Risky Business

Posted by on 09/25/12 in Behavior, Debt, Markets, Risk

No one can pinpoint the start date, but many experts acknowledge that as of the dot.com bust, Volatility had earned the de facto title of America’s Greatest Risk Factor. By the beginning of that decade, investment analytics often used Volatility and Risk interchangeably, assuming that measuring volatility meant measuring risk and that reducing volatility meant reducing risk. It was a heady time for Volatility and his companions—the software programs, academics, and money managers who built careers around allegedly diagnosing, measuring, and managing volatility.

But Volatility no longer can claim to be the undisputed Champion of Risk. Other risk factors are making legitimate claims to the title and demanding their opportunity to step forward as the Greatest Risk standing.

We invited the top Risk Factors to state their cases before hundreds of investors. Volatility, who fully intended to defend his crown, was given the opportunity to lead off the presentations. He was to be followed closely by four other Risks that have been exerting influence and demanding more attention, Volatility, Illiquidity, Pricing, and Inflation.

Volatility
Good evening ladies and gentlemen—No it’s not! Yes, it is! No, it’s not! Let’s give it up for volatile humor!! (nervous laughter) Look, you’re here tonight because I am here tonight, so let’s not spend a lot of time going back and forth about risk. (Adopting a somber tone) It’s not funny when you lose money. You don’t invest in order to watch your wealth fluctuate, at least not to the downside. Is your $10 million worth $10 million? Or is it nine or eleven or seven? Some people say volatility doesn’t matter, but I ask them, ‘What else could possibly matter more?’ (smattering of applause) Shouldn’t your primary focus be on managing volatility, reducing standard deviation as much as you can while still creating opportunity? I don’t LIKE being uncertain, but I am. Forget 2002 and 2008. Remember September 2011? May 2012? Do you want that in your portfolios? Of course not. No investor likes to wonder whether or not they are doing the right thing, even for just a few weeks. And if you think my time is past, just you wait. Let’s see how you like the feel of algorithmic trading 24/7, of global currency markets that whipsaw you faster than you can say “Mario Draghi,” of Fed statements read with greater fervor than the Oracles of Delphi ever inspired. Dot Com bubble? Real estate bubble? Be ready for more of these “100 year” events. That’s the world we live in folks. Because of me, you’ll keep paying for those expensive annuities and alternative investments because whether you like me or not, I remain, humbly, your Greatest Risk Factor. (cheers, applause, a few complimentary boos)

Illiquidity
Well Volatility was predictable (laughter). It always saddens me when someone like Volatility overstays their welcome, and I say that as a fellow Risk that has helped make Volatility famous. You see, I am that Risk that nobody thinks about, that nobody considers when they are so busy trying to manage my friend, Volatility, a friend who gets some of the credit for my rise. While it used to be that investors just accepted Volatility as a Risk they could do nothing about, over the past decade they have instead traded their Volatility Risk for Illiquidity Risk without realizing that most of them were better off before. Volatility talks a mean game, but just isn’t that bad over the long-term. Unless you panicked, you survived September 2011 and May 2012. Likely, you’ve done fine over the past 12 months. But look at a typical university endowment with 30 – 60% or even more invested in illiquid investments. Sure they want better return, but most illiquid hedge funds have performed poorly relative to stocks and bonds over the past four years–and didn’t protect that well in 2007-08 anyway. Many private equity and private real estate investments have struggled to keep pace with their more liquid public market peers. The truth is, many institutional investors and those who mimic them have accepted restricted access to their own capital so that they can create the illusion for themselves and their stakeholders that they are managing Volatility. But what happens when illiquid investments put up their gates and refuse to release funds? What happens in a crisis when you most need your money and managers are least likely to let you have it? The choice between Volatility and Illiquidity is simple: If you were CFO, would you rather tell the Board of Directors ‘We experienced Volatility,” or that ‘We can’t access our money?’ Boom. (Shouts of ‘ouch’ and ‘that’s right’ from the audience). Hands down. Illiquidity is the Greatest Risk Factor. (Applause)

Pricing
Now before my good friend and Risk partner Illiquidity, steps away, remember a third statement you don’t want to tell the Board of Directors. No one wants to inform the Board that ‘We don’t know what we’re worth.’ (crowd murmurs and nods). Let’s face it folks, Pricing Risk has become a dominant concern as more and more institutional investors—and those who think they are institutional—tie up their funds in private investments that get carried on statements and performance reports at valuations that are hard to prove or justify. Now, turn to the colleague next to you. Look each other in the eyes. C’mon, you can do it. Now, repeat after me: ‘If I liquidated our entire portfolio today’ (audience repeats); ‘I am 100% confident’ (audience repeats again); ‘that our portfolio is worth exactly what the performance reports say’ (some giggles, nervous titters, and a few hearty guffaws from the crowd). See folks, we all know that private real estate and private equity investments are hard to value in the best of times and these are not the best of times. We understand that hedge funds and hedge funds-of funds are difficult to assess, particularly when they hold assets that do not price frequently or transparently. We know that financial incentives throughout the system reward managers and advisors for overstating values. If you’re having a hard time knowing what your house is worth—and you know who you are—how much more difficult is it to know what your portfolio of alternative investments is worth? Volatility Risk is irrelevant if you can’t trust the values used to measure it. Sure, Illiquidity Risk is scary, but the real fear is not knowing what your wealth is worth whether it is liquid or not. Pricing Risk—you better be thinking about me. (knowing nods around the room).

Inflation
If you want to question the value of your wealth, then say hello to Inflation Risk. I destroy wealth, ladies and gentlemen, and even if I am modest, I am devastating. (Boos, hisses) Thanks to me, those of you with long-term or perpetual time horizons don’t know what you’re worth now do you? What is the present value of your perpetual spending regime? (questioning glances, shrugs all around). Exactly—you don’t know. You can’t know and that’s why I matter so much. You see, we live in a world where central bankers from America, the EU and Japan are doing everything in their power to stimulate Inflation; meanwhile, much of the world is afraid I will grow too quickly. Never before in history has so much money been created by central banks; yet, there is no explicit plan for pulling that liquidity back out of the system once it has served its purpose. There is no plan because there can be no plan because you can’t take candy back from a baby. But forget policy, the real problem—pun intended—is that you have no risk-free way of keeping pace with me. None. The US will sell you a ten-year Treasury for 1.8% but that won’t do. I’ll erode that growth and then some for the next decade without breaking a sweat. So what do you do? You buy lower quality. You buy less liquidity. You buy uncertainty. And you do it all because of me. You don’t need me in double digits anymore—even 3-4% in this environment is more than enough to erode your wealth bit by bit, day by day and you won’t really notice until it’s too late. How’s that for scary??

So here we are, folks, our four contestants for Greatest Risk Factor–our incumbent, Volatility, and the three challengers, Illiquidity, Pricing, and Inflation. It’s a tough decision…

“Excuse me. But I believe you have forgotten someone in your deliberations.”

Umm, I’m sorry but who are you? I don’t believe we had another contestant.

“On the contrary. I have been here all along, just binding my time, waiting my turn, knowing that in the end, you would have to concede that you have no Greater Risk Factor than me.”

And who are you, if I may be so bold?

“I am the US Treasury Bond and I am the new Greatest Risk Factor. (Pause for effect. Gasps and puzzled glances fill the room) Volatility, my dear friend and collaborator? You compare yourself to me all the time to prove your might, yet going forward I could whipsaw many a portfolio faster than you can say Timothy Geithner. Interest rates have been falling for over 30 years creating an illusion that there is no such thing as bond risk. All of your fancy capital market charts assume I am predictable, but I’m not, am I? And while that’s our little secret for now, wait until they see how unpredictable I can be. Oh, they’ll remember Volatility, but they will know it was me that made you what you are.

“Illiquidity, my young colleague? No investment has been more liquid than I have been. But should interest rates turn, sell me into that frenzy and see how much you earn. And remember, they can keep making more of me and I can flood the system and all that excess liquidity could be far worse than your measly Illiquidity.

“And Pricing, my naive one? You think you know what I’m worth, don’t you? But do you? Sure there is a market price for me every second of the day. But no other security is so intently manipulated by policy makers around the globe as I am. What happens if the Fed changes tactics or the White House changes the Fed? What if interest rates are allowed to be set by the marketplace for the first time in nearly four years? Imagine if the Fed reverses their so called quantitative easing program? Or even hints that they might stop it? Oh, yes, my price can be quite the uncertainty. Don’t be so sure you know what I am worth.

“And then you, my respected nemesis, Inflation. You had your go at me 30-40 years ago and we had quite the duel. Double-digits both of us while the world held its breath. But this time, you have no chance. This Fed has decided that more of me means more of you, they have determined that without me, you disappear and your rival deflation comes to the fore and we are Japan and the world passes us by. You think you’re so special because my investors are stuck with a negative real return. They are not “stuck” with it; they crave it. They seek what they think is my safety. They will suffer volatility and liquidity squeezes, they will accept price manipulation and inflationary losses. All because they think I am safe.

“And isn’t that the Greatest Risk of all? When the world thinks that one asset and one asset alone is the epitome of safety? When they ignore fundamentals, turn a blind eye to basic math, and weave a tapestry of assumptions meant to alleviate their fear rather than confront their reality?”

The crowd is silent, perched on the edges of their seats. The Treasury Bond gazes confidently across the huddled masses.

“You see, dear citizens, there will always be volatility and illiquidity, pricing irregularities and inflation. But only I can promise you that today’s investors in me are certain to lose the purchasing power of their monies over the next decade. That the only way to sustain the current policy of borrowed and printed stimulus is to keep borrowing and printing stimulus. Yes, interest rates could spike and my investors would suffer. And yes, interest rates might not rise for a very long time and my investors would suffer. Win-win for me; lose-lose for them. I do believe that I have stated my case, ladies and gentlemen, and I do believe that I am now the Greatest Risk Factor.”

Illiquidity, Pricing, and Inflation sat dejected, knowing that they could not compete with this new colossus. Volatility rose and passed its crown to the US Treasury. The bond smiled, winked, and thanked the gathered crowd for their confidence. “You will be seeing me soon,” he said, “lots of me.”