Its Friday and its been a long week…

• When risks are high one reasonably expects the risk free rate to be low.

 

• Buy when interest rates are high, sell when they are low.

 

• ‘Tis calmest before the storm. ‘Tis very calm. Corollary: risk is high when VIX is low.

 

• Markets are attached to fundamentals by psychology, a very elastic couple.

 

• When the pie shrinks, people are less happy to share. There is a point when economic considerations give way to strategic considerations.

 

• ‘You got to know when to hold ’em, know when to fold ’em’. Kenny Rogers, The Gambler.

 

• “My options are decreasing mostly rapidly.” Gordon Sumner, Seven Days.

 

• Money can buy almost anything, even and especially experience. But pay as you go, there is no need for a retainer.

 

• Often the way to an efficient portfolio is a short memory.

 

• Often the way to successful trading is a long memory.

Painkillers are addictive. People follow the path of least resistance. Principles are always compromised. The prudent are the few. And often made to pay.

 

When unconventional policy was deployed to rescue a global financial system in crisis in 2008, we went down a slippery slope from which we have not recovered.

 

This time is different in that we have financial tools at our disposal that we had not in previous financial crises. This time is still the same in that we are human and we will repeat ourselves, and there are certain immutable laws of economics.

 

The most remarkable thing about policy response in 2008 was its intention to avoid any and all pain, its aim to bail out every investor, institution, company and country. Was not the idea of capitalism that the free market punishes in equal measure that it rewards? Has the culture of entitlement pervaded the human psyche to the extent that we expect no one and never to lose? Have we uploaded the ‘cheat codes’ (to use PC game jargon) so that all may use them? It is well known that players who use ‘cheat codes’ simply cannot survive when these codes are withdrawn. And what if everyone uses ‘cheat codes’? If one person uses them, then there is an incentive for everyone to use them. The result is a simultaneously chaotic and boring game.

 

One cannot help but feel that capitalism has failed. And that its death knell was sounded by the death of communism, its great nemesis. Without communism as a foil, capitalism evolved in a cancerous and uncontrolled fashion, resulting in the perverse form that rules us today.

 

One cannot help but suspect that a new system will emerge to challenge capitalism as an economic philosophy. But economic philosophies are born out of necessity. It is hard to see how the world will wean itself off our morphine induced dream.

 

Debt is being created even as it is being repaid, a self evident observation were it not for that the crisis was born in excessive debt, and the solution to its precipitation seems to be the creation of more debt. As debt is repaid, nominal output must fall, all other things being held constant. This accounts for the economic weakness observed across the world. Central banks only available response to stoking economic growth has been to apply more debt in the hope of igniting self sustaining growth. So far it has obtained limited success. 

 

It is certainly possible that our debt creation has outpaced equilibrium growth rates ex debt to the extent that the mean reversion cannot be adequately compensated for by conventional policy, or unconventional policy for that matter. If so, then our prospects are to wait for time and the natural cycle of recovery to stabilize output growth, once it has reached its negative extremities, and have it mean revert to positive territory. Given the extent of the debt fueled overshoot, this could take a long time.

 

In the meantime central banks have decided to act. Their efforts are aimed at staving off any kind of default or slowdown. They intend that the market must punish no one. What they may achieve, is an event or phenomenon that punishes everyone. Without the guiding torch of principle, capitalism has been distorted to a form of socialism.

 

Every central bank which can is monetizing its sovereign’s debt, or expanding its balance sheet, or trying to debase its own currency. Mutual and universal success must be evidenced by invariance of relative prices. Failure is likely to produce discontinuous price actions, which are not addressed by current option pricing models.

 

In theory, no country need default in the debt denominated in its own currency. In theory, a government cannot be obliged to pay back its debt. It can be compelled to do so by martial force (Britain has an excellent track record in this regard. Call it foreclosure with extreme prejudice.)

 

The l
argest creditors of national debt are the respective central banks. This presents an interesting discussion as a country drifts towards insolvency. Certainly it is the intention of each central bank to engineer inflation at least to the extent it erodes the value of the stock of debt. In the case of a reorganization, however, it is not clear what the objectives of the central bank will be as regards the claim it holds. This has implications for other claim holders who will almost surely be in the minority. Will their interests be aligned? For almost all investors, this question is academic and far off. But as this point approaches, it could crowd out private demand for government bonds.

 

In the meantime, controlled and moderately high inflation appears to be the plan for debt management. The risk is that the inflation becomes less controlled than planned. With a money base as large as has been created by the central banks, any pick up in the velocity of money or the money multiplier, is quickly multiplied through this money base resulting in the potential for some very interesting inflation levels.

Finally Bernanke has tired of announcing successive bouts of quantitative easing, he’s just announced that the Fed will be buying assets until the labour market picks up.

Buying what? US treasuries don’t really need a lender of last resort; Basel 3 has made them the asset of last resort for all the private commercial banks, who incidentally have loaded up on over twice the amount they bought last year, and this just till August this year.

 

 

So what’s all this MBS buying all about? For commercial banks, creating a mortgage consumes capital. The capital efficient trade is for banks to keep buying US treasuries. So what gives? What’s the Fed up to?

 

The Fed is not buying non-agency MBS, arguably a better trade given that the market has dumped them with the bathwater. But profit is not the objective.

 

The Fed is hoping that supporting the housing market will restart the credit machine.

 

A rising housing market would reduce the proportion of homeowners with negative equity, providing them the opportunity to refinance.

 

Bank’s lending standards since the crisis has tightened up considerably. The Fed hopes that rising housing prices may loosen lending standards.

 

Rising housing values opens the avenue to HELOCs, once an important source of funding for discretionary consumption.

 

Perversely, lower mortgage rates discourage mortgage lending since cost of capital is fixed. Only a robust securitization market might encourage mortgage origination.

 

Also, banks will not loosen underwriting standards unless they are able to transfer the credit risk off their balance sheets. With the Case Shiller index turning just positive, the first time since the crisis in 2008, the Fed may be attempting a momentum trade by encouraging a stronger recovery in housing.

 

Its not entirely responsible to address a problem of excessive debt by creating more debt, but what can you do? They have to try something.

 

Since the US economy recovered in 3Q 2011 asset prices had stabilized until the Europeans and their half baked efforts to secure the Euro fell flat and China landed with a thump (and is still looking moribund.) Today, the global economies look to be in a synchronized slowdown. Policy makers the world over certainly think so. Every central bank has plans to print and every government who can afford it has plans to build.

 

While the real economy sags, asset prices have been buoyed by super-loose monetary policy. There is a chance that animal spirits may be invoked to rescue the world. However, the exit is as yet unclear. What exit? Why the unwinding of banking system balance sheets which now stand at 5-6 times multiples of what they used to be before 2008. If there’s a plan for reversing the balance sheet inflation that has so far been deployed to save the world, once the world has been saved, I’d like to hear it.

There’s just this little risk of inflation… QE, Debt Monetization and Hyperinflation Risk

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In a previous article (Private Wealth Management) we explored the failings of the current model of wealth management in Asia. Now we look at possible solutions.

 

Regaining Investors’ Trust:

 

For reasons of alignment of interest, the ideal model of an Asian wealth management business would always ultimately involve the deployment of the firm’s own capital in the same or related investments as that offered to its clients recalling  the merchant banking model of the 1980s. The level of mistrust of financial advisors in Asia resulting from the experiences during the financial crisis in 2008 require such alignment of interest in order to restore the trust between principal and agent. A more direct alignment between principal and agent can be achieved by requiring or encouraging staff to invest alongside clients. The bonus pool is a convenient pool of staff capital that can be deployed to this purpose.

 

 

Building Long Term Relationships:

 

Staff turnover in Asian private banks is acutely high and confounds the objective of building lasting relationships. Bankers retain their relationships instead of transferring them to the firm. The result is a constant rotation of clients through firms as their relationship managers rotate. An appropriate compensation scheme for talent acquisition and retention and alignment of interest would involve partial retention of bonuses which would be invested in the firm’s products or services.

 

 

Winning Discretionary Mandates:

 

While there is a proliferation of private banks in Asia, most of them are in fact expensive retail brokerages with a small percentage of their revenues coming from traditional private banking services. Discretionary investment management mandates are difficult to win and grow as discretion requires more trust than clients are currently willing to bestow.

 

Discretionary mandates need to be won in stages. Asia’s wealthy families are mostly first or second generation wealth and continue to grow their operating businesses. This provides a strong pipeline both in the demand and supply of PE directs. This deal flow presents the opportunity for a wealth management firm to bootstrap its business with a placement and advisory business where it provides due diligence and cornerstone capital to transactions which are then syndicated to its clients. The client base itself as well as selected GP partners are a rich source of origination. The discretionary asset management business can be built upon the foundations of a successful placement and advisory business. It is important to differentiate this business from the low value-added, low margin discretionary portfolio management services offered by garden variety asset managers. There is a dearth of absolute return, long term, policy mandates designed for long term legacy management while controlling downside risks to avoid interrupting the compounding effect. Alternative investments are under-represented in garden variety discretionary portfolios. Anyone who has done an unconstrained optimization will obtain significant allocations to alternatives, allocations which are often suppressed in traditional portfolios for no other reason that the investment manager is patronizing and pandering to their expectations of client sophistication. This is counterproductive to client objectives and to the managers’ fee margins.

 

Difficult market conditions and negative past experience with private banks have driven up liquidity and control premia in Asia. Investors are acutely more willing to invest in very liquid investments, substituting this liquidity away only in investments where they have extraordinary transparency and control. Quarterly and monthly redemption hedge funds are notoriously difficult to raise capital for. So too are long duration blind pool PE funds. Investors tend to favor daily liquidity funds or if they invest in private equity, prefer directs to funds where they often seek some level of control. A positive experience needs to be built with investors before discretionary mandates can be won.

 

 

The Asian International Nexus:

 

Asian wealth management sits on a goldmine of investment opportunities which exceeds the regions ability to absorb them. Diversification also advises Asian investors to invest at least a portion of their assets elsewhere. European, US and LatAm investors, however, are seeking Asian investments, and often require help in due diligence and deal analysis to weed out unsuitable investments. The Asian wealth manager may seek to place Asian investments internationally, helping businesses to diversify their investor base.

 

Asian investors’ international experience is yet immature and a significant proportion of them do not plan to diversify internationally. The propensity to venture abroad comes with understanding. The Asian wealth manager should invest in the education of their investors to bridge this gap. In fact, investor education is an important component of any credible wealth management business, not merely to bridge immediately evident gaps, but to maintain the level of sophistication of the partnership.

 

 

Fear of the Road Less Travelled By:

 

Asian private banks have been active since the mid 1980s. Few have broken out of being a transactionally driven brokerage business with expensive products, services and staff. Management have taken the international private banking model and attempted to get there in a straight line. In doing so, and ignoring cultural factors, they have created their own impediments, which they now cannot recognize or address satisfactorily. A different approach needs to be taken which puts the client first in practice and theory, and not just in rhetoric. The path is easy to see, its just very difficult to take.

Uncertainty and the Futility of Having A View.

 

Financial markets are highly uncertain today. As the great workout of 2008 continues to unfurl, the interplay of politics and policy on economics has blunted the traditional methods of fundamental analysis and asset allocation.

While the investor who is able and willing to invest in hedge funds can still make a decent return without being forced into taking inordinate risk, the investor in traditional asset classes is faced with high uncertainty as to the returns prospects of equity and debt investments. In response to this more uncertain landscape, we approach the problem of a long term policy portfolio from a simpler, and arguably simplistic approach seeking a portfolio construction that is more parsimonious and which uses only the information we have and are confident about, and disregarding the information we have not or are less confident about.

 

 

The Construction of the Risk Neutral Portfolio.

 

We consider a world where we can invest in equities, bonds, commodities and absolute return alternative investments. We have excluded less liquid asset classes such as real estate and private equity.

 

• We will not impose any expectations for the asset class returns, only that they are positive.
• We have chosen to arbitrarily assume a long term mean of 4% p.a. This has no bearing on the actual calculation, it is a convenient and reasonable number. The point of making all ex ante expected returns equal is that we provide no expectations to the optimization problem.
• We have expectations as to correlations based on historical correlations and we amend these according to our understanding of asset class inter-dependencies.
• We have expectations for volatilities based not on historical volatilities but based on the levels of volatilities at which the asset class becomes a concern to us.
• Note that we have used substantially higher correlations between fixed income and all other asset classes as we believe that the sensitivity of fundamentals and asset prices are considerably greater now than ever.

 

 

Correlation Table:

 

 

 

 

 

 

 

 

Asset Allocation Table:

 

 

 

 

 

 

 

 

Asset Allocation Chart:

 

 

 

 

 

 

 

 

While the allocation to bonds looks inordinately large it is in fact contributing the same marginal risk to the portfolio as the 3% commodities allocation or the 10% equity allocation. The whole point of this exercise is that each asset class is contributing the same amount of risk to the portfolio. We chose this by design since we had no prior view on the relative performances of the asset classes.

 

 

 

Extensions:

 

We can extend the methodology to building an equity portfolio, a fixed income portfolio and indeed an alternatives portfolio. By iteratively separating the portfolio to its components and applying the risk neutral methodology, then reconstructing the portfolio, one can arrive at an efficient portfolio which is view agnostic.

 

 

Equity Asset Allocation Chart: (This can obviously be performed with more sub-categories as desired.)

 

 

 

 

 

 

 

Fixed Income Asset Allocation Chart: (This can obviously be performed with more sub-categories as desired.)

 

 

 

 

 

 

 

Putting it all together:

 

 

 

 

 

 

The Use of the Risk Neutral Portfolio:

 

 

1. You should use the Risk Neutral Portfolio if don’t have view or if you do but you don’t have a lot of confidence about it.
2. Undoubtedly, you will have a view. The Risk Neutral Portfolio is a minimum variance portfolio around which your tactical views can be built. Tactical trades can be appended to the Risk Neutral Portfolio to express your tactical view.
3. The current environment favors this approach whereby a stable core portfolio is held to fund tactical trades which tend to be short duration in nature to capture event driven opportunities. Cash is a poor core portfolio as inflation risk has increased with successive rounds of debt monetization (QE).
4. To scale your level of risk, there is no need to adjust the relative allocations. For a conservative, lower risk portfolio, a positive amount of cash should be held together with the Risk Neutral Portfolio. For a more aggressive, higher risk portfolio, a negative amount of cash should be held together with the Risk Neutral Portfolio (i.e. leverage should be applied.)
5. The Risk Neutral Portfolio is best populated with appropriately chosen Funds. Direct securities are cumbersome to manage and require constant management, monitoring and rebalancing to handle index changes, bond maturities, corporate actions.