Satyajit Das: Capital Preservation Key to Survival

Satyajit Das
Profile: He is an expert on financial derivatives and risk management
Known for: His book ‘Traders, Guns and Money’ was almost prescient in the way it foresaw the troubles of corporate India with derivatives in 2007

Investors approach investment in the same way that Woody Allen approached the subject of divinity: “If only God would give me some clear sign! Like making a large deposit in my name in a Swiss bank.” For the last 20 years, despite occasional lapses, the mysterious investment gods have given clear signs of their existence — showering munificent high returns on investors.

As smart investors know, investment genius is a long position, leverage and a rising market. A rising tide, as they say, lifts all boats. But that may now be all in the past.

The global economic recovery is stalling. Major economies, such as the US, Europe and Japan remain mired in slow, low growth as they deal with legacy problems of debt, banking problems and deep-seated structural imbalances. Germany and emerging market economies, like China and India, which have contributed the bulk of global growth since 2008, are showing signs of slowing.

Government policy options are severely restricted because of excessive debt levels and the reluctance of investors to finance indebted sovereigns. Interest rates in most developed countries are low or zero, restricting the ability to stimulate the economy by cutting borrowing costs. Unconventional monetary strategies — namely printing money or quantitative easing — have been tried with limited success. Further doses, while eagerly anticipated by market participants, may not be effective.

If markets seize up again, then “this time it will be different”. There might just not be enough money to bail out everyone and every country that may need rescuing. The rapid and marked deterioration in economic and financial conditions means that the risk of a serious disruption is now significant.
Emerging markets face additional problems. The effects of the excessive credit expansion in China and India are showing up in bad bank debts. Emerging markets face significant losses on their holdings of G-7 securities in which foreign exchange reserves are held. Imported inflation, primarily in energy and commodities, is also an increasing concern.

The Viagra of investment – leverage – which drove high returns pre-2007 is also now unavailable as the global economy reduces debt.

As the global economy resets, the prospects are for lower returns and increased volatility. The US stock market took 25 years to regain its highs after 1929. Japanese stocks (down some 75 percent from its peak) and property markets (down between 50-70 percent) have still not recovered the levels of 1989.

Decent returns can be still earned during periods of great uncertainty. They just require different investment approaches.

Governments bonds are no longer risk-free safe havens. The risk of default or loss of purchasing power either through devaluation of currency or diminution of purchasing power is prominent.  

Risk premiums are frequently negative as investors flock to safe assets or the latest and best investment — US and German bonds, high-yield corporate bonds or high-dividend stocks.

Diversification to mitigate risk is difficult as correlation between different investment assets has become volatile. The fundamental risk of domestic shares, international shares and property is similar in the current economic environment. Even returns on cash are positively correlated to risky assets as interest rates have fallen in the recession.

Tail risk, the chance of large and frequent increases and decreases in prices, is also evident.

Investment structures compound the investor’s dilemma.

Traditional mutual funds operate to generate relative returns measured against a benchmark. Unfortunately, beating a benchmark by 5 percent provides cold comfort to investors when the investment manager is down 15 percent and the market falls by 20 percent. Only absolute return now counts.

Management fees and fund expenses are a significant drag on returns. Management fees and expenses of 2 percent are tolerable when the returns are 12 percent, but difficult to bear when the returns are 5 percent or lower.

In choppy markets, rapid changes in the composition of the portfolio — including switches between assets and instruments (physical versus derivative; symmetric versus asymmetric exposure) — is required. Long periods of staying uninvested, holding cash or other defensive assets, may be necessary. Today, investment mandates require investment in a single asset class or limit switching. Such mandates constrain the type of instruments used and force the fund to stay substantially invested at all time. This restricts the ability to generate positive returns.

Traditional investment styles may not work. Value investing, buying stocks based on fundamental analysis when they look cheap, has historically been successful. The hidden value can be released through cash flow, dividends or acquisition in the long run. But since 2008, value investing has performed indifferently. Arbitrage strategies, such as relative value trading and long-short equity or equity pairs trading, have also performed poorly.

The failures reflect uncertainty about correct values, risk-on/ risk-off trading, risk aversion, illiquidity and the lack of convergence to theoretical values.

Pooled investments also present problems. In commingled funds, where the investor is invested alongside others, performance may be influenced by the weakest holder. As weaker investors withdraw, funds may be forced to liquidate in unfavourable markets, driving down valuations even further. This affects the returns of the most stoic long-term investors.

Mark-to-market, often based on illiquid and uncertain prices that do not approximate true values, compounds the problems. Investments which may prove sound in the long term cannot be held because of the difficulty of absorbing short-term valuation swings.

Nothing illustrates the problem better than the fate of the legendary Bill Miller whose Legg Mason Value Trust outperformed the broad market every year from 1991 to 2005. A self-confessed failure to appreciate the severity of the problems and the changed investment environment resulted in persistent poor returns. Assets in the fund fell from a peak of $21.5 billion in 2007 to $2.8 billion. In November 2011, Miller retired from managing the fund. Fidelity’s Anthony Bolton, Pimco’s Bill Gross and hedge fund manager John Paulson (who capitalised on the subprime collapse) have all struggled with poor performance in the altered market environment.

Investors may now need to follow comedian Will Rogers’ advice: “I’m more concerned about the return of my money than the return on my money.” Capital preservation will be the key to survival. A large sustained loss of capital is currently the major investment risk. This favours debt over equity or other risky assets, even though the safety of government debt is increasingly in question. It also favours defensive stocks or hard assets, like commodities.

Investment income (dividends or interest) may be the major source of return. Capital gains will be more difficult as the period of consistent stellar rises in price may be less likely in the future.

In bull markets, investment approaches focus on capital gains, income and capital return in that order. The current environment requires re-prioritisation of those objectives.

Investors have increasingly embraced non-traditional investment. There has been strong interest in gold and other precious metals. Gold prices have risen strongly, although gold prices remained below their 1980 peak for 26 years.

Hedge funds and private equity funds continue to attract money, despite variable performance. The attraction is a focus on absolute return and greater investment flexibility.

Despite well-documented problems, structured products — where investors assume credit risk or fluctuations in interest rates, currencies or equity prices in return for a higher interest rate — are making a comeback, driven by low interest rates.

Disillusioned with financial assets, the ultra rich are focussing on scarcity — farmland, prime real estate in world cities with desirable properties and collectibles (fine arts, rare cars).

Increasingly, investment approaches focus on matching future cash flows, irrespective of whether it is a known future liability or retirement income needs. Products such as annuities targeted at retirees or specific saving plans that provide a guaranteed lump sum are growing in popularity.

A key element is capturing volatility to take advantage of large price fluctuations. This can be done by purchasing out-of-the-money options which provide the investor unlimited gains from tail risk for a known fee. Alternatively, volatility can be captured by allocating a portion of investment capital to either stocks which benefit in periods of “irrational exuberance” (typically growth stocks) or “irrational pessimism” (defensive stocks).

High levels of cash allow investors to capture volatility, taking advantage of sharp falls in value. Warren Buffett’s Berkshire Hathaway maintained high levels of cash running into the crisis — around $20 billion. This liquid reserve was expensive to maintain as interest rates were close to zero. But it allowed Buffett to make very high yielding strategic investments in Goldman Sachs, GE and Bank of America.

A key concern is counterparty risk to financial institutions, which are extremely vulnerable in this environment. Synthetic Exchange Traded Funds, which are in vogue, generate their return through a derivative transaction with a dealer. The bankruptcy of the dealer would result in losses to the investors as in the default by Lehman Brothers. Minimising this risk where possible is essential.

Success also requires avoiding common pitfalls. Successful investors often succumb to what theologian Reinhold Niebuhr termed the “most grievous temptations to self-adulation”. Success is 10 percent skill and 90 percent luck, but it is unwise to try it without the quotient of skill. Hubris has resulted in a greater loss of wealth than market crashes.

Adjusting return expectations to more modest levels is essential. Samuel Loyd, an Englishman who made his fortune in finance and was considered an authority on money and banking in his time, observed: “No warning can save a people determined to grow suddenly rich.”

Investment is a relatively simple activity, which is frequently over complicated by complex beliefs and theories that owe more to fashion and a particular market environment than any fundamental truth. In the end, the simple logical rules win out and must be re-learnt painfully.