% of exports and 20.2% of imports). For more detailed information we refer the reader to the CIA Factbook.

Not surprisingly with the US being so important and with economic results being relatively OK, the country had no difficulty to maintain a more-or-less stable exchange rate vis-a-vis the US Dollar. The TT dollar sells for about 6.2-6.3 to the US dollar ever since 2004.

The ambitious government of Patrick Manning, the prime minister, has indicated that its target is to become a developed nation by 2020. From frontier to developed in 15 years. Not impossible (look at Singapore), but a lot has still to be done. Especially in the financial system, and a government white paper, written in 2004, shows that the government is aware of this. The ambitious goal is to transform TT into an International Financial Centre (IFC) for the region. This regional approach of the government does also show a sense of realism (TT as stand-alone entity is probably too small to achieve very ambitious goals). But creating this IFC is easier said than done, knowing that we come from a low base in the financial sector and that regional cooperation through CARICOM implies that some 15 nations one way or another have to cooperate.

But there are a few factors that might help the government. First, due to the economic development in South America (mainly Brazil of course) and its strategic location between South America and the US, the interest in the region is indeed growing. Not just from regional parties, but also from Europe. The latter is also helped by actions from various European governments against tax havens like Luxemburg, Switzerland, Monaco, Liechtenstein et cetera. The region is already known for having a few alternative tax havens here (Cayman Islands, Virgin Islands, Barbados, Turks and Caicos et cetera) and TT will not copy their effort, but when international money flows will lead to a net inflow into the Caribbean area, the better developed nations will benefit if-and-only-if they do provide the financial infrastructure for the regional money inflow. Something similar happened to Singapore in Asia and Dubai in the Middle East. And that is the two examples that the TT government probably has in mind. What are the odds?

Trinidad: The Exchange

When comparing Dubai with Singapore as the two main examples we would like to use for TT, there are a few differences and they are important. Singapore has been successful because it was capable of not just transitioning the economy (with a huge role as regional transportation hub via the harbour and its prestigious Singapore Airlines), but also as financial center with a well-respected, developed stock exchange.  The creation of strong Sovereign Wealth Funds like GSIC and Temasek played an important role as well.

The Dubai story is younger of course, but we are not convinced yet that this ”walking on two legs” (economy and exchange) is successfully implemented here already. There is still a long way to go.

The same holds for TT. The first tier of the TT stock exchange lists some 30 stocks with a total market capitalization of TT $ 73.5 billion as of March 27, 2009. That translates into some US $ 12 billion, i.e. about 50 percent of GDP. A stock market size of 50 percent of GDP is reasonably OK for Emerging or Frontier Markets standards, but still low compared to levels in developed nations. And the reason is immediately clear when analyzing the group of 30 Tier 1 firms. With oil and gas being the main drivers of the economy, they are more or less absent from the exchange. A lot of economic activity is done by affiliates of foreign oil/gas companies and the main exception is Neal and Massy Holdings (NML). The NML conglomerate (with activities in other industries as well) is in market cap only 6.7% of the exchange, but holds an 18.4% stake of total annualized turnover. What is needed are more listed proxies for these two most important sectors of the economy.

In this respect, TT resembles Iran a bit. The Tehran Stock Exchange is also dominated by firms outside the oil and gas sector (with Iran Telecom since its IPO in 2008 being dominant). But countries that want to grow their economy and financial sector should be aware of the fact that international investors do not really like exchanges that are not a good proxy for the underlying economy.

Lesson 2 for the Country:

Do what is needed to increase the percentage of oil and gas related listings and trading at the Exchange

In terms of market capitalization the following 5 firms are the most important ones:

  1. Republic Bank TT $ 13.8 billion (=18.8%)
  2. First Caribbean International Bank TT $ 13.7 billion (= 18.6%)
  3. ANSA McAl TT $ 7.7 billion (= 10.4%)
  4. Scotiabank Trinidad and Tobago TT $ 4.9 billion (= 6.7%)
  5. Neal and Massy Holdings TT$ 4.9 billion (= 6.7%)

And in terms of stock market turnover, the top-5 is as follows:

  1. Republic Bank TT $ 604.1 million (= 31.2%)
  2. Neal and Massy Holdings TT $ 357.0 million (= 18.4%)
  3. Sagicor Financial Corporation TT $ 197.2 million (= 10.2%)
  4. Guardian Holdings TT $ 175.2 million (= 9.0%)
  5. Trinidad Cement TT $ 78.8 million (= 4.1%)

The much lower numbers of the turnover are illustrative of the illiquidity problem. In line with the government plans to stimulate the financial industry, both the market value and turnover lists show 3 financial firms: Republic Bank, First Caribbean International Bank and Scotiabank TT in the market value list; and Republic Bank, Sagicor and Guardian in the turnover-based list.

When looking at stock market performance over the period 2005(May)-2009(March), the top 5 performers were:

  1. Readymix West Indies (0.51% of the mv weight and 0.75% of the turnover weight) +37.67% annualized
  2. Trinidad Publishing Company (1.24% of mv and 0.28% of turnover) + 19.24% annualized
  3. Williams LJ B (0.05% of mv and 0.03% of turnover) + 11.34% annualized
  4. ANSA Merchant Bank (3.32% of mv and 0.69% of turnover) + 10.19% annualized
  5. Angostura Holdings (1.82% of mv and 0.68% of turnover) +8.60% annualized

In other words: the five best performing stocks were all relatively small (or less tradeable part of a bigger entity). Readymix is a cement producer, Trinidad Publishing Company is itself part of the also listed ANSA McAl conglomerate with the bulk of shares still being owned by the latter. LJ Williams is a trading / manufacturing conglomerate. ANSA Merchant Bank is just like Trinidad Publishing Company also part of ANSA McAl. Angostura is one of the main producers in the beverage sector.

The worst performers were mainly in the financial industry, albeit not necessarily the general banks.

Challenges for the Country

The big challenge for the country, when embarking on this route towards developed status by 2020, is how to attract foreign capital. Foreign – if possible institutional – capital will not only boost the economy, it will also provide it with the necesary seal of approval when moving towards International Financial Centre status within the region. Foreign ‘neglect’ by portfolio investors will automatically be interpreted as a logical confirmation of the ‘neglected country’ status.

But, to attract foreign capital, the stock market infrastructure needs to be improved. The 2008 survey by Transparency International from Berlin (Germany) gave the country a score of 3.6 on a scale from 10 (perfect) to 1 (totally corrupt). With that number the country ranks at place 72 in the world. The score is equal to that of China and Mexico. It is not dramatic, spot 72 in a list with 180 countries, but it is definitely not good enough if your ambition is to become a regional financial center.  

But there are good initiatives on its way or they have already been started. One of them is the creation of a Caribbean Procurement Institute in close cooperation with specialists from abroad. Assuming that TT can be successful in creating an improved regulatory framework, the next step is to ensure that there is enough to invest in for the foreigners.

Something that makes sense also when comparing it with the structure of the underlying economy. Some kind of (semi-)government vehicle could do the trick for the oil and gas sector, i.e. through some energy fund. An IPO of (part of) the telecom provider TSTT would also be an interesting idea, basically copying the example of Iran.

Fears about the outflow of capital are not valid in a country with such a huge current account surplus and a relatively small public debt service. The improvements in regulatory framework and liquidity of the exchange will translate in a reduced corporate cost of capital as well, thereby stimulating the economic growth further.

The expansion of the exchange and improvement of average liquidity of the available listings will also help in strengthening the case for the IFC when having to negotiate about it with the other CARICOM nations. In and of itself we do believe that TT does have the potential to become an important factor in the region. But to get from potential to realization in what has to be political lobbying with about a dozen of other nations will only work when the first seeds are sown. The economy is interesting for Frontier standards, but we at Lodewijk Meijer are less convinced that the financial system is as interesting yet.

That is not to say that knowledgeable investors should avoid investment in the country, if they want to allocate to Frontier Markets. But, only if you really have expertise in the country and a long term outlook (because of the illiquid trading) a direct investment in the stock exchange could be considered. There are some investment fund opportunities available. But they are illiquid as well. The alternative is to buy a stake in a mix of Neal and Massy (proxying the oil / gas industry next to some other industries where they are active), ANSA McAL (itself also a diversfied portfolio) and one of the banks (Republic Bank) as reasonable portfolio following the fate of TT in its quest for regional economic leadership. 

Challenges for Frontier Investors

TT is not different from any other Frontier economy in this respect. Thin trading, unclarity about rules and regulations and a developing financial industry with probably on average still quite a bit to learn compared to standards at home are all factors that Western investors willing to invest in the country will have to deal with. But for a long term investor, carefully following the macroeconomic story and politics while closely working together with a local/regional specialist it might be worth the effort.

The world is changing. Emerging Markets are here to stay in the New World Order and selected Frontier Markets are definitely gemstones in the years to come. Those with a solid economic base or commodity reserves might be the first to benefit from the globalization of investment portfolios of Western pension plans and Sovereign Wealth Funds from other places on the globe. Although of course relatively small, TT’s role in the Caribbean might make it a valid building block within a Caribbean Frontier portfolio. We at Lodewijk Meijer will carefully watch developments for you.


Professional Money Managers Admit: Risk Management Can and Should Improve

Posted in Manager Selection, Portfolio Optimization, Risk Management with tags , , , , , , , , , , , on March 23, 2009 by evd101

By Erik L. van Dijk

The EDHEC Risk and Asset Management Research Centre  has done a lot of good work during recent years. Especially in the area of hedge fund research, where it tried to bridge the gap between sophisticated academic work on the one hand, and the use of these concepts in practice on the other.  Lately, their work in the area of Asset Allocation has drawn attention as well. In 2008/09 researcher Felix Goltz of the French institute first surveyed a group of almost 300 high level European money managers, and then – based on the outcomes of the survey – contacted them again to discuss the results. The study led to some remarkable conclusions that shed new light on both the quality of players in the industry AND risk management quality during the credit crisis. We can therefore say that the study corroborated findings discussed earlier in this blog.

You can find the full EDHEC paper in the link below (at the end of this entry), but first we will provide you with a summary of the main results.

The main conclusion of the study is a harsh one:

practical applications of portfolio construction/optimization techniques and risk management in the institutional investment world fall short of what has been described in the academic literature as ‘state-of-the art’.

To some extent your author should feel guilty about this, because our Markowitz-Van Dijk framework for risk management and optimization/rebalancing is one of the more advanced systems that are available to practitioners when trying to better manage risk. Actually, MIT professor Mark Kritzman and State Street Scholars Seb Page and Myrgren, wrote a nice paper in 2007 indicating that our methodology was actually superior to other available methodologies. But there are more good systems. What is important is that risk management is not about doing things right whenever we feel like ‘doing another risk assessment’. No, what it is all about is that we apply the technique chosen ALL-THE-TIME and USING THE RIGHT ASSUMPTIONS.

The EDHEC study indicates that there is still a long way to go. Professional money managers do – as a group – apply optimization and risk management tools, but often not the right ones. Or they use the right ones, but use the wrong assumptions, or they do things right, but forget to continuously apply them.

A few of the major mistakes:

How to measure risk? Absolute versus Relative, and What About Outliers?

Optimization of an investment portfolio is about trying to achieve the maximum amount of return for a specific level of risk during a specific investment period. Or, the minimum amount of risk for a specific level of return. With respect to the calculation of returns there isn’t much of a problem. We all know that it is equal to the price return plus percentage dividend (in the case of stocks) or coupon interest (in the case of bonds).  More problematic is the derivation of the right risk definition. It turns out that by far the largest group of professionals uses an absolute risk definition, be it the so-called Value-at-Risk (VAR) or the volatility. Absolute risk factors are good when analyzing a portfolio decision, without comparing it to some kind of benchmark. However, professional investors are by definion always invested in something. They could for instance hire our friend King Kong with the darts to manage portfolios or flip coins. The market average of such a strategy would then provide a good benchmark, with the difference compared to this benchmark being the quality/skill (or lack thereof!) of the professional money manager. Strange therefore that only a minority of professionals is thinking first and foremost in relative terms, notwithstanding the fact that folkore (?) within professional circles always explains that wealth management for private investors is about absolute risk and return indicators, with the real institutional professionals focusing on relative return and risk indicators. It is true that professionals do pay special attention to alpha as a measure of excess return (= Return strategy minus Return benchmark) and tracking error (= standard deviation or volatility of the excess return), but somehow they do not integrate this in the optimization or risk framework. They seem to use excess return for the calculation of variable fee (bonus!!!!) levels and tracking error as a kind of constraint (‘avoid tracking errors in excess of x percent’).

VAR and the Normal Distribution of Returns

Another mistake made is that – when applying absolute analysis – the majority is using a Value-at-Risk (VAR) framework while assuming a normal distribution of returns. However, we all know that – during extreme periods like the one at hand – the likelihood of extreme events happening is far larger than what the normal distribution tells us. Normal distribution theory assumes that events that are 3 standard deviations away from the average have a chance of occurence of 1 percent maximum. Events 2 standard deviations away from the average have a chance of occurence of 5 percent maximum and events 1 standard deviation away from the average  about one-third. Result: dozens of chief risk or investment officers of even big firms (e.g. Bob Littermann at Goldman) had to tell journalists last year that things that initially were supposed to happen just once every 10,000 years happend two times within a year. In other words: due to the normality assumption there was an underestimation of the ‘fat tails’ in return distributions caused by the fact that people either exaggerate when in panic (excess pessimism) or when too enthousiastic (irrational exuberrance). As a result of the fat tails the value-at-risk is much larger than what can be derived based on the mean and variance. Actually: what is the use of applying VAR when assuming that distributions are normal? In that case the whole distribution is already defined by the mean return and the variance of return!

‘Too complicated for the clients’

Some managers even suggest that they do not apply top-level risk management and optimization techniques because clients don’t ask for them, or would actually not understand them. That is an insane line of reasoning when you would for a second see the investment specialist as a kind of medical doctor trying to cure the financial health of his patient, a.k.a. the client. The average patient in a hospital doesn’t understand anything about Medicine or all the complicated machinery and/or pharmaceuticals used by the doctor. But be sure that patients wouldn’t be too happy if their doctor thinks like this! Thank God it was just a minority of specialists putting forth this line of reasoning. But the fact that alleged professionals dare to think like this is outrageous and indicative of the necessity for increased professionalism within the industry.

The Not-Invented-Here Syndrome

Academic risk and optmization techniques do have a large quantitative component at a level considered difficult by most graduate students or professionals that went for an MBA. It is Ph.D kind of stuff. As so often things that are considered difficult are surrounded with a feel of them being ‘magic’ (at best!) or even ‘pure theory’ (very often!). Result: to the extent that senior management in an investment organization is willing to apply these methods it is too often the case that the one’s that have to decide are not themselves specialists. This creates a feeling of not being totally in control as a result of which there is a preference to use these techniques only when the knowledge is available internally. Why? Well, external specialists cannot be that easily controlled and they are also more expensive. ‘Prudent’ thinking implies that you do not spend too much on things that you don’t totally understand, right? But after some time in this inward-looking culture within the machoist financial industry something else happens. People start to actually believe that they are good internally, not hearing the real specialists (who work outside the firm) anymore and being surrounded within the firm by youngsters that won’t dare to be too critical because that might hurt their career. A so-called Not-Invented-Here syndrome can then set in easily.

The Age- or Vintage-related Knowledge Gap

As long as it is true that senior managers are on average by definition older, with knowledge developments in the young investment science going relatively quick, we will notice that the average younger graduate – still working at lower levels within the organization – is more knowledgeable than the older, senior people. Sure, the older ones have more experience and qualitative knowledge. But risk management and optimization are first an foremost about quantitative skills. And that leads to an age- or vintage-year-related knowledge gap with the ones that probably understand less about risk management and optimization being the ones that have to decide. This is dangerous, and we do strongly believe that to some extent the credit crisis is directly related to this problem. Not to the least, because men have a tendency to be overconfident, as we already indicated in an earlier contribution.

What is New! Sign of Changing Times: Mea Culpa

Not much good news, it seems. However, in one area there was a remarkable difference between the reaction of the top-level professionals to the EDHEC researchers when asked about the survey results now, compared to similar reactions before. Before it was almost standard that – whenever something was academically-oriented or mathematical – practitioners would discard it as being ‘theory’, ‘impractical’ and/or ‘irrelevant’. They would never ever confess that it was too complicated and that they actually did not really understand what it was about. Maybe also due to the credit crisis, and the resulting first indications of some modesty, do we now see that there was something of a ‘mea culpa’ with professionals admitting that they were the ones that were to blame most. There was according to them a big need for additional education. Something that we at Lodewijk Meijer would be pleased to be involved with. But as a kind of mea culpa on behalf of all academics or semi-academics with strong professional roots, we also admit that too often university- or business-school-organized courses were indeed to theoretical. The top scholars never had the responsibility over big multi-asset portfolios that had to be managed on behalf of an end-client represented by a board who applied complex goal functions concerning the way in which the portfolio should be taken care of. And that was difficult, because traditional optimization techniques suffer from the existence of too many constraints. Constraints that are the standard reality of life for practitioners. That is why Harry Markowitz and I myself worked on our new ‘near’ optimization technique, later labeled Markowitz-van Dijk by Kritzman c.s. Scientists with at least some knowledge of hands-on asset management should also try to explain things in a clearer way. But the majority of the professionals with self-criticism made it clear that this was only a secundary reason.

What about the US?

The EDHEC study was primarily about asset management within the European institutional community. What about the US? We said at many occasions that the level of asset management in the US was on average higher than in Europe, and we still believe it is. But even there, the situation is not good but at best mediocre. The focus on stock picking and return is too high, which leads to overconfidence. Results can be improved by better incorporation of risk management and portfolio optimization. It is illustrative how Kritzman’s study indicates that something as simple as efficient rebalancing using Markowitz-van Dijk can easily improve net results by 0.5 percent or more per annum. And that is a lot of money for institutional investors who often have assets under management in excess of USD 500 million. A simple statistical tool can in that case already improve net results by USD 2.5 million per annum! It is therefore not surprising that almost none of the participants in the survey listed ‘costs’ as a prime factor for not applying these modern, state-of-the-art techniques.


Professional money management is an industry under construction. Knowledge levels can and should be improved in a few areas, with risk management and portfolio construction certainly being one of them. Based on the findings in the EDHEC survey it is not surprising that something like the credit crisis could happen. When you are not in the driver’s seat in a risky and changing market, how can you expect to be able to avoid major pitfalls and panics?

It is good to see that the prime actors are at least modest in this respect, something that we did not see sufficiently yet when it comes to bonuses. We are convinced that – with the guidance of the regulators and the interest of the main actors in ongoing education in these areas – improvements are possible. Increased competition between providers, better manager selection by specialized parties who help distinguish between the good and the bad, and interesting opportunities for implemented consultants willing to organize courses will collectively help improve things. But in the meantime end-clients have to make sure that they select professionals that do pay attention to portfolio construction and risk management in a sophisticated manner. Something easier said than done, because of the high abstraction and math levels involved in these applications. Whenever you feel that our support could be of help to you in taking the right decisions in this area, do not hesitate to contact us.




Investments 101; What we can learn from Chess Grandmasters

Posted in Behavioral Finance, Manager Selection, Uncategorized with tags , , , , , on March 17, 2009 by evd101

By Erik L. van Dijk


Two years ago I had the pleasure to sponsor of a chess team. Not just that: the pleasure even extended to becoming Dutch champion with the team. Even some of the big teams in Russia saw us as serious contestant for the European Club title. Unfortunately we didn’t get the funding right so as to compete with the Russians in that competition. But that we made it to Dutch champion was nice. And to a certain extent not so complicated: analyzing my budget (the cost side), I explored what good grandmasters would cost per game. And then we hired some of the strongest players in the world, using the FIDE (= World Chess Federation) rating list. This rating list was based on a methodology developed by the Hungarian professor Arpad Elo. Basically what that rating system does is giving players points for victories and penalties for losses, while at the same time incorporating differences in playing strength based on earlier achievements. The latter is important: if I join a chess club as a new youngster, and happen to be in the same club as a famous grandmaster, obviously my draw against that guy is not really a draw when trying to calculate my rating score. It is a sensation that should be rewarded with an increase in number of rating points. The same token, the grandmaster should be penalized for this unexpected lousy draw. Et cetera. If you then continue with that performance calculation system for many years, rating all the players in the game, you get a very nice system that will give you quite some accuracy with respect to expected  tournament results. Result: Grandmasters are really Grandmasters! The nice thing was that – both as a sponsor and representative of the board of the Dutch Chess Federation – I met with quite a few of those geniuses. And geniuses they are. Nothing like King Kong beating the professionals here. Top grandmasters can play blindfold chess against you as an amateur having a board, seeing the pieces, in not just one game, but dozens of them! Yep…the incredible quality of a top specialist.

Now back to investments. It looks so simple. All investments are about return (the positive variable), stability of returns (also positive), risk (negative to the extent that it is bigger than what an investor is willing to take), risk preference (who is the investor, what can he afford, what is his investment style, et cetera), investment type, correlation with the rest of the investments in portfolio (the lower the better), sensitivity to outliers, et cetera. Yep, everything in there can be measured to quite some extent.

Now, how come we find it so difficult to distinguish between good and bad investors or investment opportunities? If you talk to the average professional investor and tell him about the chess grandmaster, his first thought is that chess is a far simpler activity than investments and that it is being played by nerdish, mono-focused guys. Most of the time they tell you so, without even really knowing the game. And in the end, it cannot really be true. Take the following example: if we simply ignore the factors in the ”model” that you are using (either an implicit model when you are a fundamental style investor, or explicit when you are a quant), then at the end of the year you either beat the benchmark (be it some kind of index, or your required rate of return if you want to define the game in absolute space instead of relative space), are about equal (i.e. a draw), or you lost (underperformance).

The averave chessplayer, when talking to him about investing, never assumes that his game is more complicated, but it is striking that brilliand amateur investors (read: chess players) do often have very smart things to say about the problems facing investors. Reason: they recognize it as another kind of game. And chess grandmasters are game specialists. But investments defined the way we did before are a kind of game too. It is you out there against the competition, i.e. the other investors / the market. There are certain rules, there is a (hopefully level) playing field, there are various competitions (Dutch equities, US bonds, Asian Real Estate and so further), so play if you wanna play.

The main difference is also not the decision models used. Sure, there are a lot of important factors to take into consideration when analyzing your investments. But top-level chess is multi-factor as well. It is just that the factors are different ones. And the number of opportunities in investing is not necessarily bigger than that in chess. Equity strategies, or hedge fund strategies can be compared with playing ‘open’ positions with either not too many pieces on the board anymore and/or pawn structures where nothing or not too much is blocked. Blocked, closed structures are more like fixed income strategies, et cetera.

No, the real difference is that somehow big investors can make far more money than top grandmasters. And investors work in firms/structures led by shrewd managers that are all about indeed making a lot of money, not just for the investor, but for themselves as well. The average chess grandmaster is far less money savvy, and often more interested in playing a nice game, enjoying a nice location when playing a tournament, et cetera. How does that translate into differences between investing and chess? There is more at stake when being ‘bad’. Clients will withdraw money from your portfolio, bad returns translate into lower fees on existing client money, your boss might fire you, et cetera. So basically, whereas chess players didn’t really mind Professor Elo and the FIDE to develop that nice rating system, there is some kind of tendency among the average player (and that is the majority, just like in chess) to avoid becoming the bad guy. Result: smoke screening and a lack of performance measurement in a robust way.

Parties like Morningstar, Lipper and some of the better institutional manager selectors like Bfinance, Russell and ourselves (albeit all with slightly different decision models and goals) try to change that. But, professional investors are most often dealing with money from third party clients. Chess players on the other hand play for themselves. Sure, sometimes they do participate in team matches, but even there you can see that this ‘collectivity’ aspect doesn’t really change things, because it is in the end about the impact on the rating. And rating in turn decides on your position in the World Rankings.

The confusion about performance in investments has been further articulated by the fact, that clients and their advisors are sometimes not really certain of what they want and how they want it. Indeed, that is related to what we said earlier about ”Good Reasons”. They often assume that naive simple performance graphs over the last 2-5 years tell the story about how good or bad a manager is. And the traditional overconfidence aspect is also there: when we ourselves as investor go through a nice series of good performance, we often assume that we are a great investor. But as we saw in an earlier presentation, you need 8 years before 100 naive King King investors flipping coins might be de-masked as charlatans.

So we truly need more objective, Elo-like analysts of markets. A role that we at Lodewijk Meijer try to fulfil. Not to be the standard criticaster standing at the sideline, blaming the professional asset managers for doing a bad thing. It is a fantastic, difficult, impressive thing to outperform the market. So we are full of admiration for the truly strong ones, but only if they do have the investment philosophy and detailed analysis to show that it was skill and not luck. In other words: just like it was in chess, the strong guys like me, the not-so-strong guys that want to learn might still like me (maybe I know some place where they can improve skills in the area that led to the defeat they just experienced!) and some of the sincere bad guys might for the same reason still like me.

But….who really won’t like me, is the big investor trying to look bigger and better than he is. We will do all we can to de-mask him, warn potential clients. Not just in the interest of the client, but also in the interest of the asset manager. If ther is one thing to be learned from markets, then it is that being in there for the quick buck will in the end always hurt you. Tulipomania in the Middle Ages, Daytrading without having either a structured model to exploit small inefficiences and/or a position as broker so that your costs are lower, Insider Trading, Stock Market Fraud, short-term decisions based on short-term factors whereas you are a long-term investor…they all have led to disaster for the investors following that kind of strategy.

And even if you work hard, avoid overconfidence and specialize, you still need to make sure that you do not put all your eggs in one basket. Diversification – one of our core themes as incorporated in the Markowitz-Van Dijk approach to asset allocation – is part of the story as well. Even the strongest of grandmasters, be they Fisher, Karpov, Kasparov, Kramnik or Anand, they all have a so-called repertoire in which they play more than one opening so as to be sure that a) they are less predictable; and b) in case one or the other opening is somehow not functioning, that at least the results in the other opening might probably be uncorrelated.

From the grandmasters mentioned Russian Anatoli Karpov was probably the ”laziest” with the narrowest reportoire. So why was he world champion for such a long time? Was it luck, because the rest was bad? No, I do not think so. He was very much aware of the fact that he was not the hardest worker on new ideas at home. But he also knew that his endgame strength was fantastic. So even if the position during opening and middle game was somewhat inferior, he might still turn the tide in the endgame. Knowing that, he in a way optimized his strategy by focusing on a simple game plan, exchanging pieces relatively quickly, avoidance of hectic turbulent positions with potential for dangerous attacks and sacrifices, all to just get to the endgame quickly. Isn’t that like top specialists in low-beta, low-volatility asset classes? E.g. Fixed Income or Money Markets. On the other hand guys like Kasparov who play every game for a spectacular attacking win, have to work harder at home so as to know much more by heart before the game. Similar to what we can expect from an equity or hedge fund manager, for instance. Or a specialist in Emerging Markets, where often the data set available is still too short.

So, as long as we do not have a rating system like the Elo system in investments, it pays to compare asset managers (either at the firm level or at the level of individual products/lead portfolio managers) with chess players. If they like that or not, we don’t care. It will help us avoid all kind of pitfalls in what is in the end a similar type of game.

From to Chess to Credit Crisis

So why then the credit crisis? Can we still use the metaphor of chess when looking at the crisis? The answer is yes. When alleged specialists turn out not to be specialists, i.e. the players in our championship weren’t the best, there is a big chance that organizers and owners/sponsors (us as end-investors) might freak out and put pressure on our non-delivering ‘stars’ that weren’t stars after all. OK, there are excellent specialists out there that couldn’t help us avoid the crisis, but at least they will ex-post know that the basis for their giant status was laid in periods like the one at hand. When the going gets tough, the tough gets going.

In the mean time we have to go through the motions and make sure that we filter out the bad guys. As long as the ideal rating system is not there, we might use ”bonus” and ”fee levels” as a proxy. Research has indicated that the best money managers are not the ones charging the highest fees. On the contrary, true specialists want to attract a large portfolio so that they can earn their excess return fee over a larger Assets Under Management base. Attracting a large portfolio is easier when fees are not too high. Lousy players pretending to be good know that the likelihood of earning that performance bonus is small. Therefore it is better to charge a high ex-ante fee.

And about performance bonuses in banks. Nothing wrong with it if the bonus is related to TRUE outperformance. But too often do we see that bonus structures in big financial institutions are not related to a definition of performance that is in the end in the best interest of their clientele. Not even is it in many cases based on benchmark levels that are really difficult to beat. And in some cases there are no high watermarks assuring that lousy performance in the past will have to be compensated for in the future, before being entitled to a new bonus.

Obama was right to be angry to many bankers and to investigate what he could do. What we can do in the mean time is use eagerness to score bonuses or fees as a negative proxy with respect to future performance.

I hope that this chess-based reflection gives you some basic ideas concerning what you could look for if you do not have a full-fledge rating system.


Within the chess world there is a lot of discussions going on, indicating that even there people are not fully satisfied with the Elo rating system. However, it is far better than nothing, and far better than what we have in the financial world. There is still a long way to go. And it is good to see that there are a lot of intiatives going on that will help you to distinguish good from bad much better than you could in the past. I will be more than pleased to brainstorm about this more, if you desire.

In our next entries we will of course go from metaphor back to daily market movements and hands-on analysis of products and markets.

Word from the author (belonging to the entry below about Fund Manager Selection by Institutional Investors)

Posted in A word from the author with tags , , , , on March 15, 2009 by evd101

Our entry about the activities of Institutional Investors and their investment styles – see below – is rather long. I am aware of the fact that readers don’t like blog entries to become too long. Normally we will limit our entries to some 1000-2000 words, like we did up until now.

However, because of the important link between actions by institutional parties and the current crisis, we did believe that it would be wrong to oversimplify things. We therefore decided to use 3000 words to explain things more rigorously.

I hope that the reader will appreciate this. By distinguishing between types of institutions, we learn a few things. First, some of the institutions invest like private investors, but with the an added knowledge base, whereas others are actually working in such a structure that the true specialists have insufficient power compared to non-specialists taking the main decisions. Result: awful mistakes, excess middle-of-the-road strategies, overconfidence in allegedly big names and not enough focus on performance and risk management.

To some extent we can therefore conclude that – whereas the system was supposed to rely on institutional investors being true specialists advising the non-specialists – institutions were instrumental in explaining the credit crisis and not in helping to avoid it.

On the other hand, the bravest of these institutions will probably also help us out of the crisis, together with Sovereign Wealth Funds. The Wealth Funds are a new category of investor that became important during the last 10 years. We will study them separately in a future blog entry.

For individual investors and their advisors reading the entry on Institutional Investors: we hope that our critical notes will help you in your decision process. Some are good in one thing, others in another and as a group they were disappointing. That is not to say that there aren’t true best-of-breed champions out there. There are, and we are of course pleased to help you finding them, when you come to the conclusion that it is too complicated to distinguish the good from the bad.

And of course, non-specialist institutional investors that have to invest: use a good consultant. Investing is complicated in and of itself, and knowing how complicated it becomes to take investment decisions in a decision structure in which you also have to incorporate the desires and demands of non-investors and/or take into account non-investment-related aspects (e.g. very important in family offices or endowments!), it is good to know who is good or bad in what.

That is what we try to achieve with or long piece. If instead of making you fall asleep, it will trigger discussion or comments, we will feel that our decision to write something too long for blog entry standards has actually worked!

Enjoy our next entry,

Erik L. van Dijk

Fund Manager Selection Part 2; The Institutional Investor

Posted in Behavioral Finance, Financial Markets, Manager Selection with tags , , , , , , , , , , , , , , on March 15, 2009 by evd101

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.


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.

The Social Face of Banking

Posted in Financial Markets with tags , , on March 8, 2009 by evd101

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.

What we can learn from the Credit Crisis

Posted in Asset Allocation, Emerging Markets with tags , , , , , on March 6, 2009 by evd101

By Erik L. van Dijk


On Feb 11, 2009 one the brighest minds in asset allocation, Robert Arnott, gave an interview to US market information provider Morningstar. Arnott, the founder/former CEO of First Quadrant, a firm specializing in asset allocation strategies, made a few things clear:

1) As we already knew from earlier work from French scholar Prof. Bruno Solnik, the only thing that will certainly go up in a period of crisis is global correlation levels. With the exception of maybe gold and frontier markets that are truly secluded – like for instance the IR Iran, the topic of our previous post – everything will one way or another be hurt. Even the Fixed Income markets are not really providing investors with a safe alternative in a period when panic strikes, risk premiums go up and even the safest of the safe end up in big turmoil. The developments in the financial sector were indicative in this respect.

2) When looking at a Diversification 101 lesson that can be learned from our own Harry Markowitz’ s work, or from any MBA text book, the basic idea ‘Stocks for the long run, and Fixed Income and other securities for the periods in between when stocks are not delivering’ is fine. However, we should never forget to define our risk budget in a clear way and above all: stick to it.

3) With respect to 2): the lesson to be learned from Behavioral Finance is that people tend to overestimate their skills in good times, and then – when disappointed – turn to a kind of total disbelief in their own or other’s skills. The outbreak of panic that will follow can lead to disasters, similar to what can be seen in tragic accidents in football or soccer stadiums, when a little fire can cause many deaths in the audience. Not because of the fire itself, but because – in panic – most people want to leave via the same exit. It is the stampede that follows that kills, not the fire. Actually: if all those people running away from the scene would have joined forces, take of their jackets and throw them on the fire it is quite certain that the problem would be solved. The big killer in the crisis is the actions/trades of the ones in panic.

4) So basically, what will happen then, when markets slide into an enormous downfall because of the massive sell-off of shares with all ‘smart’ loss-takers thinking the same smart thing at the same time – as a result of which it is not that smart anymore – is that a situation is created in which smart money can earn a lot. Real winners are made in periods of crisis, not in normal periods. However, when everybody gets crazy and the savvy hold their breath and wait for the bottom level of the market to arise, we should be aware of the fact that the best investors that want to wither the storms by telling their followers that markets are exaggerating will look just as wrong as bad investors do in a normal period. Distinguishing between a top-level investor and an idiot becomes harder in a crisis period.

5) And there will be chances, a lot. Especially further from home, in niche markets that are allegedly risky in the eyes of the global investment community. It is a given that both private and institutional investors tend to have a stronger home bias in crisis times than in other periods. Result: the sell-off was largest in the Emerging and Frontier markets, notwithstanding the fact that economic growth numbers in these markets were not as bad as those in the West. And this is especially strange when also taking into account that these countries have a much smaller percentage of their market cap weights in financials, the sector were it all begun in the 2007/08 (and maybe 09?) market meltdown. I am sure that there will be blue chip investment opportunities in market leaders in Emerging Markets at a price of 3-5 times earnings. PE’s that low do not make sense, and neither does the  fact that the global market cap weight of Emerging Markets is down to 7 percent, a similar level as before the 1997-98 Emerging Market crisis. Things are really different in these countries this time around. China, India, Brazil and Russia (the BRIC nations) are big players now with solid economic home bases, notwithstanding their short term problems because of the crisis. Oil and gas prices are higher than back then and will definitely go up again to levels that might not be as high as what they were last year, but still.

6) But now we have another problem that haunts us. It is risk budgeting related. Institutional investors work with risk budgets, and they should. The ones that apply this technique in a prudent way and directly link it into their asset liability modelling should actually apply the technique in such a way that they do – as an average over the cycle – take a bit more risk when prices are low and less when prices are high. Unfortunately, we often see the opposite. Above average risk taking in times of positive momentum and high stock price levels and below average risk taking when prices are low. Reason being primarily that it is easier to convince the board to allow more risk when you can show nice, upwardly pointing stock price graphs than when you see disastrous graphs with share prices going down, lots of firms going bankrupt et cetera. Psychologically, investment specialists in the pension plan community are normally not fired when buying stocks with nice track records too high (”How could I have known that some kind of change of fortune was on its way? All colleagues were buying this stock too!”), but when something goes wrong with their investment advice when things are going down the drain, the risk of being fired is much higher. This kind of people risk, is a behavioral factor that is still playing an important role in day-to-day institutional money management. Actually, a much bigger role than it should.

7) Now, the problem with market extremes is the following. A simple mathematical exercise will provide you with a clear example:

When prices drop 10 percent (from 100 to 90), we need an 11 percent (10/90) increase to be back at the 100 level. When prices drop 20 percent (from 100 to 80) we need a 25 percent increase (20/80) to be back at the 100 level. When prices drop 50 percent (from 100 to 50) we need a 100 percent increase (50/50) to get back to the 100 level, et cetera.

In other words: the rebound of a market has to be bigger the bigger the crisis is. And the current one was and is big.

8 ) Now, another characteristic of crisis periods is that most risk indicators – like market volatility – go up tremendously. Often to levels 50 or more percent higher than normal. This will imply that market participants that are willing and able to take the plunge and act countercyclically to be among the first to benefit from the crisis will need big risk budgets to benefit. And often, besides being counterintuitive because of the personal risk involved, they don’t have space for that after the calamities that have happened during the crisis.

9) This will in turn imply that two things are really important during the recovery period after a crisis:

9a) Try to find recovery opportunites that add as little additional risk to your portfolio as possible. That is why actually some frontier markets might be of extreme interest (low correlations; compare Iran in our previous post), or asset classes that normally get a relatively low weight.

9b) Buy quality for the longer run. One of the characteristics of a crisis is that people in panic don’t care about anything anymore. For them shares are not securities that entitle them to a share in the firm’s profit, but lottery tickets or casino games that only cost them money. And not just that, they are financial instruments that embarrass them. Sell, sell, sell! But this implies that – when the crisis reaches its end – the battle field will be full with quality firms with now amazingly high dividend yiels (often many times higher than the interest rates available in the market), low PEs and huge potential for growth in the years ahead of us. These strong firms will have themselves nice opportunities to acquire struggling colleagues so as to stimulate revenue growth further, et cetera. In other words: it is the period when the difference between growth and value stocks, and growth and value markets is smaller than ever. Use that fact.

10) Are guys like Arnott and ourselves optimists? Nope, we are just the ‘boring guys’ (Harry Markowitz once used this phrase). Most people – be they institutional or private investors – don’t like what we do in good times (since we don’t take enough risk and are not willing to pay 50-100 times earnings for great momentum stocks in IT, Biotech et cetera) and neither do they like our relative calmness in periods of collapse and crisis. This is not the end of the world, just the end of momentum hunters that went in too late when markets were going up, and now go out too quickly when markets go down. Since we do not know exactly when the shift into upwardly trending markets will be there, it is quite well possible that we will be too early. If that is the case, we will loose a bit before we will win. That is the price of being a smart asset allocator: people will not really like you in the upward phase of a cycle and neither will they in a crisis period. They will only love you over the whole cycle, and even more so over more cycles. This is about sticking to a long-term rational philosophy in which the technique of how to do things is universal and eternal. The individual stocks, asset classes, countries that we like and don’t like do however change, because they will be going through phases. Paul Kennedy’s book The Rise and Fall of the Great Powers gives a good example of how this same line of reasoning applies in history and politics as well.

11) Last but not least: it is not the end of the world. The growing opportunity set is already visible. Be prepared – if and only if you do have space in your risk budget – to try something, but be also prepared to buy things you didn’t buy before. Fundamental indexing is an interesting tool to help you now. Analyzing the difference between stock markets based on market value weights vis-a-vis fundamental weights based on PE, PC, PB, dividend yield, earnings growth and/or revenues might reveal easily where the opportunities are. At the same token, we should concentrate again on Emerging Markets: the fundamental weights of this part of the world are indeed already in the 30-35 percent area with market cap weights now as low as 5-10 percent. That is a huge mismatch. In other words: due to behavioral factors too much money flew back into Western stock markets or savings accounts when things went wrong. Now, with rock-bottom stock price levels and interest rates, it might be worth the effort to look for the true gem stones in the emerging markets. But, never ever forget the risk budget. And the old Markowitz diversifications lessons: when understanding that Gazprom in Russia is now really to cheap, don’t put all available equity money in that stock but add the best opportunity in an country/industry least correlated with Russia and Oil/Gas that also provides you with a quality bet. Optimization and risk management become more important in a period like the one immediately after the crisis, because a good approach in that area will help you recover quicker with relatively less risk which will improve the return/risk profile of the portfolio substantially. And that is really necesssary after the disaster of the crisis period that has just ended.

For the full 4-5 minute interview of Arnott with Morningstar CLICK HERE.