Blain’s Morning Porridge October 5th 2022 – Investment Management Wakes Up To Risk – Too Late for Many!
The only way is up.. till it isn’t.
This morning: Risk does not disappear. It hides in plain sight – as the investment industry will increasingly discover as crises mounts. Fortunately, there are SOB’s who have seen it before and are too aged to panic…
The market famously has no memory. But Smart Old Blokes do…
The Morning Porridge started as a client note around the time of the Northern Rock bank run in 2007 as a note on how to play unstable Fixed Income markets and bank capital in particular. Through the years I’ve warned many times about how markets make the mistake of facing new crises with the same mindset and approach with which they fought the last crisis!
There is a brilliantly clear piece by Brooke Masters in the FT this morning: Asset Managers may regret becoming the new banks , which encapsulates how that vibe is playing out in reality today. A massive shift in risk has occurred which has been coloured by new investment concerns and the utter distortion of the QE Decade. It means the landscape and weapons of the next financial crisis have changed entirely – and its already clear we’re struggling to understand the consequences.
How did it all happen?
Every financial event has consequences – crises particularly so. I’ve written many times about how hurried ill-considered regulation in the wake of the 2008 Global Financial Crisis simply transferred risk rather than transformed it. Regulation, rules, and intent never improved our understanding or ability to mitigate risk.
Instead, these forces changed the management of risk from an issue of hard-earned experience and market knowledge into what we have today: risk management through compliance with regulatory tests, tick box checks on risk identification and legions of risk managers who haven’t been down to the coal face.
Speaking to literally thousands of investors over the years, I have reached the conclusion there are many firms where regulatory tail is wagging the risk-taking dog!
It’s all come to the fore following the Kwarteng Not-a-Budget farce pummelled the UK Pensions sector. The chaotic price action in Gilts triggered a series of margin calls that simply exacerbated the crisis rather than calmed it – forcing pension managers to sell gilts (their highest quality liquid asset) into a tumbling market.
Oh dear. Deja-vu all over again…
The instability in the UK Gilts market triggered destabilising margin calls on Pension mangers exposed to LDI (Liability Management Investing.) (Good explanation of the history of LDI here: A brief history of LDI.) LDI is safe and generally good for pensioners – right up to the moment chaos means its not. Doh!
If it’s been happening in Gilts, you can bet it’s been happening across the market. Of course it has – for the last decade we’ve all been trying to ramp up returns and maximise fees in an increasingly competitive market. Fund managers had two choices:
- They will either seek to pump-up returns by taking more risk via yield tourism, and leveraging absolutely SAFE investments like UK gilts with a bit a derivative “speshul”-sause spiced with derivatives.
- They will remain passive, do little except track the markets, and make all kinds of statements about preserving customer assets which charging them outrageous fees for doing so, while hoping the markets will bail them out..
Doomed if you did and doomed if you didn’t.
If you juiced returns with leverage and clever derivatives, then these could well go wrong, magnifying losses.
If you went passive and followed the market higher – which, to be brutally frank, made every investment manager look genuine utter-geniuses through the last decade – by tracking… then you are going to get crushed as markets correct.
Thankfully there are many investment funds run by smart old blokes (SOBs) with the wit and wisdom to have avoided running with the pack and risk management by committee. If you are lucky your wealth will be managed by one of them.
Sadly I personally seem to be lacking the first letter of SOB. Investment management is a funny old game. Where I’ve made money, it’s generally been on heeding my own advice. I don’t listen to my experience enough.
I simply don’t know much money I’ve paid fund managers in fees for not making me decent returns. In my quiver of multiple pension schemes collected over my inglorious career is an investment I took out in 1990 with a (then) leading UK investment firm. I put the then enormous sum of £20,000 into its Far East Fund – because that was where the growth would be. Over 30 years Asian economies have blossomed and expanded multiple times over. The value of my fund? At the last look a mere £15,000. All the upside has been consumed in fees and management incompetence. I keep thinking I should complain, rant and roar about it.. but I keep it as a painful reminder to minimise costs.
Anyway, back to the story…
Following the collapse of Lehman and the Global Financial Crisis of 2008, global central banks and regulators set to with a will to ensure it would never happen again. They could not resist the opportunity to make up for years of being second best to the City and Wall Street. They sought to minimise banking risks by massively increasing capital requirements and neutering their ability to take risks.
There are always consequences – global banks, which once provided the economy’s life-blood of capital and debt and the market making that drove markets, became little more than processors of transactions – milking the process for fees at every step. It led to a fundamental, yet largely unremarked change in the structure and dynamics of markets; the investment management sector became the repository of risk… not the banks.
Back in 2007 the banks ran massive, tightly focused teams of highly experienced bond, credit, risk, equity and derivative analysts. Their project development and loan teams could identify multiple construction and innovation risks and mitigate them. Risk Mitigation was tattooed across the foreheads of the functionaries managing banks middle and back offices. They were trained to deal with guys like me.
I was then a young investment banker busily originating bank loans and capital raises across Europe. We did some extraordinary things with complexity driving up our fees through derivatives, swaps and “stuff”. I will never be able to shake the box diagrams that explained how they worked out of my head. The largest banks sold themselves as one-stop shops for every kind of financial need. The repository of market knowledge and expertise in banking was enormous – and fairly well disciplined.
If a shaggy haired entrepreneur had blustered his way into a pitch-meeting with bank lending officers to expound how his half-baked concept of leasing office space long-term to rent it out short-term was actually a new economy digital tech revolution play – he’d been gently escorted out the door.
By the early 20-teens, risk taking had been transferred. Banks no longer took risk. The investment firms were on the front lines of risk. They found themselves faced with the managing the consequences of the liquidity glut fuelled by QE and Monetary Experimentation. As Central Banks flooded markets with cash and easy interest rates, returns tumbled forcing Investors to seek higher returns by taking more risk in financial assets.
For 10-years till 2021 it looked like it was working. Central Banks kept juicing markets with low rates. The chase for higher returns drove markets higher and higher, making more and more improbable bets on returns continuing to move higher look less risky.
Oh Dear. Do I have to spell it out?
Basically….. when bull markets made everyone looks a genius, it was because no one was looking at the build up of risk. Now it is being exposed. Hullo Cathie Wood, Masayoshi Son and a host of others from Net3 to NFTs – go stand in the corner. And be joined by hundreds of other new economy mavens, tracker managers, cryptos and other shysters milking fees… It was the age of fabulosity and possibility – which has just been punched in the gub with the fist of financial reality.
Fortunately… it will not be the end of the World. There are still smarts out there, and I am fortunate to be working with a bunch of these SOBs.
I was reading through an excellent Investment Manager letter yesterday – from The Shard Capital investment team. (My day job is with Shard.) It sums up the events of recent months rather well. On the topic of Alternatives the manager wrote: “We are overweight alternatives for two main reasons: 1) we saw no value in fixed income (save government bonds as liquidity reservoirs,… and 2) we expected increased market volatility….” Spot on – but as it’s the firm I work for, I’d expect them to be ahead of the pack.
The manager went on: “the era of irresponsible “easy money” monetary policies is now (thankfully) behind us, markets are more likely to remain more volatile and certainly not trend as passively as they did previously. Active management will become necessary to ensure returns generated can exploit this new dynamic and benefit for generating positive returns from both long and short position….”
And on that note…
5 Things to Read This Morning:
Out of time, and back to the day job..