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 The story of the past 25 years in investing is largely one of taking
an increasingly complex and opportunistic approach, with much
emphasis on illiquid and opaque holdings.
This is best exemplified, among large long-term investors, by the
widespread adaption of the Endowment Model, sometimes called the
Yale Model because it was pioneered there with great success by
David Swensen. Under this model, the traditional debt and equity mix
is eschewed in favor, partly, of higher concentrations in private
equity, hedge funds, commodities and sometimes land.
Risk management, under this model, is usually down to quantitative
models of expected portfolio characteristics.
This approach, in essence, is too clever for its own good, argues
Bob Maynard, Chief Investment Officer at the $14.7 billion Public
Retirement System of Idaho. While risk management difficulty rises
as portfolios and underlying investments become more complex, a
simpler approach can offer better stability.
“The cockroach lives in a highly complex environment with one of the
best long-term success rates of any creature. Yet it has only one
defense mechanism – running in the opposite direction from a puff of
air,” Maynard writes in a new paper on risk management.
(http://www.the300club.org/WhitePapers.aspx)
“The equivalent for the investment world is, at the core, a very
simple structure founded upon public market diversification with one
basic defense mechanism: see a volatile movement, react in the
opposite direction (i.e. rebalance into it). A simple structure and
strategy, if adhered to, has one of the best chances of surviving
for many decades.”
Maynard was writing as a member of the 300 Club, a global group of
investment professionals concerned about the long-term shift within
the industry toward more costly and complex models and products.
While cockroaches, unlike managers of hedge funds and private
equity, don’t build mansions in Greenwich, they do as a species
survive. And what’s more, the cockroach approach to portfolio
management does not depend on identifying genius, and praying that
it never fails. Instead a cockroach portfolio, with a traditional
spread across equity and debt and a tenacious dedication to
rebalancing, whatever the weather, can do all right at low cost. Or
rather can do all right in part because of low costs.
NON-LINEAR
In the good old days, think about early 1990s and before, risk
management for pensions and endowments was relatively easier, in
large part because nearly all holdings were transparent securities
which priced constantly, and, importantly, independently. That means
that when a sell-off happened, or when a bubble formed, managers
could easily and quickly see what was happening. The response, and
this is not rocket science, is simply to re-balance, to buy or sell
that which has changed in value in order to keep one’s proportions
on target.
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In contrast, to manage risk when owning timberland or private equity
limited partnerships is far more complex. Not only are the prices
neither independent nor continuous, the efforts toward controlling
these idiosyncratic risks rely mostly on math and assumptions.
Rather than following a coin flip or linear distribution, Maynard
argues, markets in the short term are highly volatile, behaving more
like seismographic data, including earthquakes, than a “normal”
random distribution of movements.
The good news is this smoothes out over longer periods, but the bad
news for endowments is the tools they have are ill-suited to the
risk-management task at hand.
“During the financial crisis, the different nature of shorter-term
markets turned out to offer only opportunities for pain, not gain,
for the endowment model because it is opaque and non-transparent,
relying instead on quantitative risk-control systems and models,”
Maynard writes.
Be it value-at-risk, with its naive coin-tossing assumptions, or
regression analysis, with its reliance on linear relationships, all
of these tools inevitably fail when markets, as they inevitably do,
erupt.
Think of it this way. Managing based on risk-management tools is
like flying an airplane by instruments. But instrument flying is
predicated on the fact that mountains don’t move, and nor do
runways. Instrument flying a portfolio, which is what one is forced
to do when it is chock full of complex and opaque (and expensive)
products, is extremely dangerous.
Better then, in investment, to lower the altitude, if that is what
is needed, so that one can fly by eye and react to those moving
mountains of the financial markets.
Cockroaches don’t instrument-fly airplanes at 40,000 feet, but they
don’t crash them either.
(At the time of publication James Saft did not own any
directinvestments in securities mentioned in this article. He may
bean owner indirectly as an investor in a fund. You can email himat
jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft)
(Editing by James Dalgleish)
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